Cisco Systems - Citigroup Throws Salt In Cisco's Shareholders' Wounds

Dec.12.13 | About: Cisco Systems, (CSCO)

Investors in Cisco Systems (NASDAQ:CSCO) are having another difficult day following some bearish research comments issued by analysts at Citigroup. While I feel that Citigroup's sell recommendation is a bit too aggressive, it is still too early to catch the falling knife, with second quarter revenues falling off a cliff.

I remain on the sidelines awaiting signs of a stabilization of the business before initiating a position.

Citigroup Is Bearish

Analysts at Citigroup (NYSE:C) initiated their rating on Cisco with a "Sell" rating, accompanied by an $18 price target. The price target implies some 15% downside potential from Monday's closing levels.

Analyst Ehud Gelblum believes that Cisco's market share in the core routing business is at risk due to competition from Alcatel's new line up and "confusion" of new products being introduced by the company itself.

On top of that, Gelblum sees Cisco losing share in data center switching on the back of proprietary solutions from Insieme as the market is moving towards open systems. Combined, Cisco is expected to miss the 5-7% long-term growth trajectory.

Valuation

Halfway through November, Cisco released its first quarter earnings report. The company ended the quarter with $48.2 billion in cash, equivalents and short-term investments. Total debt stands at $16.3 billion, for a net cash position of nearly $32 billion.

Full year revenues for the fiscal year of 2013 came in at $48.6 billion, up 5.5% on the year before. Earnings rose by 24.1% to just below the $10 billion mark.

Trading around $21 per share, the market values Cisco at $112 billion, or its operating assets at $80 billion. This values operating assets of the firm at 1.6 times annual revenues and merely 8 times earnings on an operating basis.

Cisco currently pays a quarterly dividend of $0.17 per share, for an annual dividend yield of 3.3%.

Some Historical Perspective

Long-term investors in Cisco have seen a lack of returns with shares trading in a $15-$35 trading range over the past decade. Shares are currently trading at $20 per share, trading well off their highs of $26 reached in the summer of this year.

Between the fiscal year of 2010 and 2013, Cisco has increased its annual revenues by a cumulative 21% to $48.6 billion. Earnings rose by 29% to just below $10 billion. The company retired roughly 7% of its shares in the meantime.

Yet the first quarter reveals that revenues are almost stagnating, while earnings already fell compared to a year ago. The outlook for the second quarter was outright disastrous.

Investment Thesis

Cisco has been dead money ever since the company released its disappointing results halfway November, which were accompanied by a very soft outlook. Citi's warnings is adding pressure to shares which despite a 20% sell-off from the highs of the summer are still trading up a buck from levels at the start of the year.

The difficult operating environment with spending under pressure and the political controversy following the US spying scandals is putting pressure on the business. Yet it is clear that Cisco is partially to blame as well. The core hardware networking business is under threat, and part of this could be sustainable with more competition emerging from Western companies, as well as increased price competition from China.

The company is focusing on cloud-based solutions as well, which will show growth and will be profitable, yet these efforts will not be enough in the short term to offset the pressure on the core business. The good thing is the very solid nearly $50 billion cash position, which can be used to fence of competition, as Cisco can nearly buy every competitor with its huge cash balances. Key competitors of the business include Huawei, Juniper Networks (NYSE:JNPR) and Alcatel-Lucent (ALU) among others.

Halfway through November, when Cisco released its second quarter results, which triggered a massive correction, I last took a look at Cisco's prospects. Disappointment among investors was well deserved as the turnaround plan under long time standing CEO Chambers is not working as planned. Despite cutting 12,000 jobs and buying 60 companies in recent years, innovation and revenue growth has not materialized in a sizable way.

For now, Cisco is actually moving into a decline mode as investors have grown skeptic about the credibility of the long-term 5-7% revenue growth target. Cisco admits, that revenue growth on an annual basis is not likely until at least August of 2014. Even the announcement to repurchase $15 billion of its shares, or 13-14% of the current share base outstanding, could not save the day.

As should be clear by now, the core business of Cisco are in some degree of turmoil. Luckily, Cisco operates with a very strong balance sheet and the operations are still hugely profitable.

Despite these comforting circumstances, the dramatic shortfall in the second quarter outlook is a big worry. Cisco guided for an 8 to 10% drop in revenues, which will take a toll on earnings as well. As such it will be inevitable that full year revenues and earnings into 2014 will decline.

I feel that it might be a bit too aggressive to join Citigroup's sell rating in search for modest potential, while paying high dividends in the meantime shorting the shares. Yet short-to-medium term appeal is arguably limited, as things are getting worse before they improve. Luckily the valuation already reflects this amidst a very solid financial position, making Cisco still appealing in the long term when Chambers manages to stabilize the ship.

As such I remain on the sidelines. I will not chase shares down, as suggested by Citigroup, yet I will not make a bullish investment yet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.