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Looking for Virgil

20 Oct 2011 By Robert Cyran

After years of chasing growth – and seeing its stock crumble – Cisco is sensibly focusing on the bottom line. This should buy longstanding Chief Executive John Chambers enough time from investors to retire gracefully in three years. But it probably won’t result in big gains for investors, if rival tech valuations are any guide.

For more than a decade, Cisco plowed burgeoning profits from its networking equipment business into lower margin, if faster growing, areas like set-top boxes and consumer electronics. Meanwhile, Cisco’s core markets, such as switches, were under assault.

Shareholders failed to see the merits of this tradeoff and became increasingly worried about the durability of Cisco’s profits. That resulted in what Wall Streeters call “multiple compression.” In other words, while this fiscal year’s earnings per share should be about 90 percent higher than they were in 2006, the stock has lost about 30 percent of its value. Cisco now trades at a pedestrian 13 times estimated GAAP earnings. While other big tech firms also saw their multiples fall, Cisco suffered disproportionately.

Chambers has now aligned Cisco’s future to meet the expectations of investors. He’s forswearing big acquisitions and focusing on smaller bites like the $99 million purchase of BNI Video announced Thursday, paying dividends and investing more in key businesses. All of this is healthy. But increasing the amount investors are willing to pay for Cisco’s profits, which would put a rocket under the stock, is a tall order.

At around $17, Cisco shares trade at a slight premium to IBM’s and a 17 percent discount to Oracle’s, based on estimated earnings. That’s probably about right, because Cisco is more exposed to rampant hardware deflation. A big decline in prices could have a big impact on Cisco’s profit margins. So the company needs to show investors it can grow faster if it wants a better multiple.

Unfortunately, as part of its new bout of realistic thinking, Cisco estimates revenue will increase by 5 to 7 percent over the next three years. That’s the same as analysts predict for IBM and Oracle. Of course, the networking market overall is growing at about 8 percent, meaning Cisco may be setting a bar it can easily vault. Or it may have a dour view of the market. The company doesn’t think it will lose market share, but rivals like Juniper Networks and Riverbed Technology, not to mention emergent Chinese powerhouse Huawei, are gunning for Cisco.

Cisco’s new, down-to-earth approach to its future is a welcome change. But while it may halt the decade-long descent of its share price, a period in purgatory may still await investors.


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