This column was originally published on RealMoney on Sept. 29 at 12:30 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.
The more popular a stock is, the more efficient it is, and therefore the less likely it is to outperform. It's not rocket science, and I'm not the first to say it, but that is market efficiency.
Earlier this month, I spelled out why
will stagnate despite seemingly strong fundamentals, and today I want to explain why I believe networking-equipment giant
, another so-called
"best of breed" name, could suffer the same fate.
To start, let's take a quick look at Cisco's stats. The company sports a sparkling balance sheet that shows $16 billion ($2.56 a share) in cash and no debt, and it produced $6.9 billion in free cash flow and $5.7 billion in net income in its most recent fiscal year, ended July 30. The stock is also trading at just 17 times expected 2006 fiscal earnings per share, which seems cheap for a company with such superior fundamentals. With such a cheap valuation, why aren't investors piling into the stock?
The answer is that they're already there and are unlikely to put more money into the company, which increasingly looks like a slow-growing behemoth with little ability to generate excitement. Cisco remains one of the most widely held stocks in America, by both individuals and institutions. As I've said before, when everyone is already at the party, there's no one left to invite.
Consider how closely the networking giant's every move is followed. Thomson shows 35 analysts following the stock -- 26 of whom have buy ratings, plus eight holds and a solitary sell. Normally, a high number of buy ratings indicates very positive sentiment that potentially limits upside, but in Cisco's case I don't really care. Here, it's the sheer number of analysts that concerns me more than their actual ratings. Even more problematic is that the number doesn't even include the thousands of buy-side analysts and the untold numbers of individual investors who track the company closely.
One of the key factors in a stock's ability to rise is the likelihood of positive surprises. With thousands of professional investors closely following Cisco, it is safe to say that the company has been examined from every angle, and this limits its ability to surprise, becaue so much information and so many ideas are already factored into the stock price.
Investors will always pay for growth, even without surprises, but growth isn't happening here either. Analysts are currently forecasting earnings of $1.03 per share in fiscal 2006 (12% year-over-year growth) and $1.18 per share in fiscal 2007 (15% year-over-year growth).
These are not the kind of growth expectations that generate excitement in a shaky market, especially with hot, secularly growing companies such as
Unfortunately for Cisco, its secular growth days are over, and the company is highly dependent upon unpredictable corporate IT spending cycles. In fact, the company still hasn't matched its quarterly revenue peak of $6.7 billion, achieved in January 2001. On the other hand,
, Cisco's staunchest competitor, continues to set quarterly revenue records beyond what it achieved in the bubble years.
In addition, while the company is increasingly diversifying away from its hardware dependence with a focus on providing complete networking solutions including software and security services, hardware remains the revenue driver, and hardware has limits. Advances in technology constantly allow gains in processing power at lower price points. So when the secular volume growth is gone, it becomes increasingly difficult to maintain outsized growth over time.
Cisco is straddling the line between growth and value.
Investors often raise the question of whether Cisco should pay a dividend. This is an extremely tricky area, because while the company could give shareholders a solid instant return, it would signal to the market that the company has limited investment opportunities.
The company operates in what sounds like a growth sector, networking equipment, but as I've noted above, it isn't delivering much in the growth department. At the same time, Cisco already has many of the attributes of a solid value stock, namely strong cash flow and moderate organic growth, and a dividend could tip the scales in favor of value, leading momentum-seeking investors to look elsewhere for growth.
The company's shareholder profile isn't encouraging, with 19% of Cisco stock held in index funds where managers can't actively choose to rotate funds into the stock. As with General Electric, a rise in Cisco will likely be driven by a rise in fund flows, rather than by company fundamentals. And the way to play rising fund flows is obviously through the absurdly profitable asset managers such as
T. Rowe Price
And then there's the people issue. Like
, Cisco has a huge size and a stagnant stock price that are a turnoff to young, bright, aggressive potential employees looking to do cool things and get rich in the process.
Better Plays in Corporate IT
Competition is also a serious issue facing Cisco. Juniper is still growing at a torrid rate, and China's
, which in the past has been accused of infringing upon Cisco intellectual property, is aggressively ramping up its increasingly legitimate networking-equipment business, which can deliver products at a substantially lower cost than U.S.-based competitors like Cisco.
With a slowing economy and a market unfavorable to cyclical stocks, the best plays in corporate IT seem to be those companies whose products and services offer immediate cost savings, including outsourcing companies such as
, and hosted customer relationship management software companies such as
, all of which have been growing revenue at rates of 40% or more annually.
Cisco's networking solutions may offer efficiency gains, but it is difficult to prove it can save customers money in the short term.
Growth investors looking for outperformance are likely barking up the wrong tree with Cisco, though value buyers will find the stock appealing. But that very dynamic could be causing confusion among market participants, and the result is few new buyers, and this leads Cisco to compete with Intel for the crown of ultimate tech sector market performer.
On the plus side, the obstacles blocking a rise in Cisco will also likely keep it from falling too far, but that certainly doesn't sound like a reason to buy any stock.
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In keeping with TSC's editorial policy, Comeau doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Michael Comeau performs stock analysis for
. His market interests include consumer technology, retail, and small- and mid-cap financials. He appreciates your feedback;
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