It is no secret that Cisco Systems, Inc. (NASDAQ: CSCO) has stumbled.  It has been just about the only real loser of our ten stocks to own for the next decade from the end of 2010.  The reason is obvious and was obvious long before John Chambers decided to enter the confession booth with his letter and memo to employees this week.  We have evaluated what Chambers comments were and what the business model changes will likely be.  There is an obvious outcome that is going to happen if Cisco wants to turn its ship around.  This coming change can ultimately be a great move for shareholders.  Still, there are risks.

First,  Chambers said  that the tech-outfit has become slow to make decisions, has had unexpected surprises, and that it has lost its accountability with customers and shareholders.   Chambers  vowed to attack these shortcomings which he called unacceptable.

The big worry is the internal stress that is going probably be seen.  Chambers noted, “With change comes disruption, and you will see this necessary and healthy disruption… We will address with surgical precision what we need to fix in our portfolio and what we need to better enable.”  In short, areas of the business that are not core and which are not deal-makers may be scaled back even if they are kept alive.  This also means likely changes to employee reporting standards, and likely means changes to compensation.

Chambers also promised to make work easier at Cisco as it aims to make it easier for customers and partners to work at Cisco.  If you are a Cisco employee, that will (hopefully) mean less micromanagement.  Still, having sales managers and division managers give up this control will be no simple thing.  Power, control, and oversight are hard things for anyone to voluntarily give up.  Another promise is to reshape the operational foundation to help the teams.

The new role of Gary Moore as COO is not a coincidence.  Chambers has been the king of acquisition and counting his total acquisitions would be like tallying the number of kills by Conan the Barbarian.  It has been hard to imagine it, but Alcatel-Lucent (NYSE: ALU) has even reportedly been able to get back some of its lost footing.  It is Alcatel-Lucent which almost doubled so far in 2010 when Cisco lost almost one-quarter of its 2011 highs.

Cisco picked a very interesting time to go after the data centers.  It can be no surprise that this disrupted the model.  There was a time that it planned to be the one-stop shop for communications infrastructure.  What changed this notion was the great recession.  If a company could suddenly save 10% or 15% rather than deal with headaches, maybe it was just that fewer number of technicians and IT-support staff that a company would have to give a pink slip to.

Cisco still has a major opportunity ahead.  It is dealing with what is a shrinking pool of companies in communications and its real growth will hopefully come from the wave of content and services providers.  It will continue to see huge international opportunities ahead in emerging markets.  It should not expect that growth will come from government spending any longer.

What about the future of John Chambers?  Jim Cramer just this week turned and capitulated with “It’s time to go” for Chambers.  We have noted that Chambers might not be the right guy to fix Cisco.  This may be true.  He may not even have enough youth left.  Still, John Chambers has grown this company massively and it is hard to imagine Chambers not running the show.  He will eventually go and he has even said that Cisco would likely be run more similar to an oligopoly.  How successful that can be is anyone’s guess.

We have been critical of what has proven to be a silly use of capital to buy back shares.  How has that $60 billion worked out so far?  All that has been accomplished is less dilution from employee options and from dilutive shares to acquisitions.  Chambers has also been too slow to adopt a dividend model and what has been telegraphed to date feels too little and not fast enough.  The company is going to also have to stop making so many acquisitions.  It is very likely that many of those acquisitions have not generated a single real product and many have probably been surpassed as technology has evolved.

There is an obvious outcome that is coming.  International Business Machines (NYSE: IBM) and other tech outfits have recently gone through some changes on compensation for income-producing employees.  While that might not be new, generally speaking companies try to get more output for less compensation.  As businesses mature, management often decides that cutting employee compensation can become the next growth model.  Cisco is going to have get more and more off the stock options model as it is a mature company.  Cisco has historically had many of its sales team members and its support teams under non-compete contracts, but it is very possible that it will face defections to competitors if it changes compensation too much.  The company will have to tread lightly in its “change.”

In competing for business, it is more likely that Cisco is going to get more aggressive on pricing earlier.  Remember, it picked this data center war with Hewlett-Packard Company (NYSE: HPQ) and others.  The result is that Cisco will learn to live with lower margins.  If margins aren’t lower, it may be that Cisco figured a way to compensate workers less and to squeeze vendors more.

Cisco’s stock chart is literally uglier than a hat full of fingers.  The only good news here is that the recent NASDAQ 100 rebalance and the letter from Chambers has helped to generate some added interest.  This will not be a fast turnaround.  The turnaround is also going to fall entirely upon the reputation of John Chambers.  If the turnaround fails, Chambers will be a case study of what not to do for a major company.  A focus on share buybacks, picking a fight on too many fronts, making too many acquisitions and changing models… There are more aspects of course.

When we evaluate companies for a decade, the stumbles of a year are not really an issue.  There is a significant risk that Cisco shares could drift lower yet.  It has not rallied with the stock market of late.  Imagine if there was really a weak stock market.

If Cisco can figure out a way to repatriate much of its locked-up overseas cash, the company would be a huge beneficiary.  About $40 billion of its total market cap is cash and equivalents.

The data center move may only be dwarfed by the move to the consumer level.  UMI is too expensive and there are much cheaper options out there for personal video conferencing.  Linksys brings lower margins, and this Flip product is a so-1990’s model that has probably been eaten alive by the world’s migration to smartphones with ample video recording capabilities.

If you look at the stock chart from StockCharts.com, there is a very worrisome pattern.  Gap-downs are generally followed by recoveries, but the gap-downs that follow are worse than the prior one.  This is simply lower highs and lower lows.

The weakness is likely going to prove to be an opportunity for those who can wait this out.  Investors just need to understand that John Chambers admitted long ago that its mega-growth days were over when it confessed that its growth was going to be tied more and more to global GDP.

Here is the real shocker.  If you saw his admission this week, then why should you not expect another weak forecast ahead?  If things were rapidly correcting themselves, none of the news flow would have been around an apologetic John Chambers with a promise of change.  The translation is that the stock may have still not bottomed out.

At $17.91, the 52-week trading range is $16.97 to $27.74.  Analysts now have an average price target of closer to $23.00.  The trend has been lower and lower and that means a much more tepid set of expectations from the company.  We would not be shocked to see Cisco shares go as low as $15.00 before it is all said and done.  At that point we are under 10-times forward earnings and we would be getting closer to a realistic premium over the real book value of the company.

The good news is that Cisco probably won’t see its shares fall forever… Cisco’s stock might not even get back down to $15.00 again without a real market sell-off.

JON C. OGG

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