Cisco's Still Misunderstood

TheStreet.com

NEW YORK (TheStreet) -- Shares of Cisco have been down by as much as 12% since the company reported its fiscal fourth-quarter earnings results and are still under pressure. The Street, which has taken a "wait-and-see" approach towards Cisco, continues to show a lack of confidence in its management. While I don't necessarily have a problem with that, I don't believe investors who have taken only a cursory look at the company's performance truly understand what Cisco has been trying to do.

Take, for instance, analyst Kulbinder Garcha of Credit Suisse, who recently initiated coverage of the stock with an "underperform" rating. Garcha noted that Cisco's software-defined networking (SDN) strategy will "ultimately threaten the oligopolistic structure and superior levels of profitability seen in switching and routing." The stock price fell 1% on that report alone.

Garcha continued: "While the company aims to offer an SDN platform, we expect this product evolution to shrink gross margins. While the company aims to grow its services base, this is unlikely to be a sufficient offset."

I completely disagree with this assessment. While Garcha is correct to point out the potential slide in Cisco's gross margins, I don't believe the company's operational leverage would have been cited had Cisco's margins not taken a slight dip in the recent quarter. But Cisco's management had already signaled that margins were going to take a hit as the company got more aggressive to spur revenue growth. Plus, this strategy had nothing to do with the company's long-term SDN ambitions.

As with rivals like Juniper and F5 , the entire sector has underperformed due to shrinking enterprise budgets. I've spoken about this on more than one occasion. To counter the weak spending environment, Cisco resorted to "aggressive discounting" of some of its gear.

As a consequence, though, margins took hit, to the tune of a 1% decline. But it's no cause for panic, especially since Cisco continues to beat or reach the upper-end of its guidance on every other metric that matters. In Garcha's argument, I understand why it's prudent to cite margins as an area of caution. But for a company the size of Cisco that's still amassing $4 billion in operating cash flow, it's a bit overblown

The other thing that struck a chord with me was that Garcha suggested that Cisco's SDN strategy will "threaten" its routing and switching business. Essentially, Garcha is trying to preserve Cisco's legacy hardware business, while management has been working hard to transition the company out of that mindset. It's not going to happen overnight.

The routing and switching businesses have been on the decline over the past year. Management has instead made significant investments into higher growth and higher margin businesses like Meraki, Cariden and Broadhop. Not to mention, on Wednesday Cisco closed on its deal for anti-hacking giant Sourcefire for $2.7 billion. These moves intend to offset the slow-moving hardware business.

In other words, Cisco's near-term strategy is to sacrifice some margin to squeeze out smaller rivals like Aruba Networks and Palo Alto Networks while (at the same time) diversifying its business into higher-margin areas. To that end, I don't believe Garcha has taken full appraisal of what's going on at this company or the value management is trying to return to shareholders.

Cisco is still a high-quality company trying to navigate a soft corporate IT-spending environment. From my vantage point, at around $22 per share, the stock remains cheap. When applying a modest 4% to 5% long-term free-cash-flow growth, it's not of the question to expect Cisco to trade north of $30 per share. It just takes a little understanding.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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