Cisco Sets the Stage for Renewed Growth

• ByDavid Sterman, RealMoney Contributor
• On 2:45 pm EST, Tuesday January 6, 2009

Over the last three years, Cisco Systems has been showing subtle signs of major strategic shift into the consumer sphere. Starting with a major product demo on Wednesday at the Consumer Electronics Show (CES), the company is finally unveiling a master plan. And within a few years, it could provide 5- to 10-percentage-point gains to the company's core enterprise-focused growth rates.

Until now, Cisco has been content to say little about seemingly disparate acquisitions in the consumer sphere. The company bought wireless router vendor Linksys in 2003, acquired set-top-box maker Scientific Atlanta in early 2006, and in July purchased privately held Pure Networks, which makes home networking software.

Taken together, these purchases have come to constitute an entirely new platform for Cisco. This platform should enable consumers to better manage their traditional cable and Internet-based entertainment content, streaming it to any part of the household. And that's just the start.

The company also hopes to provide tools to manage all manner of appliances in the home, many of which will have their own level of intelligence and communications built into them. And looking out into the second half of 2010, Cisco even aims to finally bring the much-promised, oft-delayed vision of high-definition video conferencing into a mainstream, affordable consumer device.

The appeal to consumers is quite clear. Right now, most stereos, TVs and computers operate as silos, with little interoperability. Moreover, most consumers have to switch devices when viewing cable TV streams and Internet video streams. The time has come to get all of that content through the same device in a more seamless -- and wireless -- way.

Looking beyond the specific announcements at Wednesday's CES show, look for Cisco to continue to target the video market, which the company believes will continue to be a major growth driver of Internet traffic. Cisco would likely look to develop an equivalent to the set-top box for Internet video. But the company must be careful not to alienate the existing base of cable TV customers, who could start to shift business to rivals such as Motorola .

Of course, Cisco runs a risk by moving away from its biggest strength: an extremely effective sales force that has developed a lock on the enterprise space. Moreover, other tech firms such as Gateway and Hewlett-Packard have found that it can be tough to generate reasonable profit margins in the consumer market. Even Apple's Apple TV has had an underwhelming reception in the marketplace. But no one can accuse Cisco of moving hastily and with naivet�. The company has been fine-tuning its approach for quite a while, and waited until all of the pieces were in place for this consumer strategy to coalesce.

For investors, the key question involves how big the market opportunity is, and how much it can move the needle in terms of firm-wide sales growth. Right now, that needle is moving in the wrong direction. A sharp pullback in demand for high-end routers and switches means that Cisco will likely see sales drop about 5% in the current fiscal year (end July), and analysts are not anticipating much of a rebound in fiscal 2010 either.

But Cisco is still taking share in key segments and should grow its legacy businesses at an above-trend rate when the capex spigot finally reopens. For example, Cisco and Juniper Networks have been strengthening their grip on the enterprise/carrier communications space and should be a prime beneficiary when the time comes for investments in next-generation equipment, especially with the current woes and retrenchment at Nortel Networks . Cisco has also been taking market share in enterprise IP phone handsets from former industry leader Avaya, according to Infonetics.

To be sure, it is very hard to gauge specific projected growth rates for the next 18 months in both legacy and new businesses. But it is clear that the company intends to maintain at least moderate bottom-line momentum, through both cost cuts and share buybacks. Cisco's share count has fallen by more than 300 million over the last four quarters to around 5.98 billion. Those buybacks came at far higher stock prices (averaging $26), and the company will presumably be inclined to trim at least another 300 million from the share count over the next four quarters now that shares are below $20.

And Cisco is now in the midst of trimming expenses in a variety of areas, which should enable net income to grow by at least 2% in the next fiscal year (July 2010), even if revenue growth is flat. Combined with the smaller share count, Cisco could boost EPS between 5% and 10% in fiscal 2010, even as demand remains challenging.

Yet in this case, it is important to track the company's longer-term direction, and as noted above, Cisco will continue to fuel new growth verticals, even as many other tech firms such as Dell appear to be sitting on their hands.

And in the context of robust long-term growth prospects, shares look quite appealing right now. The company sports a $103 billion market capitalization, and an enterprise value of around $80 billion. Meanwhile, the company is still generating $10 billion in operating cash flow, even in this depressed environment. Shares trade for about 2 times sales on an enterprise value basis, which is quite low for a company with 64% gross margins and operating margins of 25% to 30%.

Shares of Cisco have been steadily falling for two years due to a perceived lack of catalysts. Although Wednesday's CES announcements are unlikely to immediately change perceptions, Cisco will probably be seen as a "catalyst-driven" stock in the quarters to come as its consumer-focused strategy comes into better view.

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