Time is never kind to tech companies. Even those that manage to stay on the leading edge of technology and evolve with the times have to face that difficult transition from the "valuations don't matter" high-growth phase to the "how will they ever grow again?" lower growth phase. IBM (IBM) is probably the best example of that transition done right (though Oracle (ORCL) seems to be managing it quite well), while Microsoft (MSFT) and Intel (INTC) are still struggling to reorient themselves.
That brings us to Cisco (CSCO). Plenty of companies, ranging from F5 (FFIV) to Palo Alto (PANW) have looked to build their own fortunes by going straight at Cisco in particular markets and/or positioning themselves for evolving markets like software-defined networking (SDN). While Cisco will indeed never grow again like it used to, the Street's addiction to growth seems to be seriously underpricing Cisco's probable cash flow stream.
Fiscal Q2 Earnings Come In Alright In A Sluggish Market
From Hewlett-Packard (HPQ) to Juniper (JNPR) to F5, there was no particular reason to expect a blockbuster quarter, and Cisco didn't deliver one. What the company did produce, though, was a solid result in a challenging enterprise IT and carrier market.
Revenue rose 5% from the year-ago period and 2% from the prior quarter. Cisco's traditional twin pillars, switching and routing, diverged this quarter as switching revenue rose about 3% while routing contracted about 6%. Most of the growth businesses did substantially better, as video and wireless both grew more than 20% and data center revenue grew 65%. Security revenue growth of 1% was pretty feeble, but then we saw a weak result from Check Point (CHKP) as well as these established vendors are struggling relative to newer entrants like Palo Alto.
Cisco's margin performance was mediocre, albeit better than sell-side analysts expected. Gross margin (non-GAAP) fell slightly from last year and the prior quarter, largely on a mix shift that included the weaker routing results. Operating income (again, non-GAAP) grew, but at a slightly slower rate than revenue (up 4%) and the company saw some very modest year-on-year erosion in the operating margin.
Soft Guidance And A Conservative Tone Fit The Sector
Investors have largely gone through this reporting cycle with clenched teeth and white knuckles, as the beat-and-raise reports have been few and far between. To that end, while Cisco's second straight quarter of flat order growth (despite easier comps) and conservative tone weren't great news, they also weren't significant surprises.
It doesn't really seem to matter where investors look; the tech spending environment just isn't looking that strong early in 2013. Networking, storage, security - all of the major categories have slowed, and growth markets like Wi-Fi just aren't big enough yet to make up the difference for companies like Cisco.
Cisco's Transition Should Start Showing Results
Cisco has spent the last year or two undergoing a pretty significant transition and transformation, and I believe this is a significant driver for the next leg of its corporate life. Gone, I think, is the skirt-chasing obsession with growth and the notion that just because they're Cisco they can just put any product they want in the market and it'll sell. Instead, I see a company that is now considerably more serious about costs, more serious about returns on capital, and more serious about making sure that the Cisco name on a box actually means something again.
At the same time, Cisco has accepted that the tech world is changing and that they're too large to ignore the trend toward blended hardware, software, and service. While I don't believe Cisco is specifically looking to become another IBM, I do believe that software and service is going to be a more significant factor in the company's future, and acquisitions like the recent deal for carrier network automation specialist Intucell will be a part of building that future.
Likewise, I think the company is going to make major efforts to establish itself in Wi-Fi, SDN, and other next-gen IT categories. While there's plenty of cash flow to be harvested from routing and switching, Cisco has an opportunity to evolve with the times that more challenged rivals like HP and Juniper don't seem to share. I would expect competition in those businesses to get pretty fierce, but I don't think HP, Dell (DELL), Juniper, and Alcatel (ALU) can really get very far in switching and routing with fierce price-based competition (and I'm not sure they have the resources to compete on next-gen product/technology capabilities).
The Bottom Line
As is usually the case, the Street isn't giving all that much respect to Cisco's modest, but cash-rich, growth prospects. Given time, though, I think investors will reach an IBM-level of calm/appreciation about Cisco's qualities. I'm looking for Cisco to grow its revenue at a rate of about 4% over the long term. At the same time, I'm expecting that the company's transition to new addressed markets and less focus on hardware will lead to some downward pressure on the free cash flow margin, such that I only expect about 2% to 3% free cash flow growth.
Even if Cisco only grows free cash flow at a 2% clip, my model suggests that the stock should trade in the high $20s. Given that I think I'm being conservative on the margins and discount rate (basically giving the company the doubt of any benefit), I see Cisco as an appealing risk-reward proposition at these levels. While the first half of 2013 won't be great for IT spending and may lead to stagnant tech stocks, long-term investors should take a look at this one.