gone from a "must own" to a battered bargain?
It's a shocking commentary that this is the level of conversation about the networking giant's once-unbreakable stock. After all, more than 80% of big-cap growth funds owned the stock at the end of last year, according to
. But Cisco's "must-own" shares have tumbled 58% from their high; meanwhile, some Cisco watchers
see more clouds on the horizon.
Because Cisco posted earnings today, it seemed natural to discuss the company's prospects with top-shelf fund skipper Jeff Van Harte, whose
Transamerica Premier Equity fund beats more than 90% of its big-cap growth peers over the past five years. Van Harte, who recently shed his entire Cisco holding, expresses grave concerns about the company's reliance on acquisitions for cutting-edge technology amid fierce competition from networking upstarts. However, as you'll see, a midinterview gander at Cisco's charts made Van Harte wonder if the upside potential outweighs the downside risk.
TSC: Until not too long ago, Cisco was the must-own stock for growth funds. Recently, you started to sell off your fund's stake.
That's right, we sold the last part of our stake in the first quarter of this year. We started in the fourth quarter.
TSC: What made you decide to pull up stakes?
The first reason was simply valuation. At that point, Cisco's market cap was about $500 billion or $600 billion. At that level, you have to ask yourself: What kind of investments can a company make to continue to drive the market value higher? Mathematically, it's just a big hurdle.
The second reason was that, at the margin, the routing industry and telecommunications industry are shifting to higher bandwidth, optical-type technology. Cisco's routers are not really high-end. I want to be careful here regarding the definition of what's a high-end router and what's not a high-end router. Put it this way: As bandwidth increases -- and clearly all the telecommunications companies are making these investments -- you're shifting to a router that needs to do a lot more. Optical routing components, and the people like
that have that technology, are going to be there.
We felt Cisco was in a position of having to acquire their technology as opposed to creating it. Now, when you acquire it, it costs you more. You have to issue stock, and equity is always your highest cost of capital. The great thing about Cisco is that if they acquire a great technology, they can put it in their system and product offerings and, because they have so many clients, they can make it successful pretty quickly.
But at the margin, it's getting a little tougher. You can't live as a technology company, in my mind, with a sustained competitive advantage over a long period of time unless you're creating the best technology. Why did
or Juniper not sell to Cisco? I'm sure they probably could've had the opportunity if they wanted to. I think they didn't because they felt that they had technology that was ultimately worth more in the marketplace than selling to a big competitor. That's where I see difficulty for Cisco, when you acquire technology as opposed to creating it.
TSC: What do you think we're going to hear today with Cisco's earnings? Some folks think they are going to guide forward expectations lower, even if they meet their current estimates.
Clearly, things have changed. Wasn't it two or three quarters ago that the company said they see growth unbroken for several quarters out? I don't remember how far out the outlook was, but it was an amazing statement.
Since then, Cisco has made more cautionary comments about their outlook for growth going forward.
I don't know what they're going to say tomorrow. I think they're going to make some statement about the current environment and it won't be particularly positive.
TSC: If we can revisit the first point you made, which is a key point, that Cisco has defied the law of large numbers for a while by buying folks in stock transactions -- but right now the stock is in the penalty box.
This puts them in a chicken-and-egg situation: Can they keep acquiring if their stock doesn't go up, but can their stock go up if they don't keep buying?
Laughs. That's great, that's really the right way to think about it. That happens with a lot of companies. If you look back to the '60s, that was how the conglomerates got formed. The just kept using their equity to make acquisitions. And as soon as that game ran out, it got ugly. That's how pooling of accounting method of reporting acquisitions ultimately became popular. Now that's gone. But it really doesn't matter. The fact is, you're right. Once your equity is not as attractive, the sellers won't sell to you; you can't acquire. Analysts have made statements about Cisco, saying the company is in need of acquisitions. They're in a vulnerable position if that equity is not viewed as attractive anymore.
The stock might be a better value here -- certainly, it's a lot less market cap. But I guess I just fundamentally feel that when a company owns its technology, such as a
, I feel better about that.
TSC: Now, in what way could you be wrong about Cisco? What could happen today, or going forward, that could surprise you and make you scratch your head and say, I really have to rethink this stock?
I think it would probably be something like that the demand for networking equipment is so endless that companies have to make such huge investments in telecommunications infrastructure that it doesn't really matter whether you have low-end or high-end routers. Everybody's going to benefit.
TSC: Where do you see this stock going? It's fallen quite a bit, could it get cheaper?
Oh, boy. That's a tough one to answer. Let me look at the earnings estimates and stock price real quick; what's the multiple on this stock right now?
Van Harte checks his terminal.
Looks to me like estimates going forward suggest earnings per share growth of about 25%. You know, Microsoft kind of bottomed out at about 30 times earnings. That's where I can see this stock settling at that level for a while.
TSC: Does that mean it's worth hanging on to Cisco at these levels?
Yeah. Maybe I will have to look at it again!
Laughs. Really, I thought the stock was at least in the high $30s; I'm surprised. It's really down there.
TSC: Given the vast number of funds that own Cisco, is this institutional support going to be a positive or a negative if this folks lighten their exposure to the company?
You know, back when we were selling, there was a lot of money coming out of Cisco. Probably people like
were selling, I imagine. At this point, the stock is at a more reasonable position. It may be that these institutions shaved their portfolios down to where they need to be.
Even if they miss estimates, you've seen a lot of companies miss and miss. At this valuation, it may be that it's priced in. I have to tell you, just looking at the numbers, my mood on Cisco brightened up a bit. I'd have sworn it was a high $30 or $40 stock.
TSC: Any other thoughts on the networking sector?
We're putting some of the optical stocks on the radar screen. We haven't have bought any yet, but the fact that they've come down a lot makes us interested. If we do another investment at this point, we may need to look at a Juniper or come back to
. We owned a little JDS for a time, then sold it. It just ran up too much.
TSC: Would you look at these companies before Cisco?
My bias, again, is to look at the companies that really own the technology. But it also depends on the valuation.