A Modest Industry Leader: Cisco

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Born to address the need of a husband and wife located in different office buildings to communicate with each other, Cisco Systems (NASDAQ: CSCO) has, since inception, catered to the needs of small and big enterprises with viable and innovative networking products and services. Cisco’s growth has slowed down slightly in the recent past owing to a challenging macroeconomic environment but nonetheless, it has been successful in beating street estimates.

Not the best, but good

For the third quarter of fiscal year 2013, Cisco reported net sales to the tune of $12.2 billion (growth of 5% year over year) and non-GAAP EPS of $0.51, which narrowly beat the Street estimate. As CEO John.T.Chambers pointed out in the earnings conference call, the company achieved a commendable performance in US and emerging markets. It scored a double digit growth on a year over year basis in these markets. The Street reciprocated well after the earnings call, with trading volumes increasing by almost 250% and Cisco's share price shooting up by approximately 15%.

Results for the quarter were aligned with the financial guidance given by the company a quarter earlier, thereby enhancing investor confidence in the stock. On top of delivering a commendable performance, the company gave its investors another reason to celebrate: it returned $1.8 billion to its shareholders in the quarter, which included $860 million by way of share repurchase and $905 million through quarterly dividends. Thus, Cisco scored high on both the counts, i.e achieving robust results as well as creating value for shareholders.

A glance through the quarterly results definitely gives a flowery picture considering important metrics like revenue growth, EPS, operating margin and free cash flow. But, as with any business, there are potential risks that get camouflaged by a praiseworthy state of affairs. Before going into a discussion on business risks let us first take a look at Cisco’s competitors to better understand the industry.

Industry rivals

Cisco leads the networking and communications industry with market cap of a whopping $127 billion, which gives it various advantages like sophisticated R&D, stable client base and economies of scale in production. The company faces direct competition from Avaya, which merged with Sierra Merger Corp in 2007. For the 2nd quarter of fiscal 2013, Avaya reported revenue of $1.12 billion (down 11.1% from prior period quarter) and adjusted EBITDA of $172 million, a decrease of 14% from 2012.

As it can be seen from the results, Avaya could not successfully sustain the challenges of a sluggish economic environment mainly because it lacks a robust presence across global markets as well as a reasonable size of operations. A slowdown in growth was spotted for both enterprises in the Asian markets.

Ericsson (NASDAQ: ERIC), with a market cap close to $39 billion, provides networking solutions through its product and services to its customers, who include telecom operators, utilities industry, automotive, etc. In terms of key balance sheet metrics, DSO, or days sales outstanding, stood at 108 days, reflecting a poor collection system. In fact, the DSO in Q1 2013 was higher than any of the previous four quarters. Cash flow from operating activities was negative in the quarter mainly due to increase in working capital requirement.

Another distant competitor for Cisco is Alcatel-Lucent (NYSE: ALU), a global telecommunications equipment company. A major area of concern in Alcatel’s results was generation of free cash flow that got hit by negative changes in working capital. Hence, management needs to frame appropriate strategies for effective working capital management in order to maintain sufficient cash flow levels. As in the case of Avaya and Cisco, Alcatel also faced a negative trend in the Asian markets, sending its revenue down by 5.8% in the region.

Risk factors to keep in mind

Coming back to my point of potential business risks, one of my biggest worries regarding Cisco is the slowdown in Asian markets. As per the earnings call, Japan and China grew orders by just 1%. These two markets have seen phenomenal growth in past years, and hence a sudden slowdown can become hazardous for the company’s overall revenues. The other emerging countries like India and Brazil performed well for the company, giving it double digit growth rates.

Another challenging aspect for Cisco is the fact that markets are transitioning at a fast pace and customers are willing to switch to new and better hardware and software products. As I mentioned, Cisco’s size of operations enables it to experiment and adapt to the changing demands of its customers. In order to keep pace with market transition, it is making considerable changes to its product portfolio, and as such increasing business risk. For instance, the company is heavily investing in its SDN strategy (Software-Defined Networking) to provide customers with complete solutions regarding network programming.

The bottom line

I began this article by stating that Cisco has been successful in beating Street estimates even under tough macroeconomic conditions, and I think this is the one thing that makes me confident about this stock. Moreover, Cisco’s valuation is modest, with a P/E of approximately 13, and its tradition of creating value via share repurchases and dividends more than makes up for the risk of downside movement in share price. In my opinion, it makes sense to have this stock in your portfolio.

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Mihir Mehta has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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