Cisco's Great Execution Goes Unrewarded

Cisco is a fascinating case study in company strategy and a bit of a puzzle.  The networking equipment giant is known for being phenomenally well-run and dominates many of the markets in which it competes.  In the 1990’s, Cisco advised many companies not just on networking equipment, but also on how to use the Internet in general for business purposes.  Recently, they have been expanding into diverse areas including the smart grid, set-top boxes, and even server hardware, and they are becoming known as a leader in online collaboration.  Yet the stock has gone sideways since 2001, not even taking into account the huge drop after the dot-com bust.  Part of that is simply bad timing, but Cisco is also struggling against the age-old problems of extremely successful companies – maturing markets, the law of large numbers (the difficulty of maintaining growth rates as a company gets bigger, not to be confused with the statistical law), and maintaining adaptability as an ever-larger organization.  Is Cisco’s strategy really all that great, and if so, will it be recognized by the market?

From a financial perspective, the 2009 fiscal year at Cisco was a difficult one.  Revenue was down by 9%, operating income by 22%, and operating margins by 3.6 percentage points (20.3% versus 23.9%).  However, a big part of the reason for the drop was Cisco’s continuing investment in future growth in the face of the recession.  Cisco maintained R&D spending despite the revenue drop and acquired Pure Digital of Flip video camera fame.  After the end of the fiscal year, Cisco also snapped up Tandberg for $3.4 billion and Starent for $2.9 billion.  The company also apparently expanded the number of “internal startups” it funds, from 20 to 30, and made a somewhat controversial push into the server market with its Unified Computing System initiative.

I am a huge fan of contrarian business strategy, and Cisco is a great example of it.  Investing while other companies are pulling back is a wonderful way to position yourself for growth down the road.  Cisco is one of the few firms that can afford to do it in spades, sitting on $35 billion in cash at the end of the fiscal year.  Some complained that Cisco overpaid for Starent, which made equipment for smartphone networks, but that arena will clearly be one of the main growth drivers in networking equipment for the foreseeable future.  In addition, Starent turned in 74% revenue growth the year before being acquired.  Cisco has also built one of the best track records for successfully integrating acquisitions and generating value from them.  So in my mind, a slightly richer acquisition price is warranted.

That’s not to say that Cisco hasn’t seen a misfire here and there.  They acquired Navini in the WiMax equipment market for $330 million in 2007 and recently announced that they were exiting that market due to lackluster results.

Opinions are also mixed on their Unified Computing System strategy, where Cisco is seeking to sell bundles of servers as well as networking equipment to their enterprise data center customers.  This approach pits them against HP and IBM, both of which have the potential to nudge customers away from Cisco in their roles as vendors and technology consultants.  Of course, given that blade servers are one of the few bright spots in the $50+ billion server market, maybe taking risks like that is warranted.

The bigger problem  from a stock perspective is that Cisco is now a huge company, and huge companies tend to produce only modest revenue and profit growth.  Circa 2000, Cisco’s enormous valuation was driven by growth and potential.  Since then, revenue has risen only modestly.  Average revenue growth between 2002 and 2008, the most favorable endpoints I could find, was only 11%.  The company has certainly achieved much of its potential, but meeting expectations doesn’t result in an ever-higher stock price.  Recently, Cisco has also seen a bit of market share slippage in its core product lines of switches in routers.  That development merits its own line of analysis, but at face value it’s not reassuring.

Cisco has been addressing the organizational aspects of size with a big culture shift.  The top management team traditionally ran the company in a top-down manner, but over the last several years, CEO John Chambers has led a drive to delegate authority down the chain.  Now a variety of internal teams are empowered to rapidly launch products without the involvement of senior executives.  It’s hard to say whether this change will be enough to keep Cisco nimble as a larger company, but the company deserves credit for going through a challenging internal transition to attempt to avoid becoming too slow to react to market changes.

Overall, I’m still quite confident in Cisco’s business strategy and its ability to continue to rule the networking market and perhaps make strong inroads into a number of adjacent markets.  Having said that, I will be surprised if the company can generate enough growth to move its stock price significantly upwards.  Sometimes the stock market doesn’t really capture the value a business generates for customers, and this looks like it will continue to be one of those cases.  Or more accurately, the huge run up in the stock in the late 90’s captured the value of the company’s good execution now and perhaps into the future.

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