Few fields move as rapidly as technology. Businesses creating outsized profits and returns for shareholders quickly get a bull's-eye painted on their back as they become targets of other companies looking to disrupt their products by selling cheaper alternatives that still prove "good enough." Not only that, but even if a company continues to dominate its particular field, other changes in technology can shift spending away from their products. Think about how Microsoft still dominates PCs but feels pressure from the sales shift toward mobile devices such as smartphones and tablets.

With that in mind, today we're looking at how Cisco (Nasdaq: CSCO) innovates. Technology companies can innovate either through acquisitions or by spending more money on research and development. We'll compare Cisco's spending in these areas with that of its closest peers and assess whether the company is investing enough in its future.

Research and development
Over the past five years, Cisco has spent an average of 14% of revenues on R&D. The following table summarizes how Cisco's R&D expenditure relative to revenues compares with some of the company's closest peers.

Company

2006

2007

2008

2009

2010

LTM

Cisco

14%

13%

13%

14%

13%

13%

Juniper

21%

22%

20%

22%

22%

23%

F5 Networks

12%

13%

16%

16%

13%

13%

Source: Capital IQ, a division of Standard & Poor's. LTM = last 12 months. Dates above are calendar years; yearly total is for company fiscal years closing in that period.

The advanced technology necessary to compete in networking is evident from the table. Companies have to invest in R&D at extremely high rates to stay competitive. As you can see, while Cisco vastly outspends smaller rival Juniper in absolute terms, Juniper spends significantly more on a percentage basis. With Cisco looking to trim some fat in the wake of several disappointing quarters, its R&D expense could come under further pressure.

In the past, Cisco has been able to rely on its brand and unique advantages, such as its operating system, to make switching out to other vendors more difficult. However, competitors have been making recent inroads. A troubling statistic from the table is that even with similar R&D expenditures, upstart F5 Networks has been able to trounce Cisco in the rapidly growing "load balancing" market. Years ago, it was assumed that given enough time, Cisco would come to dominate emerging areas of networking. Today, a wide group of upstarts is capturing key opportunities such as load balancing, WAN optimization, and specialized networking security.

Acquisitions
In technology, some of the best companies have turned growth through acquisitions into an art. IBM has adeptly spun off capital-heavy businesses such as the hard-drive and PC segments, while it focused on acquiring additional services and software expertise that have transformed its business model.

On the opposite end of the spectrum, Hewlett-Packard is often criticized for underinvesting in R&D, to the point that it has to overpay on acquisitions to catch up with its competitors.

Investors should remember, most of all, that companies are valued by the cash flow they can bring in for their shareholders over time. If companies need to continue making purchases in perpetuity to keep growing, that amounts to a reduction in cash flows, and investors should treat acquisition spending as a continuing outflow against cash flow.

Let's look at Cisco's free cash flow over the past five years against cash spent on acquisitions.

Source: Capital IQ, a division of Standard & Poor's. Dates above are calendar years; yearly total is for company fiscal years closing in that period.

Cisco has a lumpy amount of acquisitions, but barring a slowdown during the recession, it's been highly acquisitive in recent years. The company has a history of targeting long-term growth of 12%-17% per year, a figure based on having acquisitions play a part in fueling growth. That ambitious target has fallen by the wayside recently as struggles mounted. If you're investing in Cisco, keep in mind that consistent acquisitions could that mean free cash flow to investors might not be as robust as it looks upon first glance. 

Final thoughts
For investors who have long seen Cisco as an innovative force in IT, its current slump is a shocking change of pace. One of Cisco's main problems has been focusing too much on consumer markets -- highlighted by its failed Flip acquisition -- and not enough on networking technologies. Although the most obvious manifestation of Cisco's neglect of its core business is slumping sales in switches and routers, the company has also failed to capture new growth markets.

While focusing on areas such as consumer routers and video communication, Cisco let upstarts such as F5, Riverbed, Acme Packet, and Aruba Networks establish leadership in emerging areas of networking, and they're beginning to capture the most sales growth in the industry. If Cisco wants to remain the technology leader in networking, time is running out for it to become relevant in these growth markets that increasingly suck up IT budgets.

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Eric Bleeker owns shares of Cisco. The Motley Fool owns shares of IBM and Microsoft and has created a bull call spread position on Cisco. Motley Fool newsletter services have recommended buying shares of Cisco, Riverbed Technology, Acme Packet, and Microsoft and have also recommended creating a diagonal call position in Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.