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Cisco (CSCO) is amongst the major players in the technology industry as the company has managed to expand its product portfolio to an exemplary extent. The company's high degree of product diversification has lowered its risk exposure to a certain business segment. The geographical diversification is also at hand as the company operates in a range of geographical segments. Apart from limiting the exposure to specific risks, the across the board diversification strategy has introduced the company to a wide range of competitors in each of its segments. The company has announced its third quarter results for FY12-13, and the company's earnings have beaten analyst estimates. The investors' expectations regarding the company can be estimated from the trend in the company's stock price.


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Source: Bloomberg

The chart above illustrates the stock performance of Cisco (YTD). We see that the price has improved from approximately $20.4 to $21.21. The increase is not very substantial which indicates investors' concerns regarding the performance of the company. These concerns have occurred despite the stable outlook of the industry. Specifically in terms of telecommunications, Deloitte has posted a positive outlook based on technological innovations in the industry.


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Source: Cisco Financial Statements

The above table illustrates a breakdown of the company's revenues into its various business segments for the first three quarter of FY12-13. According to this table, the largest segment of business operations in terms of revenues is switching which accounts for 29.4% of the company's third quarter total revenues. A decline of 3.4% is also witnessed in the revenues of this segment as compared to the previous quarter. The other major segments project a marginal improvement in their revenue generation capabilities.

Growth Concerns

These marginal improvements have not been able to meet investor's expectations. Specifically, growing businesses like data centers have made substantial contributions towards the growth of other companies due to the expansion caused by cloud technology. However, for Cisco, the contribution of data centers has remained limited to less than 5%. Similarly, the overall picture appears to be grim as the primary business operations of the company are not driving growth in full force. On the other hand, the company has stated its intention to pursue strong growth by focusing on acquisitions. Announcements regarding the acquisition of a few companies have been made recently. Cisco has shown intent to acquire Ubiquisys, a U.K.-based privately held company which provides LTE, 3G and Wi-Fi small cells. The company has also acquired SolveDirect to increase its exposure to the new and growing cloud technology.


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Source: Bloomberg

The chart above illustrates the growth trend of Cisco in the past few quarters. The year on year growth appears to be declining form 13% in April last year to 7.1% this quarter. This is a strong indicator of future performance of the company. As the company is operating in high growth businesses, the limitation of the company's overall growth is of huge concern to investors. This is primarily because of the high degree of diversification adapted by the company. Moreover, the high degree of diversification induces expectation about the low risk of the stock; however, Cisco is currently projecting a beta of 1.42 (Data source: Morningstar).

Concerns Regarding Cisco's Earnings

Cisco operates at exceptionally high gross margins. For this quarter, the gross margin was 60%. The slowdown in Europe is also adversely affecting the company as the revenues from EMEA region only account for 26% of the company's total revenues as compared to the 59% contribution of the American regions. At the same time, the gross margin attained in the EMEA region is higher as compared to that of American regions. Furthermore, huge concerns are associated with the sources of Cisco's earnings.


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Source: Bloomberg

The above chart demonstrates the trend in sales and marketing costs as compared to the company's sales in recent quarters. We see that since January last year, the company has managed to reduce its proportion of these costs from 20.8% to 19.4%. This expense cut strategy has contributed towards earnings but the question I intend to raise is that of sustainability. There is a limit to the expense cut strategy and in time, the company will exhaust its expense cuts in which case the performance of the company will start to stagnate.

Conclusion

In conclusion, we see that the growth of the company is unsustainable if the management of the company pursues its current strategies. As the growth in the industry is taking place at a faster rate, I find that Cisco is improving its stock price with weak growth prospects. Furthermore, the increase in trade of the company's $17 put option for October and the upper management's comments about a decrease in the rate of closed deals also support the notion that investors are losing interest in the company and they expect the market to revalue Cisco based on its expected declined growth. Keeping these points in view, a sell recommendation is proposed for as long as the company fails to produce convincing evidence of future growth.

Source: Cisco's Profitability Is Unsustainable With Current Strategy