Wednesday, September 26, 2012

Cisco Becomes a Value Stock

Tech investors have learned to brace themselves for Cisco $CSCO results, so it was a pleasant surprise to see such a positive reaction. My take on the results is that they read quite well for the technology market but less positive for Cisco itself. However, in terms of Cisco as an investment I think the outlook just got better. The company is doing the right thing in accepting its slowing growth trajectory and now sees itself firmly as a value proposition. It's usually a good thing when investor and management perceptions are aligned.

In summary, I think there are a lot of key takeaways here for other tech investors.

Enterprise Spending Comes Back but Not in Cisco’s Core Markets

The wider tech market got really spooked at the last set of results when Cisco talked of broad based weakness and reported enterprise sales down 1%. This was supposed to be the area of relative strength in the economy so the market reacted badly. However, enterprise spending saw a 6% rise in this set of results with the weakness in service provider revenues (down 1%) coming as no surprise to telco watchers. I don’t think that enterprise spending was anything as weak as implied by Cisco’s previous results and the evidence is now here to support that view.

There is also evidence to suggest that Cisco’s core markets remain challenged while other parts of its revenues are faring much better. To demonstrate this here is a graph of the latest results by product line. Note I have excluded data center growth for the sake of clarity, even though it is the fastest growing division. Also note that the product divisions are arranged in terms of size from left to right.

Clearly we are seeing slowing growth in the core markets of switches and routers and the next two largest divisions are both in negative territory. We can see the relative importance of these divisions in a breakdown of Q4 revenues.

The top four product lines account for 65.4% of revenues and aggregating them produces a 1.4% decline in revenues.

So what is going on?

Cisco Gives a Mixed Outlook

Essentially I think that telecommunications carriers have slowed spending this year. I’ve discussed this at length in an article linked here. AT & T is expecting spending to rise in the second half but Verizon Communications $VZ continues its drive to reduce capex/revenues. There is a sense that Verizon has largely completed its big network rollout and it is gearing itself to utilize its network in the next few years rather than expand it.

In addition, a Chinese rival to Cisco (ZTE) recently downgraded its outlook for China carrier spending. Competitors such as ZTE and Huawei are increasingly threatening to grab market share from Cisco in switches and routers and with their domestic situation worsening, it is reasonable to expect them to get more aggressive in North America. Indeed, Cisco CEO John Chambers was clear in his estimation that Cisco is responding to competition and winning. So far, so good. Nevertheless, the outlook in Cisco’s core divisions doesn’t look great and there is a limit to where cost cutting and price reductions can get you.

Moreover, question marks need to be raised about the collaboration division and in particular the purchase of Tandberg Television. The 7.8% decline in revenues is not a good sign. Even worse, it is in line with what key competitor Polycom $PLCM have been reporting which suggests that the industry is weak. I’ve discussed this industry in an article linked here. Simply put, videoconferencing and ‘telepresence’ are solutions looking for a problem right now. Companies don’t invest in expansionary projects when economic growth is slowing.

On a more positive note the wireless, security and data center spending are all doing fine. Going back to the telcos, there has been a pronounced shift in spending in recent years from wire line to wireless spending and based on the large service providers commentary I would expect this to continue. This is good for the companies like Aruba Networks $ARUN that specialize in mobile technologies.

As for security, I think there is clear evidence to suggest that spending here is holding up and Cisco is confirming this. The recent results from IT security company Fortinet were pretty good and the recent IPO of Palo Alto Networks $PANW has been warmly received by the market. I think the sector has further to run and evaluations don’t look stretched.

Turning to Data centers, spending has also been extremely robust this year and it’s interesting to contrast the capital expenditure plans of data center companies like Equinix with that of the telco carriers mentioned earlier.

Where Next For Cisco?

The dividend hike and the declaration that it wants to return 50% of free cash flow to shareholders in future is a good move. It is an implicit recognition of the fact that growth is slowing and investors want to see the value released by the management. This is fine because it puts the management in tune with how many investors view the stock.

Growth prospects in the core divisions look somewhat difficult in the near to mid-term but the periphery activities are suggesting that other areas of technology are holding up well and the return to growth in enterprise spending is a major plus. We know government and European spending will be weak for a while, so any good news on enterprise spending is warmly received. I think this report is a positive all round but perhaps more for companies in the areas of technology that Cisco is reporting growth in than Cisco itself. From an investment perspective Cisco is now doing the right things in order release value.

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