The returns in the networking equipment manufacturing industry have been poor over the last few years. Some of the participants have had a tough time, and companies like Alcatel-Lucent (ALU) have suffered heavily. However, during the same time period, Cisco Systems (NASDAQ:CSCO) has been able to grow its revenue. Nonetheless, the performance of the stock has been moderately impressive, in my opinion. Cisco's stock has gained around 25% during the last three years - at a time when the S&P 500 has returned more than 41%. ALU has also underperformed the index (loss of about 27% for the last three years), despite having gains of about 176% during the last year. The situation in the networking industry has not changed dramatically - however, the focus on the software-driven solutions and streamlining of the products line is playing a part in the revival of the industry.
Slow Change in the Products Mix at Cisco
The contribution from the products segment is slowly decreasing for Cisco Systems - the company reported about 80% revenue from the products segment at the end of fiscal year 2011, which has now come down to about 78% - the shift in the revenue mix is slow and it is weighing on the profitability of the company, in my opinion. At the moment, the products segment is facing intense competition, and the margins are low for the segment. The gross margin in the products segment has declined over the last three years, showing the impact of the increased competition. Cisco had a gross margin of 60.5% at the end of 2011 for its products segment, which has come down to about 59% by the end of the last year. At the same time, the gross margin for the services segment has gone up from 65.1% to 65.7% - although the increase is marginal; it is clear that the services segment has more potential. The services segment was already giving a higher gross margin to the company, and the increase in the gross margin has further cemented the belief that the services segment should be the major contributor in the future.
Interests in Australia
Cisco has announced its plans to cater to the potential growth of Australian market. The company has plans to inject $100 million through its innovation fund to help the growth in networking. The fund intends to help in starting up of projects related to big data, mobility and machine-to-machine communication. The company expects machine-to-machine communications, which it has referred to as the "Internet of Everything", to have growth potential of up to $19 trillion over the next 10 years. Since the market is just starting up, the competition will not be as fierce as in the other segments of the industry. There will be new entrants coming to have their piece of the market, but Cisco Systems has the opportunity to capitalize on the first-mover advantage.
Cisco Systems is not in trouble - it is hard to say a company is in trouble when it has more than $50 billion in cash and cash equivalents, and is generating over $12 billion in operating cash flows. In fact, the trend in cash flows has been encouraging for the company. Cisco has added about $2.8 billion to its annual cash flows from operations over the last three years - the company reported about $10 billion in operating cash flows, which has now gone up to $12.8 billion. However, it is clear from the movement in the stock price that the company has been underperforming over the last few years.
The price-to-earnings ratio of the company is 14.3, compared to the industry average of 44.2 - the price-to-earnings ratio can be misleading sometimes - a lower price-to-earnings ratio does not always indicate that the stock is undervalued. However, in Cisco's case, I believe the stock is undervalued - at the same time, I do not agree with the magnitude of the difference between the company's P/E ratio and the industry average. The market is certainly attaching some discount to the stock price due to the concerns about the slow growth in the sector, and the stock price has underperformed the broader index. However, I do not believe the difference is as big as suggested by the price-to-earnings ratio. I believe Cisco will again record a good gain during the current year, but the market will continue to attach the discount until the company is able to show some serious growth.
Cisco Systems will be a moderate growth stock in the short-medium term, along with a healthy income component. The company pays an annual dividend of $0.76 per share, yielding over 3.5%. The capital gains component will remain moderate for the shareholders in the short-medium term, in my opinion - the stock is down 3.5% year-to-date. Cisco Systems' shareholders will continue to enjoy the dividends and the growth in payouts, as the company has massive cash flows and the growth in cash flows is impressive.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. IAEResearch is not a registered investment advisor or broker/dealer. This article was written by an analyst at IAEResearch and represents his/her personal opinion about the companies mentioned in the article. The article is for informational purposes only and it should not be taken as an investment advice. Investors are encouraged to conduct their own due diligence before making an investment decision. I am not receiving any compensation (other than from Seeking Alpha) for this article, and have no relationship with the companies mentioned in the article.