Slim Margins Are a Real and Continuing Problem for Cisco Stock

While the Cloud Czars and their software customers have been stars in the COVID-19 market, Cisco Systems (NASDAQ:CSCO) plods along. CSCO stock entered trade today at about $46, down 4.5% on the year. Its moves have almost precisely mirrored the broader S&P 500 average, which is down 6%.

Slim Margins Are a Real and Continuing Problem for CSCO Stock
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Cisco makes hardware at the heart of today’s Internet, but this is not where the profit is.

This has surprised a lot of investors and analysts. It surprised me. I bought the arguments about 5G driving growth in May 2019, at $51/share. I sold in March at a loss, even after booking nearly a year of dividends. It was an impatient strategy. I should have stayed in.

That dividend was recently raised to 36 cents per share, a yield of 3.18%, but it’s fool’s gold if the underlying asset’s value falls.

Government Help and CSCO Stock

The government in Washington says it is here to help. What it wants is to boost Cisco’s prospects in 5G by buying rivals Ericsson (NASDAQ:ERIC) and Nokia (NYSE:NOK), creating a stronger play against China’s Huawei.

The Trump Administration has been heavily pushing this state capitalist ideal. They’ve even talked up boosting the Europeans’ value with tax breaks or export-import credits. But Huawei keeps winning, because tower hardware is a low-margin business, and because it keeps spending on research despite those low margins. The research budget at the Chinese company is now bigger than those at its western rivals combined.

Hardware profit problems are not unique to Cisco. Hewlett-Packard Enterprise (NYSE:HPE) and Dell Technologies (NASDAQ:DELL), both long-time enterprise hardware leaders, have both stalled out. Software is so far ahead of hardware that Dell is now worth barely half of VMware (NYSE:VMW), even while holding the majority stake in it.

Carriers, customers and suppliers have organized as the Open RAN Policy Coalition, seeking open standards against Huawei, but the Chinese are still winning the race to 5G. It isn’t even close.

Security is Hard

Cisco saw this coming and had a strategy to combat it.

It entered the chip market last year with what it calls “Silicon One.”

It has also invested heavily in software, hoping to replace choppy network sales with steadier subscription revenue. It has bought security companies like Skyport Systems, Duo Security, and Sentryo, building a subscription software business CEO Chuck Robbins has promised will grow.

The most important value in Robbins’ arsenal is security, but security is hard. Cisco recently disclosed four more critical flaws in its industrial routers. While it has issued patches, 5 of the 40 vulnerabilities it has disclosed just this month are listed as critical.

The result is a lack of growth. Cisco’s 2019 revenue was just 4% ahead of its 2015 total, and its first quarter puts it on a pace below that. Cisco still had $28.5 billion in cash at the end of April, however. Its $15.8 billion in operating cash flow last year makes the dividend affordable, even at $6 billion/year.

The stock’s five-year performance under Robbins still averages 9%/year, but trails that of the market averages. While it’s a conservative holding for major institutions, it’s mainly a place to park money until better opportunity comes along.

The Bottom Line

America is a capitalist society. Our companies don’t respond well to government mandates, even when they are well-intentioned.

Investors and corporations seek the highest profit margin businesses. Smaller, less-developed states like China grow by investing in lower-margin sectors so they can scale. Large companies with thin margins draw capital by sharing profits with shareholders.

Cisco is doing the right things. That doesn’t make it the place to go for capital gains. It shouldn’t make Cisco a state-run enterprise, either.

Dana Blankenhorn has been a financial and technology journalist since 1978. He is the author of the environmental thriller Bridget O’Flynn and the Bear,  available at the Amazon Kindle store. Write him at danablankenhorn@gmail.com or follow him on Twitter at @danablankenhorn. As of this writing he owned no shares in companies mentioned in this story.


Article printed from InvestorPlace Media, https://investorplace.com/2020/06/slim-margins-problem-csco-stock/.

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