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Cisco: The Big Reversal

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Cisco (CSCO), after a few years of minimal growth and range-bound stock pricing, looks to be back on the path of growth. In late 2010 and early 2011, things were bleak with the company, which put off its traditional customers by getting into the server market; this was costing Cisco business in switches and routers which have been its core business for years.  But, the gamble of the Unified Computing Service platform has begun to bear fruit and is now putting its competition -- which has only recently sniped business out from underneath it -- on the defensive. This has led to Cisco beating analyst estimates with earnings results the past two quarters running. 

In Q2, revenue rose 10.6% from the year-ago quarter to $11.5 billion and net income was up a very good 43.5% to $2.18 billion.  Analysts on average were expecting $11.23 billion.  Excluding one-time items, earnings were $0.47 per share, beating the average Thompson Reuters estimate of $0.43.  The company -- a sector bellwether because of its global scale and diverse client base -- much to everyone’s surprise, declared an increase to the quarterly dividend to $0.08 up from $0.06. 

For Q3 Cisco reported 7% y-o-y increase in Q3 fiscal 2012 sales at $11.6 billion against $10.9 billion in the same period previous year. The company's operating expenses accounted $4.41 billion in Q3 FY12, as compared to $4.47 in Q3 FY11.

Revenue breakdown by both business vertical and geography tell a great story, and in the end, have little need for rhetorical embellishment.  The point of UCS is to move into the data center business to begin competing with players like Equinix (EQIX) and Hewlett-Packard (HPQ).

Getting ‘back to basics’ is the theory applied by Cisco to pull off this remarkable turnaround. Cisco restructured, refreshed its switching and routing products, and competed to win deals and cut costs. The company made it a goal to eliminate $1 billion in expenses on an annualized basis, which it did well ahead of schedule. To achieve that target Cisco last year scaled back on consumer businesses and laid off thousands in a sweeping four-month overhaul.  But cost-cutting is not a path to growth but rather only margin improvement in the short term; just ask HP.

Cisco needed to solve the problems of its Nexus line of converged Ethernet switches, which carry both server and storage traffic. The company's initial low margins were a direct result of greater functionality and higher port counts driving up production costs while not having economies of scale to drive unit cost down.  But, by pushing for greater integrated network engineering and servers into one seamless platform, Cisco has been able to improve gross margins on Nexus gear up to 8%.  To drive adoption Cisco has now focused on building data centers -- enabling and providing cloud computing technology and video-streaming platforms successfully breaching out from routers and switches, Cisco's core business. This strategy is beginning to pay dividends as the data center vertical is their fastest growing one with 67% Y-o-Y growth at 291 million in Q3 FY12.

However it was not all around good news for Cisco; it lost some market share in the enterprise router market to HP, which more than doubled its share in 2011 and is the key to HP’s own successful turnaround.  Cisco still owns nearly 75% of the market.  Its enterprise customers dropped 1% on a Y-o-Y basis, but this was a common trend in the industry.

Currently trading at 12.4 times trailing earnings and now sporting a respectable 1.9% yield, Cisco’s stock is looking slightly undervalued.  The $17 billion in goodwill it is holding on its books is a red flag, but backing that out still has it trading at a P/B of 1.2.  The market clearly wants to see another quarter or two of solid performance and greater contributions from its data center business before going all in.  But, unlike a number of tech giants going through reorganizations, Cisco is a lot farther along the path than others.
POSITION:  No positions in stocks mentioned.