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Brian White Comments: Cisco Battles Back

January 13, 2014, Barron's

CISCO SYSTEMS CHIEF EXECUTIVE John Chambers spoke excitedly last week at the Consumer Electronics Show in Las Vegas about an "Internet of everything "that will one day expand networks to sensor-equipped parking spaces, shopping carts, even garbage cans. But investors seem preoccupied with the prospect of an Internet of lower profits, where Cisco' s lucrative, top-selling networking gear is displaced by no-name hardware powered by third-party software. In November, the company slashed its revenue and earnings guidance. Shares (ticker: CSCO) have since slid. At $22.22, they' re cheaper than they were a decade ago.

That's an opportunity for bargain hunters. Cisco shares could return 20%% over the coming year, not because the competitive threat isn't real, but because the stock' s valuation appears to factor it in, and then some. Shares sell for just 11 times projected earnings for calendar 2014, a 30%% discount to the Standard & Poor' s 500 index. Subtracting for Cisco' s massive cash reserves, the shares sell at just eight times earnings. The dividend yield is 3.1%. Cisco specializes in networking gear like switches that connect devices within a network, and routers that connect networks to one another. It enjoys both massive market share and outsize profit margins. For example, it holds a 65%% share in enterprise switches, and gross profit margins of 60% to 70%. The company has long trained armies of experts to deploy its gear while spending its considerable cash flow on product development and convincing buyers that it's safest to stick with the industry standard.

The new threat isn't a single rival but rather an emerging trend: software-defined networks, or SDNs. Cisco has traditionally sold hardware that contains embedded software, but with SDNs, third-party software can be put to work on cheap, commodity switches. The software, such as VMWare NSX, allows for the virtual control to, say, manage shifts in data-center traffic or analyze a flood of information. Some fear Cisco could eventually resemble Sun Microsystems, now part of Oracle (ORCL), which saw market share and margins for servers drop as its combined hardware and software approach gave way to a separation of the two.

SDNs are largely in a proof-of-concept stage, and meaningful uptake won't take place until about 2017, but Chambers: "Sometimes it takes us longer to adjust than it should, but our execution is excellent. " some 20%% of Cisco customers by then could be tempted to try commodity gear, predicts Lee Doyle, an independent analyst for tech buyers. Early adopters will likely include tech firms with massive data centers and plenty of programmers on hand.

Cisco' s answer, introduced in November, is called Application Centric Infrastructure and consists of a software-based controller that works with a new line of Cisco switches. Cisco says it will offer the agility and programmability that SDN promises, with reduced complexity. It also claims the new approach is 27%% cheaper in the long run than commodity hardware, and that orders have been brisk "These challenges occur every three to five years, "Chambers told Barron's on Thursday, adding, "Sometimes it takes us longer to adjust than it should, but our execution is excellent "

Cantor Fitzgerald analyst Brian White, who has a Buy recommendation on the stock with a $26 price target, says Cisco remains innovative and that its customers will be reluctant to take a chance on other hardware.

But the new products will roll out gradually in coming quarters, and that could delay orders for current products. Cisco shocked analysts in November by predicting an 8% revenue decline in its second fiscal quarter, which runs through January, versus Street estimates for a 4% rise. It also said it expects revenue to grow at just 3% to 6% a year over three to five years and earnings per share, at 5% to 7%. That includes the current fiscal year, which ends in July, when revenue is expected to decline 5%, to $46.4 billion, while earnings per share dip to $1.98 from $2.08. In other words, Cisco expects growth to pick up following the current weak patch. Wall Street predicts 4%% sales growth and $2.08 a share in earnings next year.

Recent weak points have included China, where a U.S. ban on Huawei selling networking gear in the U.S. on security concerns may have had a retaliatory effect "I' ve been in China 30 years, "says Chambers. "I know the leaders, and I' m patient Security will be a net positive for us in the long run. "

Cantor Fitzgerald's White says Cisco is "killing it "in servers, with a No. 2 share in blade servers after entering the market five years ago. He sees potential for a similar move into storage. Brian Marshall at ISI Group has a Hold recommendation but says he' s warming to the shares. `They' ve already kitchen-sinked the guidance and expectations are low, "he says. "The financial model remains strong, and the new products could add upside. At this price, the stock has more upside 25 20 potential than downside. "

Chambers is expected to retire in the next few years and is keenly 15 focused on shareholder returns. Cisco At 11 times earnings-eight times if you subtract the cashCisco' s shares factor in rising competition and then some. A 3.1%% dividend yield and big share buybacks add allure.

Cisco has gone from no dividend to a high yield in just three years. In November, it added $15 billion to its sharerepurchase plan. It holds net cash of about twice that, equal to more than a quarter of its stock-market value.

All told, Cisco' s valuation suggests it doesn't have to remove all doubts about its shares to rebound 20%. Hewlett-Packard (HPQ) remains surrounded by challenges. Last year, its shares nearly doubled..

 

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