Is Cisco Systems, Inc. (CSCO) Destined for Greatness?

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Every investor can appreciate a stock that consistently beats the Street without getting ahead of its fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with improving financial metrics that support strong price growth. Let’s take a look at what Cisco Systems, Inc. (NASDAQ:CSCO)‘s recent results tell us about its potential for future gains.

What the numbers tell you
The graphs you’re about to see tell Cisco’s story, and we’ll be grading the quality of that story in several ways.

Cisco Systems, Inc. (NASDAQ:CSCO)Growth is important on both top and bottom lines, and an improving profit margin is a great sign that a company’s become more efficient over time. Since profits may not always reported at a steady rate, we’ll also look at how much Cisco’s free cash flow has grown in comparison to its net income.

A company that generates more earnings per share over time, regardless of the number of shares outstanding, is heading in the right direction. If Cisco’s share price has kept pace with its earnings growth, that’s another good sign that its stock can move higher.

Is Cisco managing its resources well? A company’s return on equity should be improving, and its debt-to-equity ratio declining, if it’s to earn our approval.

Healthy dividends are always welcome, so we’ll also make sure that Cisco’s dividend payouts are increasing, but at a level that can be sustained by its free cash flow.

By the numbers
Now, let’s take a look at Cisco’s key statistics:

CSCO Total Return Price Chart

CSCO Total Return Price data by YCharts.

Criteria 3-Year* Change Grade
Revenue growth > 30% 34.1% Pass
Improving profit margin (11.1%) Fail
Free cash flow growth > Net income growth 33.5% vs. 46.1% Fail
Improving EPS 58.2% Pass
Stock growth (+ 15%) < EPS growth (4%) vs. 58.2% Pass

Source: YCharts. *Period begins at end of Q3 2009.

CSCO Return on Equity Chart

CSCO Return on Equity data by YCharts.

Criteria 3-Year* Change Grade
Improving return on equity 8.9% Pass
Declining debt to equity 20.7% Fail
Dividend growth > 25% 133.3% Pass
Free cash flow payout ratio < 50% 18.3% Pass

Source: YCharts. *Period begins at end of Q3 2009.

How we got here and where we’re going
Six out of nine passing grades isn’t bad, but for a company in Cisco’s position, it’s a little disappointing. The only truly worrisome failing grade here is the one granted to Cisco on the profit margin test. Its free cash flow levels are quite close to its net income, and could easily pull ahead by the time we examine the company again. Cisco has three times as much cash as it carries in total debt, so that should not be a major issue going forward. Now, how can Cisco turn its flagging profit margins around for 2013?

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