At Cisco, Focus on Future Continues to Pay Off

To maintain the sales growth that is so dear to investors, Cisco (CSCO Quote) is forsaking current profits in order to invest in the technologies of the future.

As it enters its second decade as a public company, the San Jose, Calif.-based supplier of Internet equipment intends to vanquish an expanding field of competitors by socking profits into developing and promoting the next generation of innovative products. With its stock showing no signs of age, internal strength goosing revenue growth and investors mostly ignoring its narrowing margins, Cisco has the luxury of letting bottom-line growth take a back seat to other priorities, such as developing new network routers and boosting sales to lucrative corporate accounts and telecom-service companies.

While a host of upstart networkers can compete with Cisco on one product, none can match the breadth of its offerings or its impressive track record. That and the company's focus on the future may explain why investors have recently made Cisco the second-most valuable stock in the world, overtaking General Electric (GE Quote) and behind only software juggernaut Microsoft (MSFT Quote). The stock has surged 27% this year and is up 176% over last year.

Growth Story

One of tech's great stock stories for a decade, Cisco already appeals to investors who chase growth at any cost. For eight consecutive quarters the company has improved growth in sales to businesses and telecommunications companies. In the quarter ended Jan. 29, for example, sales jumped 53% from a year earlier to $4.35 billion. And while earnings growth lagged behind sales growth at 49% for the quarter, Cisco is still making plenty of money, earning $906 million, or 25 cents a share.

As Revenue Outpaces Operating Earnings ...

Source: Thom Weisel Partners, Cisco.

The gaudy numbers obscure the fact that Cisco is furiously plowing away profits as it anticipates another wave of growth in Internet traffic, courtesy of the proliferation of bulky multimedia messages. There is certainly a rich opportunity: In North America alone, Internet traffic will increase roughly 30-fold in the next three years, according to the research firm RHK. Cisco claims a nice chunk of the market, but has decided it must invest ambitiously in its technology to compete effectively with upstarts such as Juniper Networks (JNPR Quote) and phone-gear suppliers such as Nortel (NT Quote) and Lucent (LU Quote).

And invest ambitiously it has: Cisco invested the equivalent of 14% of revenue in R&D last quarter, compared with 6% at young networking rival Foundry Networks (FDRY Quote). As a result of its spending on R&D and sales costs, Cisco's operating profits have eroded to 27% of revenue from 33% two years ago, and analysts say they may go lower yet as Cisco CEO John Chambers vows to continue investing in the likes of new routers, specialized computers that direct messages between far-flung computer networks.

Enormous Opportunities

"We see many more opportunities in front of us than we are able to fund with current spending levels," Chambers said in a conference call late Tuesday. Therefore, "we will grow expenses slightly faster than sales for three to four quarters so that we continue to be well positioned to take advantage of the enormous opportunities that lie ahead in our industry."

... Cisco Investors Cheer

Cisco knows "you can't underspend on R&D and maintain strong top-line growth for too long," says Ned Brines, portfolio manager with Roger Engemann & Associates, which has nearly 10% of its assets tied up in Cisco and still buys shares. Cisco didn't respond to requests for comment after its earnings conference call Tuesday.

Cisco has also been on the lookout for acquisitions that can further its cause. A notable aid has been its towering stock price, which has enabled it to acquire 20 companies in the last year alone -- including the privately held Cerent in a $7 billion stock deal. That has helped Cisco weed out rivals and launch itself into the high-growth fiber-optic sector while preserving operating profits. Still, says Martin Pyykkonen, who covers telecom-equipment stocks for CIBC World Markets and rates Cisco stock a buy, Cisco fuels the bulk of its revenue growth through internal efforts. His firm has no banking ties to Cisco.

Top-Line Mania

Another fact in Cisco's favor: Focusing too keenly on profits doesn't necessarily win much favor with today's investor. To be sure, Cisco consistently beats analysts' earnings estimates. But a look at the experience of 3Com (COMS Quote) suggests that revenue growth is the surest way into Wall Street's heart.

3Com, which competes with Cisco in the corporate market, has slashed costs dramatically to meet Wall Street profit expectations in recent quarters. But its sales have been flat, and the stock zigzagged for years before doubling in the last three months on enthusiasm about the plans of its Palm unit to go public late this month. 3Com, up some 8% at 64 Thursday, is still well below the highs it reached three years ago. By contrast, Cisco also has doubled since October, reaching record highs.

Even so, in time Cisco will expand its operating margins again as it reaps the full benefits of its investments and streamlined operations, says Reed Bender, analyst with Robert Bender & Associates. His firm has owned Cisco since 1990 and still buys shares.

In the meantime, Cisco is doing its damnedest to take a Juniper-like approach to investing in network architectures that are just in their infancy.