Nothing like confirming investors’ worries about the profitability of your company’s business strategy. Investors have been worried that in its pursuit of growth—a daunting task to begin with for a company that dominates its core markets and with a market cap of $104 billion—that Cisco Systems (CSCO) was trying to expand in too many directions and that would eventually hurt profit margins. By its own count Cisco has moved into more than 30 new businesses.
Well, guess what. In the quarter that ended on January 29 (the second quarter of Cisco’s fiscal year), and that Cisco reported on February 10, the company posted a gross margin of 62.4% that was short of the 63.3% consensus among Wall Street analysts and the 64.5% gross margin in the same quarter a year ago.
Part of the lower margin story was completely explicable and shouldn’t raise any doubts among investors. In its core Ethernet switch business Cisco is rolling out new products and new products always start out with lower margins. The spending on new products here is a sign that Cisco is determined to defend this core market—good—but that it is facing strong new aggressively priced products from competitors such as Juniper Networks (JNPR) and Brocade (BRCD)—bad. But okay, this is the typical product cycle story in a technology market. Research and development costs climbed 19% percent in the quarter.
But part of the lower margin story suggests that Cisco’s basic growth strategy requires not fine-tuning but a complete overhaul. For example, while Cisco CEO John Chambers attributed 1 percentage point of the year to year decline in gross margins to the product transitions in the company’s switching business, he also said that another 1 percentage point was a result of falling sales in the company’s consumer business that includes such products as the Flip video camera and the Linksys and Valet home networking systems. Sales for the category “other products” (there are other specific lines for sales of switches, routers, and new products) fell to $211 million in the quarter from $229 million in the previous quarter.
The cable and Internet Protocol TV set-top box business that Cisco got into in big way through its 2005 $6.9 billion acquisition of Scientific Atlanta saw sales fall 11% year to year as a 47% increase in IPTV sales couldn’t offset a 29% drop in the bigger cable TV box business.
Cisco is either going to have to fix these businesses—which won’t be easy considering that the big gorilla that Cisco is in the corporate and telecom space is more like a capuchin monkey in the consumer space and that some of these products, such as the Flip video camera are really struggling against cheaper, built-in technology—or admit that it was wrong to get into them and figure out an exit. Cisco is sitting on $40 billion in cash right now. (The company said that it will offer its first dividend in the first half of this year.) While that cash assures that Cisco has got the time and resources to fix anything that is wrong with the company, it is also a temptation to continue the “buy growth” strategy that Cisco has pursued not so terribly successfully in recent years.
Before the earnings announcement Cisco Systems was a $25 stock (in my opinion) that traded for $22 a share. After it plunged on the earnings report it became a $22 stock that trades at $18.1.
My sense is that $22 is achievable relatively quickly—say by June. If the stock isn’t near that level by that time, I think Cisco becomes a sell. As of February 14, I’m cutting my target price on Cisco Systems to $22 a share by June 2011.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Cisco as of the end of December. (I will have the January portfolio holdings posted this week.) For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/