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Cisco Remains a Buy Ahead of Earnings

NEW YORK ( TheStreet) - With shares of Juniper (JNPR) spiking up 7% recently on better-than-expected fourth-quarter results, those who have been waiting anxiously to revive the debate as to whether Juniper is better than Cisco (CSCO - Get Report) have finally gotten their chance. Except - there's no discussion to be had. That ship has sailed.

While Cisco has become a punching bag for analysts lately, very few of them actually demonstrate a clear understanding of what Cisco is and where the company is trying to go. And the rush to panic over one quarter seems overdone. While Cisco is far from the heights it achieved in the dotcom era, this is still a high-quality company trying to navigate a soft corporate IT spending environment.

To that end, the Street still refuses to accept that growth is not coming back - at least not any time soon. And let's stop pretending for a moment that any growth this company produces will ever be enough. As a mature dividend payer, management's real challenge at this point is obvious; Cisco needs to demonstrate that it can establish strong competitive leverage by posting better margins.

Management understands this. And they have outlined several strategies to boost long-term profits. The Street, meanwhile, have conveniently misinterpreted management's attention to the bottom line as "Cisco abandoning growth." And these shares, which have been down by as much as 10% since the company reported its fiscal first-quarter earnings results, are still feeling some pressure.

The fear these days is that Cisco is losing market share to Juniper and F5 Networks (FFIV) when in actuality, the entire sector has underperformed due to shrinking enterprise budgets. Cisco has countered this weakness by resorting to "aggressive discounting" of some of its gear. I believe this made sense. Reducing prices helps level off inventory while at the same time squeeze out smaller rivals. The thing to remember, though, is that it will come at the expense of near-term margins.

Management hasn't tried to conceal this. And they've been very clear - on more than one occasion - about these offsetting advantages. Investors still reacted surprised. Now, it's Juniper's hardware business that's "eating Cisco's lunch." Juniper's recent results demonstrated a solid 17% revenue growth in its router business. By contrast, Cisco is projected to post a 15% decline. But so what?

It's true Juniper hardware growth has outpaced Cisco, but this has been the recurring trend over the six quarters. In terms of hardware, these two companies have been on opposite trajectories. This is far from a surprise. And Cisco investors shouldn't want it any other way. Software is the new hardware.

To that end, management has instead made significant investments into higher growth and higher margin businesses like Meraki, Cariden and Broadhop. Not to mention, the company's recent $2.7 billion acquisition of anti-hacking giant Sourcefire (FIRE). These moves were strategically executed to offset the slow-growing hardware business.

All told, what hardware market share Juniper has been able to gain from Cisco in the past 18 months are the ones Cisco was no longer interested in preserving. Cisco has made no investments in that area while Juniper has (admittedly) a more refreshed product line, especially in the key edge router market. But I don't believe there's a strong future there. Neither does Cisco's management. And it's only a matter of time before Juniper realizes this.

On Wednesday Cisco will report its fiscal second-quarter results. The Street will be looking for 46 cents in earnings per share on revenue of $11.03 billion, which would represent a year-over-year decline of close to 9%. Given Cisco's historical average of 3% to 5% growth, these numbers seem a bit low - albeit they are extremely close to management's guidance.

And while I've always been more willing to side with management's guidance than estimates provided by analysts, I nonetheless believe Cisco's second-quarter outlook (issued in November) was ultra conservative. The company cited (among other things) caution about its major emerging markets and tepid IT/carrier spending. But there's been more than a few upside surprises this earnings season, including Juniper, to suggest that Cisco will not beat this quarter.

For now, the Street is justified in taking a "wait-and-see" approach towards Cisco. But it requires more than a cursory look to fully appreciate and/or distinguish real weakness from strength-building. The way I see it; at around $22 per share, the stock remains cheap. And in the next 18 months, patient investors can expect Cisco to trade north of $30 per share on the basis of long-term free-cash-flow growth and margin expansion.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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