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Cisco: The Big Reversal

Cisco (NASDAQ:CSCO) after a few years of minimal growth and range bound stock pricing looks to be back on the path of growth. The turnaround for Cisco, where in late 2010 and early 2011, things were bleak with them having put off their traditional customers by getting into the server market, it was costing them business in switches and routers which have been their core business for years.  But, the gamble of the Unified Computing Service platform has begun to bear fruit and is now putting their competition, only recently sniping business out from underneath them, on the defensive. This has led to them 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 up a very good 43.5% to $2.18bn.  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 percent 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 (NASDAQ:EQIX) and Hewlett-Packard (NYSE: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. They 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 4-month overhaul.  But cost cutting is not a path to growth, only margin improvement in the short term, just ask H-P.

Cisco needed to solve the problems of their Nexus line of converged Ethernet switches, which carry both server and storage traffic.  Their 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 on seamless platform Cisco has been able to improve gross margins on Nexus gear up to 8%.  To drive adoption Cisco has notw 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 percent 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 H-P which more than doubled its share in 2011 and is the key to H-P’s own successful turnaround.  Cisco still owns nearly 75% of the market.  Their enterprise customers dropped 1 percent on aY-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 they are holding on their books is a red flag, but backing that out still has them trading at a P/B of 1.2.  The market clearly wants to see another quarter or tow of solid performance and greater contributions from their 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 they are. 


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Peter Pham is an author, international fund manager, and a registered financial director by the Cayman Monetary Authority (CIMA). In 2013 he published his first book entitled, The Big Trade: Simple Strategies for Maximum Market Returns. He currently manages the portfolio of a global hedge fund and runs an asset management company, Phoenix Capital.  (read more)

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