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Cisco in the crosshairs

5 April 2011 By Rob Cox

Cisco Systems makes a juicy target for an activist assault and Chief Executive John Chambers seems to know it. True, as a company with a market value of nearly $100 billion, most uppity investors don t have the means to build a significant stake in the technology giant. But Cisco s poor performance, valuable assets, cash pile and years of capital misallocation provide the kindling to spark long-suffering shareholders into an uprising.

Indeed, Chambers, who has been CEO for 16 years, seems to be bracing for just such a possibility. In an extraordinary 1,500-word email sent to staff on Monday and obtained by Breakingviews, he defended his strategy while acknowledging flaws of operation execution that have led to a loss of accountability. The memo pleads for employees to prepare for a number of targeted moves in coming weeks, but offers no concrete solutions to Cisco s problems.

And these are myriad. The former high-flier s shares have chalked up a negative return of around 55 percent since the start of 2001. By comparison, the Nasdaq Composite gained 13 percent; IBM nearly doubled. Even fellow misfit HP is in the black. And that s before accounting for dividends, which Cisco is just beginning to pay.

This has come despite Cisco shoveling money into share buybacks. In the past decade, the firm used $70 billion to repurchase some 3.2 billion shares. It paid an average price of more than $20 apiece, Barclays Capital estimates, above the stock s recent price of $17.

Since 2000, the company has also plowed $34 billion into acquisitions, according to Thomson Reuters data. Not only have many of these deals failed to deliver adequate returns, they created mission creep away from Cisco s core business serving the technological needs of big companies. The firm bought set-top box maker Scientific-Atlanta, home networking group Linksys and the makers of the Flip camera.

Those bets haven t worked out. Sales in Cisco s consumer division tumbled 15 percent in the most recent quarter. Worse, there are signs that price declines may be starting to outrun volume increases in core businesses like switches, where sales fell 8 percent. As a result, Cisco disappointed investors with a tepid sales forecast in November, and again in February, when it said gross margins shrank.

Cisco can improve its fortunes. It controls about two-thirds of the market for switches and routers. Cisco doesn t break out the figures, but its operating margin last year was 23 percent, or about twice as high as at HP s servers and storage unit and four times as high as those of many consumer electronics companies.

It should stop funneling those dollars into highly competitive and lower margin businesses. Selling or spinning off the consumer division, which represents less than 5 percent of sales, should be considered, too. Likewise, Cisco may want to shut down new operations, such as servers. The overall goal should be to refocus management on its hugely profitable markets in switches and routers.

There s also Cisco s $44 billion cash pile. Much of this is offshore and subject to taxation upon repatriation. But even that might be preferable to frittering it away on deals.

The upside could be considerable. Cisco shares now trade at 10 times estimated earnings for the next fiscal year. That s almost a 20 percent discount to IBM s. Adjust for the cash on Cisco s books, and the gap is twice as big. If Cisco can fix its problems, this discount should disappear and the stock could be worth at least $25.

Of course, all these moves would require Chambers to repudiate much of the strategy of the past decade. That would also implicate his board of directors, which is populated by Silicon Valley heavyweights, including the CEO and founder of Yahoo and the former chiefs of Vodafone, Compaq and Wells Fargo.

Given this, Cisco shareholders, not to mention its employees, who are highly incentivized with the shares, would probably only rally around an outsider with a track record for getting on the board of companies and inspiring them to do better.

Luckily for would-be cage-rattlers, Cisco has no single giant shareholder. That s an impediment to urging, say, Microsoft whose shares have underperformed Cisco s into action. Even after 16 years at the helm and some hefty options grants, Chambers has less than half of 1 percent of the company. The good news for shareholders is that he seems to be getting the message but it may be too late to avoid a fight.


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