Cisco Systems (CSCO): Watch, Wonder, Wait
Cisco Systems (CSCO) appeared in this week’s update under the flag of “Materially Stronger” and at the same time was mentioned in a series of articles that called into question the long-term viability or sustainability of some of their product lines (hardware). We talk about threats and opportunity analysis a fair amount here, so it seems like a good time for a deeper dive and closer look at Cisco Systems.
The company is #11 in the MANIFEST 40 so it’s no stranger around here.
CSCO also serves as something bigger than a poster child for rhino confusion. Why? Because when the stock price reached $80-90 back at the advent of Y2K, the company was the most STRONGLY RECOMMENDED stock on Wall Street at a time when our return forecasts were screaming SELL based on a DOUBLE-DIGIT NEGATIVE PAR! The CSCO situation (and madness) was the centerpiece of an article I wrote for Better Investing at the time.
Let’s break it down. First, “Materially Stronger” in our weekly updates simply means that the Value Line analysts have given the long-term low price forecast a significant boost. What is significant? We’re watchful for 20-25% step changes (up or down) and we share these as “flags” with our community.
The long-term low price forecast for CSCO of $30, translates to a long-term low total return forecast of 11.7%.
Business Model Analysis
Under assumptions of a 6% sales growth forecast, a projected net margin of approximately 20% and an average P/E expectation of 13x, a case can be made for a projected annual return of 11.7%.
From the Business Environment to Skeptical Rhinos
FBR Capital downgraded Cisco (NASDAQ: CSCO) from Market Perform to Underperform with a price target of $17.00 (from $22.00) saying routers and switches hit a dead end.
“We believe Cisco will become increasingly more challenged to offset weaker-than-expected routing and switching demand as it works to transition to a more software- and service-centric business model,” the analyst said in its downgrade report. “Looking ahead, we see the potential for additional negative technological trends that could significantly blur the lines between routers, switches AND servers.”
Now I don’t know anything about the track record of FBR Capital. It’d be bolstering if we had any idea how their opinions translate into long-term results, but we don’t have that.
What we have is a threat to profitability at CSCO. We could nutshell and capture this question with a potentially-similar situation from a few years ago. A number of community members at the time cautioned us to avoid the rosy consensus at one of our favorite companies. They urged us to consider reality. We ignored them (a little) at our own peril.
The company was Garmin (GRMN). The warnings had to do with a ubiquitous threat to their business model at the time. It was, in perfect hindsight — a clear and present danger. [Ed. Note: GRMN has navigated (pun intended) the choppy waters of these challenges pretty well, but it was a speed bump of considerable impact.]
So the question is: Is Cisco Systems exposed to the same type of threat to product, inventories, profitability AND STOCK PRICE as we saw with Garmin?
I don’t know.
So I turned to a very reliable research partner, our own Technology Manager, Kurt Kowitz. Kurt has a powerful skill of boiling this type of thing down into something concrete and credible. (By the way, Kurt and Hugh McManus were among the throng issuing the warning about the challenges faced at Garmin back in 2007-2008.)
As he always does, he responded with: It really boils down to one phrase/theme, Software-Defined Networking. “Companies Google and Facebook have adopted the Openflow protocol within their data center operations.” Ouch. “Yeah, sounds like a shift that might seriously undercut a traditional market.”
So it’s back to Cisco Systems. And now we’re gleaning through the most recent quarterly conference call transcript looking for signs of things related to (1) threats to forward profitability and/or (2) anything specific about this software-defined networking.
And we find a brief discussion relevant to the subject in the form of a “disciplinary lecture” given by the horse’s mouth itself, John Chambers:
“If you watch, we’re seeing a common theme, I think many of you [rhinos] were concerned in fair question two years ago about should we maintain our gross margins with the vast majority of the markets not a player, and you’re going to see rapid deterioration, it was the number one pressure on our stock margins. And if you watch what we have done is the reverse.’
Our emphasis added: We’ve prevailed, actually increased margins despite what you believed would probably happen. (Go back and review the accompanying profitability analysis graphic.)
“We have gotten very good stability across the gross margin base, you are seeing this in that 61% to 62% guidance, it will go up and down by quarter based on the mix, but you are right we are clearly modeling in continuing good growth dramatically faster in our data center business, and remember UCS is also combined with Nexus. And it is a process I want to be careful but you see it is a little bit lower half of the business Nexus, is a little bit over a third, and when you model those two together you begin to get good gross margins and that’s different than our peers.”
(He often jabs and picks on peers, nothing new to see here, people.)
“Secondly, and most of our peers when they install servers, they are selling commodity products. Have we re not selling commodity products. We get premiums, we get architectures, we get standardized on, we showed stronger margins there and yes your overall assumption is right, we are moving rapidly to software … which gets you better margins, 13 of the 14 acquisitions were software, cloud, recurring revenue streams and recurring revenue as one of your colleague said earlier, the good news about it is very predictable. The bad news is when you start from a low base, it takes you a while to get to size where it really becomes material for you, but it’s a nice way of saying I couldn’t be more pleased with the margin stability and well, it’s hard to look out very far in this industry, I like the stability we are seeing in and I see nothing that at the present time is making nervous on that …”
How much cash do they have (for further acquisitions and development?) Answer: $46.4 billion (1/26/2013) [Source: Value Line]
The Bigger Picture
CSCO has the cash and the track record. They’re actively responding to the challenge.
If you hold CSCO, be vigilant for slippage in profitability. Be aware that the global recession will certainly lead to some weakness as the worldwide economy cycles.
Here’s a slightly elongated look at one of our newly favored 10-year charts, displaying the 1990s. If you were there, you remember the 1990s. This again shows how resilient an excellent company can be in the aftermath of a corrective disruption. By the way, that 1998 contagion thing was more massive than very many of us remember. Most of us were too busy being rationally exuberant at the time.
And we close with a current chronicle going back a few years for Cisco Systems (CSCO).
The quality ranking is virtually top shelf with no signs of weakness. If profitability slips (vs. peers/competitors) the deterioration will show up in the quality ranking.
The return forecast is not exciting — equivalent to a fairly solid “HOLD” for most portfolios at approximately 11-12%. And we also see that patience can be rewarded with a return forecast closer to 20% from time-to-time. The time to accumulate would be then.
For Cisco Systems (CSCO): Watch carefully. Wonder. Wait.