3 Strikes Against Cisco's Supposed Success

What doesn't kill you makes you stronger. That's how Cisco Systems (NAS: CSCO) CEO John Chambers wants you to look at the networking giant today.

Cisco made some bone-headed strategic decisions in 2009 that came back to bite the company in 2010 and 2011. This spring, Chambers as much as dropped to one knee and begged investors for forgiveness, and promised to refocus on a smaller set of core operations. Heads have rolled, entire divisions fell by the wayside, and Cisco just reported its first quarter after adopting a three-year turnaround plan.

And Chambers hasn't lost a single ounce of confidence in his strategy. "In every major market transition, we have historically emerged even stronger, with more market share and intense targeted focus," he said on the first-quarter earnings call. "In our opinion, we are well on our way to doing this once again." This is, according to Chambers, a "reinvigorated Cisco, the aggressive, the focused, the simplified Cisco you have come to expect over the years."

Sales increased by 4.7% year-over-year and non-GAAP earnings nudged up by a penny to $0.43 per share. Analysts had expected a smaller sales gain and shrinking earnings, so that's a positive surprise. I've seen at least four analyst upgrades or raised target prices after the report and shares jumped as much as 7.8%.

Three strikes -- you're out!
This sudden outpouring of love and enthusiasm ignores a few important downsides to the Cisco story, though.

Chambers wants to focus on higher gross margins, but that story isn't playing out quite yet. Trailing gross margin actually shrunk for the fourth quarter in a row and that weakness largely keeps cascading down to operating and net margins as well. Strike one.

Revenue did grow a little, but 4.7% is a very meek growth rate for a company used to seeing double-digit numbers on that metric. This is a picture of decelerating growth, which doesn't look good at all next to shrinking margins. Strike two.

Finally, Cisco produced $2.1 billion of free cash flow this quarter, then spent $2 billion on dividends and share buybacks. You might see this as an opportunistic and perhaps brilliant use of capital, but I see Cisco artificially goosing one quarter's results with an unsustainable buyback policy. It's smoke and mirrors. Strike three in my book.

Alternative network investments
Cisco's report also pumped up the networking sector in general. Juniper Networks (NAS: JNPR) and F5 Networks (NAS: FFIV) saw gains of 5% and 3% today, and news-less Riverbed Technology (NAS: RVBD) even kept pace with Cisco's own 7% jump. For once, this sector effect makes perfect sense.

I'm more comfortable reading Cisco's news as a report on the networking market's general direction than accepting it as proof of the specific company's return to health. Other Fools may disagree. Cisco is, after all, an active holding or recommendation in three different services here, with plenty of real money on the line.

But for my money, I'd rather invest in smaller and hungrier networking players with less of a CEO ego to support. I've got a real-world position in little-known network installer Sonus Networks (NAS: SONS) for example, and would also take a long, hard look at chief rival Juniper, optical equipment expert JDS Uniphase (NAS: JDSU) , or cable-system efficiency specialist Arris (NAS: ARRS) before clicking that "buy" button on Cisco.

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At the time thisarticle was published Fool contributor Anders Bylund owns shares of Sonus Networks but holds no other position in any of the companies mentioned. The Fool owns shares of and has created a bull call spread position on Cisco. Motley Fool newsletter services have recommended buying shares of Riverbed Technology and Cisco, as well as writing puts in Riverbed Technology. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinion, but we all believe that considering a diverse range of insights makes us better investors. Check out Anders' holdings and bio, or follow him on Twitter and Google+. We have a disclosure policy.

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