Cisco's Optimism Falls on Wall Street's Deaf Ears


Cisco isn't only a marquee tech stock, it's long been a reliable bellwether for the industry. It's positioned to see changes in info-tech spending earlier than most companies, and CEO John Chambers (pictured) has often been up-front about signaling both growth and challenges.

But something unusual is happening between Cisco's (CSCO) investors and its CEO. Their views are parting ways. When Cisco reported its fiscal second-quarter earnings last week, Chambers outlined challenges, but he felt Cisco would weather them just fine.

Wall Street begged to differ. Cisco's stock has lost 15% of its value since that earnings report, closing Monday at $18.81 with a market cap just over $100 billion. That puts the stock's price-earnings ratio below 12, which might be a bargain -- except that analysts worry that Cisco's profit margins may be eroding for some time.

The big area of disagreement concerns gross margins. Cisco's $10.4 billion revenue and earnings per share of 37 cents a share beat analysts expectations. But investors often scrutinize profit margins as a sign of where profits might head in the future. Cisco's gross profit in the quarter was equal to 62.4% of revenue, down from 65.6% a year ago.

Bread-and-Butter Revenue Falls

What's more, according to Chief Financial Officer Frank Calderoni, those margins will stay between 62% and 63% for the next couple of quarters. One big reason for that involves Cisco's switches, which, along with its routers, are the bread and butter of its operations. Revenue from switches, which make up 30% of Cisco's total, fell 7% on year in the quarter.

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Chambers believes that the decrease in gross margins is a negative side effect of a larger, positive trend. For the first time, Cisco has introduced new products in all its portfolios, he says, and development costs of new offerings tend to weigh down margins early in the product's life cycle. The implication is that margins will rise across the board given enough time.

But analysts saw it differently. Some, like Citigroup and Stifel Nicolaus, cut their ratings on the stock. Sanjiv Wadhwani of Stifel said outright he believes the problems go a lot deeper than introducing a broad line of new products. They suggest that switches are subject to a price war as rivals duel with Cisco in an increasingly competitive market.

"There is a more structural change occurring in the industry with pricing pressure being exerted by HP and Juniper among others," Wadhwani wrote. "This is forcing Cisco to compete for the first time on pricing in its switching product line against well funded and capitalized vendors. Overall, the structural change we believe is likely to lead to a permanent change in gross margins."

Public-Sector Spending Slows

To make matters worse, such a change would come as local and federal governments are cutting back on their IT spending. Revenue from the public sector grew 7% last quarter, but it was considerably slower in industrialized regions like the U.S. and Europe. Overall sales in Europe grew 2%.

"From a public-sector perspective, we believe that we are not losing market share in the developed world governments. However, we believe that you're going to continue to see a rapid decrease in discretionary spending including IT in a majority of these governments," Chambers said.

The worst-case scenario for Cisco -- and a likely one -- would be that both Chambers and Wadhwani are right: that public spending on IT would start to dry up and that Cisco rivals like Juniper (JNPR) and Hewlett-Packard (HPQ) respond by cutting prices on their products. Then Cisco would be forced to cut its own prices or brace for lower volume of its new round of higher-priced products.

Judging from the market's response, investors seem to think the problems facing Cisco are largely its own. While Cisco has suffered a 15% decline since reporting its earnings, Juniper Networks' stock has risen 8% and Alcatel-Lucent (ALU) has increased 30%.

In fact, Cisco's fall from the market's grace has been some time in the making. The stock has dropped more than 10% right after each of its last three earnings reports. The first two times that happened, Cisco managed to gain most of the ground back before sliding again.

Layoffs Ahead?

And that's a big change for Cisco. For much of the past couple of years, its stock chart has tracked that of the Nasdaq. But something changed last summer. Nasdaq began a steady march upward, while Cisco kept lurching down. As a result, the Nasdaq is up 29% over the last 12 months, while Cisco is down 21%.

Chambers remains confident that the company can revive margins and remain competitive. Sales in new product areas such as collaboration, wireless and data-center technology are seeing annual growth rates above 30%. And there are signs that Cisco will lay off workers if profit margins continue to be weighed down.

So, Cisco has some ways to meet the challenges it faces. Chambers, however, has an additional one: getting Wall Street to take his optimism seriously.

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