For investors looking for a blue chip name to profit from global growth of information technology, it’s hard not to look at Cisco (CSCO).
The San Jose company provides the “guts” of information technology infrastructure – enterprise networks, network routers and switches, and other IT products and services. Cisco’s closest competitor for its core data networking business, Juniper Networks (JNPR), is comparatively tiny, with Cisco’s market capitalization five times that of Juniper’s ($83.2 billion to $16.4 billion) even at Cisco’s depressed share price of $15.12. Cisco earns almost 10 times more revenue than Juniper ($40.04 billion to $4.093 billion for the 2010 fiscal years of each company (i)).
There is no shortage of opinion that Cisco is undervalued (ii) - and I argued last August that the stock had good long-term potential at $22.05 (iii). But the shares have had a miserable year, falling 34% from the close a year ago (June 11, 2010 at $22.91) even though the company began paying dividends. By comparison, the Dow average rose 17% over the same period.
For those who believe Cisco is a bargain, this pervasive downtrend raises the question of when and what will boost the shares. I believe that the stock remains undervalued, and that three major long-term milestones can unlock its full potential:
1. Interest rates are rising. Cisco has hordes of liquidity, with $43.367 billion in cash and short-term investments on its balance sheet at the end of the company’s third quarter on April 30, or $7.88 a share. Cisco also had $38.187 in total liabilities, $5.18 billion less than its liquid assets. Juniper, reporting on March 31, had $2.994 billion in cash and short-term assets, but liabilities of $2.797 billion, a much thinner $197 million margin. Hewlett-Packard (HPQ), which has been pressuring Cisco in the switching market, draws an even further contrast, with $12.738 billion in cash and short-term investments but $83.704 billion in total liabilities, a $70.97 billion deficit from liquid assets.
The problem for Cisco is that with interest rates at historic lows, the better bond ratings its balance sheet commands vs. these key competitors (A1/A+ for Moody’s & Standard & Poor’s, respectively, versus A2/A for H-P and Baa2/BBB for Juniper) don’t matter much. But when rates finally rise, the spread between Cisco’s borrowing rates and others on the playing field can be expected to increase, so Cisco will reclaim the full competitive advantage of a stronger balance sheet.
2. Weak public sector business turning around or other markets expanding. The public sector accounts for about 20% of Cisco’s business, and it’s no secret that government budgets are becoming sparse. While there are some signs that revenue for U.S. state governments is improving, the states are still struggling with the decline in federal aid to balance their budgets (iv). And while some may argue that the need to do more with less may help the IT business through efforts to increase automation (i.e. replace people with computers), the need to cut the huge Federal deficit is likely to crimp most U.S. public sector spending for the foreseeable future.
Cisco’s CEO John Chambers has recognized the deterioration in public sector growth and the need to adjust(v). It’s logical to assume that new opportunities for Cisco will eventually develop through increased public and private sector opportunities in emerging economies, and that the pendulum may ultimately swing back for the U.S. public sector, aided by pent up demand. So unless the global economic outlook is so dismal that Cisco won’t have sufficient growth opportunities to pick up the slack in the U.S. or abroad indefinitely, the company should eventually be able to find the way, though that path isn’t clear yet.
3. Alleviate succession issues. John Chambers transformed Cisco into one of the world’s most successful companies after becoming CEO in 1995(vi), but Cisco has a succession problem. This can be understood in comparison to Apple’s (AAPL) challenge of eventually replacing founding CEO Steve Jobs. It’s well known that Apple deteriorated when Jobs was forced out in 1985, and recovered after Jobs returned in 1996. It may have seemed that Apple was doing little for a while to address the prospect of losing Jobs again when his health concerns developed. That risk has now at least been responsibly addressed (understanding that it’s not reasonable to expect that a leader of Jobs’ stature can be fully replaced), with day-to-day operations now being handled by Tim Cook, so that Cook’s leadership will be firmly established if Jobs leaves.
In contrast to perceptions that Apple had not done enough to prepare for succession, Cisco has arguably over-engineered its CEO succession planning. Cisco has a highly sophisticated executive development program (vii) and claims a reserve of 6-8 people with CEO-caliber talent who can step in (viii). But how many years will the most capable people on this bench wait? In 2007, Charles Giancarlo – regarded as a likely successor to Chambers – left soon after the departure of another top executive. This occurred shortly after Chambers declared his intentions to stay another three to five years, with observers also saying Giancarlo’s style didn’t fit the more collaborative approach Chambers then set for the company (ix), which he recently reversed (x). In June 2010, Chambers announced that he plans to stay at the helm for at least another three to five years(xi), apparently delaying the aspirations of the next cycle of potential successors.
The problem of retaining individuals talented enough to succeed a CEO is likely to be present in any hierarchical organization where a leader, no matter how capable, stays at the top for a long time. One way of addressing the challenge, especially to promote internal promotion, is to name a number 2. Recently Chambers named a chief operating officer, Gary Moore (xii), though oddly the buzz surrounding the choice points away from Moore being Chambers' successor (xiii).
The good news is that this confluence of macroeconomic, market and internal management factors makes Cisco a classic value opportunity, but it could take a while for these milestones to unfold. Interest rates may rise sometime in 2012 after the Federal Reserve completes quantitative easing and eventually retreats from keeping short-term interest rates at historic lows. But capitalizing on newer markets to the degree they make up for lost business and alleviating succession concerns – which might not happen until after Chambers departs and his successor establishes confidence – will likely take years.
Cisco’s place as an undervalued provider of critical infrastructure can be compared to where CSX (CSX), a railroad with 19th century roots, stood 10 years ago, before the value of its shares quadrupled. The factors I’ve identified reduce the prospect that favorable short-term results will unlock the full value of Cisco’s shares anytime soon. But for those willing to wait, Cisco may be a significant profit opportunity.
(i) Cisco’s fiscal year ends on July 31, while Juniper’s ends on Dec. 31.
(ii) Cnbc.com’s report of First Call consensus, with at time of this writing 19 of 46 analysts rating Cisco as a buy or strong buy, and 24 as a hold, read here.
(iii) See “The Case for Cisco Stock and Believing John Chambers,” Thoughtsworththinking.net, August 18, 2010, read here.
(iv) See Conor Dougherty, “States See Uptick in Revenue, Costs,” Wall Street Journal, June 2, 2011, p. A4.
(v) See Cisco Systems' CEO Discusses Q3 2011 Results - Earnings Call Transcript, May 11, 2011, at Seekingalpha.com, read here.
(vii) See e.g., Cisco Systems, Jennifer Chatman, Charles O’Reilly, Victoria Chang, “Developing a Human Capital Strategy,” 47 California Management Review (Winter 2005) at 159-62. Read here.
(viii) See Brandon Bailey, “Valley companies differ in CEO succession planning,” mercurynews.com, March 20, 2011, read here.
(x) See “Complete text of John Chambers' Cisco memo,” San Jose Business Journal, April 5, 2011, read here.
(xi) See Eric Savitz,“Chambers Plans To Stay CEO At Least 3-5 More Years,”Barrons.com, June 4, 2010, read here.
(xii) See Cisco’s announcement of Moore’s appointment, read here.
(xiii) See, e.g, “Cisco names first COO as company reinvents itself,” networkworld.com, February 22, 2011, read here; “Cisco: The One Question John Chambers Took Too Long to Answer,” The Var Guy, April 5, 2011, read here.
Disclosure: I am long CSCO, HPQ.
Additional disclosure: This disclosure includes holdings of immediate family members. Disclaimer: The information provided in this post does not constitute professional investment advice, and should only be used in consonance with all available information, including the opinion of a professional adviser, to make an investment decision.