Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let’s take a look at what Cisco Systems, Inc. (NASDAQ:CSCO)‘s recent results tell us about its potential for future gains.
What the numbers tell you
The graphs you’re about to see tell Cisco’s story, and we’ll be grading the quality of that story in several ways.
A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If Cisco’s share price has kept pace with its earnings growth, that’s another good sign that its stock can move higher.
Is Cisco managing its resources well? A company’s return on equity should be improving, and its debt-to-equity ratio declining, if it’s to earn our approval.
Healthy dividends are always welcome, so we’ll also make sure that Cisco’s dividend payouts are increasing, but at a level that can be sustained by its free cash flow.
By the numbers
Now, let’s take a look at Cisco’s key statistics:
CSCO Total Return Price data by YCharts.
| Criteria | 3-Year* Change | Grade |
|---|---|---|
| Revenue growth > 30% | 34.1% | Pass |
| Improving profit margin | (11.1%) | Fail |
| Free cash flow growth > Net income growth | 33.5% vs. 46.1% | Fail |
| Improving EPS | 58.2% | Pass |
| Stock growth (+ 15%) < EPS growth | (4%) vs. 58.2% | Pass |
Source: YCharts. *Period begins at end of Q3 2009.
CSCO Return on Equity data by YCharts.
| Criteria | 3-Year* Change | Grade |
|---|---|---|
| Improving return on equity | 8.9% | Pass |
| Declining debt to equity | 20.7% | Fail |
| Dividend growth > 25% | 133.3% | Pass |
| Free cash flow payout ratio < 50% | 18.3% | Pass |
Source: YCharts. *Period begins at end of Q3 2009.
How we got here and where we’re going
Six out of nine passing grades isn’t bad, but for a company in Cisco’s position, it’s a little disappointing. The only truly worrisome failing grade here is the one granted to Cisco on the profit margin test. Its free cash flow levels are quite close to its net income, and could easily pull ahead by the time we examine the company again. Cisco has three times as much cash as it carries in total debt, so that should not be a major issue going forward. Now, how can Cisco turn its flagging profit margins around for 2013?
The process appears to have already started with Cisco’s most recent earnings report, which was greeted favorably on Wall Street. Virtually all of Cisco’s key metrics showed improvement: wireless equipment, video-centric networking gear, and data center computing all showed superb growth for such an established company. With the networking giant set to report next week, another quarter of progress would go a long way toward re-establishing this industry leader and its strong yield over its smaller, sexier rivals.
Cisco’s business has been shifting away from pure networking, as you can see, to a wider-net model of connected dominance. In the last few months, it’s acquired cloud-centric Meraki, self-optimizing network software provider Intucell, and has sold off its underperforming Linksys home-networking division to Belkin. Investors may want to take these moves with a grain of salt, as an earlier acquisition of Pure Digital was one of the most panned deals in recent tech history. Hopefully Cisco will stick to what it knows best — enterprise connectivity.
It probably makes sense to diversify from networking products, as it’s come under increasing threat from software-defined networking, or SDN. Late last year, Juniper Networks, Inc. (NYSE:JNPR) shelled out $176 million for a two-day-old SDN start-up, not long after VMWare, Inc. (NYSE:VMW) spent $1.26 on SDN specialist Nicira. One of Cisco’s top SDN architects — and these guys are hard to find — jumped ship to Brocade Communications Systems, Inc. (NASDAQ:BRCD) in October. Added up, these three events spell big trouble on the networking front for Cisco, if SDN reduces the need for its costly routers and switches.
Cisco’s future may depend on getting out in front of this trend, and it’s going to have a fierce battle in store. In addition to competition from these three networking specialists, business software provider Oracle Corporation (NASDAQ:ORCL) is now positioning itself as an integrated communications company thanks to its just-announced acquisition of Acme Packet, Inc. (NASDAQ:APKT). Cisco might have size on its side right now, but there are many examples of an established leader losing its position to more determined invaders.
The article Is Cisco Destined for Greatness? originally appeared on Fool.com and is written by Alex Planes.
Fool contributor Alex Planes has no position in any stocks mentioned. The Motley Fool recommends Acme Packet, Cisco Systems, and VMware. The Motley Fool owns shares of Oracle. and VMware.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
