Is Cisco Abandoning Growth, No Longer A Tech Company?

Mar.23.14 | About: Cisco Systems, (CSCO)

Summary

Cisco sacrificing near-term margin for long-term growth was a good strategy.

Cisco has made no investments in hardware while Juniper has produced refreshed product line. But there's no future in hardware.

Patient investors can expect Cisco to trade north of $30 per share on the basis of long-term free-cash-flow growth and margin expansion.

Cisco (NASDAQ:CSCO) continues to have its share of critics. Analysts remain unimpressed by what the company has been able to do of late - a feat that includes ten consecutive earnings beats. As the stock currently sits right at $21 per share, $5 below its 52-week high, analysts are wondering if there's any value left. This, of course, goes against our prediction that the stock will soon trade at $30. From our vantage point, there is (at least) $10 worth of premium to be had. But the challenge for Cisco is convincing the market that it can get there.

Where's the growth?

Wall Street has an insatiable appetite for growth - this much is known. Companies such as Cisco, which is trying to get back to its once dominant level, absorbs more scrutiny that it deserves. Plus analysts seem too impatient. Barclays (NYSE:BCS) downgraded shares of Cisco Tuesday to "equal weight," while setting a price $23 target on the stock. They no longer believed that Cisco deserved its previous "overweight" rating and $25 target.

Investors were smart, however. Unfazed by the bearishness, the stock inched up more than half of a percent. Investors understand that Barclays' rating still represented more than 6% upside to Cisco's current value. But even more important is for investors - and Barclays - to understand what Cisco is and where the company is heading. To its credit, the company continues to worry about only what it can control, as evident by its recent performance.

In its latest quarter, Cisco reported second-quarter earnings per share of 47 cents, excluding items, on revenue of $11.16 billion. The company beat consensus earnings estimates of EPS of 46 cents on $11.03 billion in revenue. Management also raised the company's quarterly dividend to 19 cents from 17 cents a share.

But, according to some, this performance wasn't enough. In the Street's quarter-to-quarter obsession with growth, those who have been waiting anxiously to revive the debate as to whether Juniper (NYSE:JNPR) is better than Cisco have finally gotten their chance. With shares of Juniper spiking up close to 10% recently on better-than-expected fourth-quarter results, Cisco once again is relegated to a punching bag.

What is management trying to do?

It doesn't seem as if Barclays clearly understands of what Cisco is and where the company is trying to go. And the rush to panic over one quarter seems overdone. Not just for Barclays, but for any investor that believes Cisco deserves to lose its status as a technology company. While Cisco is far from the heights it achieved in the dotcom era, this is still a high-quality company trying to navigate a soft corporate IT spending environment.

The fear these days is that Cisco is losing market share to Juniper and F5 Networks (NASDAQ:FFIV) when in actuality, the entire sector has underperformed due to shrinking enterprise budgets. Cisco has countered this weakness by resorting to "aggressive discounting" of some of its gear, which has made sense - even at the risk to near-term margins.

The strategy, although highly criticized, helped Cisco reduce its inventory level, while at the same time, squeeze out smaller rivals like Aruba Networks (NASDAQ:ARUN) and Palo Alto Networks (NYSE:PANW). Cisco has been very clear about its intentions, both in the near term and long term. Management hasn't tried to conceal the impact to margins.

To offset margin pressures, management has instead made significant investments into higher growth and higher margin businesses like Meraki, Cariden and Broadhop. Not to mention, the company's recent $2.7 billion acquisition of anti-hacking giant Sourcefire (NASDAQ:FIRE). These moves were strategically executed to offset the slow-growing hardware business.

Yet, all we've heard recently is how Cisco is losing market share to Juniper. When in actuality, what hardware share gain Juniper has been able to achieve from Cisco are the ones Cisco was no longer interested in preserving. Cisco has made no investments in hardware while Juniper has produced refreshed product line, especially in the key edge router market.

But Cisco's management doesn't believe that business has a future. And it's only a matter of time before Juniper realizes this. As a mature dividend payer, management's real challenge at this point is obvious; Cisco needs to demonstrate that it can establish strong competitive leverage by posting better margins.

Summary

To that end, management has outlined several strategies to boost long-term profits. Analysts have not paid enough attention. Cisco is not abandoning growth. For now, investors will continue to take a "wait-and-see" approach. We don't have a problem with that. But with shares trading at around $21 per share, the stock remains cheap.

In the next 18 months, patient investors can expect Cisco to trade north of $30 per share based on cash flow projections and sales trends, which includes 22% aggregate growth in services (advancing 130 basis points YOY). Also, with a strong balance sheet, respectable yield and very limited downside risk, Cisco will prove to be one of 2014's top stories.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Wall Street Playbook's tech sector analyst. Wall Street Playbook is not receiving compensation for it (other than from Seeking Alpha). Wall Street Playbook has no business relationship with any company whose stock is mentioned in this article.