Can Two Tech Titans Get Off the Mat?

Two decades ago, they were the hottest companies in the hottest industry in America. Today, many investors consider Microsoft (symbol MSFT) and Cisco Systems (CSCO) anachronistic has-beens that have been relegated to the dustbin of Wall Street -- an area where even companies with good profits and powerful balance sheets don't get any respect. "These companies are universally unloved," says analyst James Ragan, of Crowell Weedon, a Los Angeles-based brokerage firm. "But that sometimes presents an opportunity."

It’s hard to find better illustrations of the fickle turn of fortune than the stories of Cisco and Microsoft. Back in the 1990s, investing in either of these tech titans was the equivalent of winning the lottery. If you had bought $1,000 worth of Microsoft shares in 1986, you would have had more than $500,000 by March 2000. The same investment in Cisco shares in 1990 would have generated a nest egg worth roughly $1 million just ten years later.

But when the tech bubble popped in March 2000, the share prices of these tech titans crashed, and they have never fully recovered. A $1,000 investment in Microsoft back then is now worth $620. The same investment is Cisco gets you $200.

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Competition from the Cloud

Weighing on both stocks is a combination of perception and reality. On the perception front, Wall Street has concluded that personal computers are yesterday’s story and that all the companies that make and support them are destined for extinction unless they find a way to hitch their fortunes to a faster-moving, more forward-thinking technology.

Tablets and cloud computing -- storing data in an organized and easily retrievable Web site on the Internet -- is the source of most tech hubbub today. But although it’s true that iPads and smart phones are taking the world by storm and that storing data at a central location that can be accessed from anywhere in the world is an appealing idea in an increasingly global economy, that doesn’t mean the PC is dead. Indeed, the Computer Industry Almanac projects that the traditional PC business will click along with annual sales of some 300 million units for the next five years.

Sales of tablets are expected to soar, but part of that forecast assumes that something called Windows 8 -- Microsoft’s upcoming software release -- will help boost business by making tablets more accessible to people accustomed to working on Windows-based products in their homes and offices. Likewise, the advent of cloud computing may nip away at Cisco’s business, but the notion that the routers and switches that essentially serve as the pipes carrying data to the right Internet ports are suddenly unnecessary is nonsense.

Stumbling Stocks

Yet for all of the negative misperceptions, some of the market’s skepticism about Microsoft and Cisco is grounded in substance. Both companies have a history of missteps and squandered opportunities.

Consider, for example, that while Apple (AAPL) is now dominating tablet computing, it was really Microsoft’s idea. Back in 2000, Microsoft chairman Bill Gates was crowing that tablets no thicker than a notebook would eventually dominate personal computing. At the Comdex trade show in 2002, he revealed the prototype of Microsoft’s Windows XP Tablet -- the precursor to the tablet technology that has now taken the world by storm.

There were just three problems: Gates was early. Even laptops weren’t pervasive at the time, so consumers were years from embracing the next generation. Second, Microsoft’s tablet and software were too clunky to overcome consumer skepticism. Finally, Steve Ballmer, who had become CEO in 2000, dropped the project in the face of lackluster consumer demand. Microsoft is now playing catch-up and has promised to deliver by year-end a new version of Windows that will work with cool, streamlined, soon-to-be-revealed tablets.

Investors who have been quietly grousing about Microsoft’s lack of focus have begun publicly criticizing its leadership. At an investment conference in May, hedge fund manager David Einhorn likened Ballmer to the hapless cartoon character Charlie Brown and called on Microsoft’s board of directors to replace him.

Yet Ballmer has managed to do many things right, says Ken Allen, manager of T. Rowe Price Science & Technology Fund (PRSCX). Microsoft’s video-gaming arm created last Christmas’s hot product -- Kinect -- an Xbox device that allows you to use your body as a video controller. In fact, although Windows sales were flat in the fiscal year that ended June 30, Microsoft’s entertainment division thrived, with revenues rising 45%, to $8.9 billion, and operating profits more than doubling from the year before, to $1.3 billion. Sales and profits at the division that sells products to corporate customers are also growing by double-digit percentages. For the year, Microsoft earned $23.2 billion, or $2.69 per share, on $70 billion in revenue -- handily exceeding analysts’ expectations. And aside from one stumble during the last recession, that kind of solid growth has been the rule.

Many analysts think Microsoft vastly overpaid when it agreed last May to buy Skype, an Internet telecommunications company, for $8.5 billion. But they acknowledge that the move makes sense strategically. The unanswered question is whether Microsoft can successfully integrate Skype into its varied product mix, from software to game consoles. For all of Microsoft's successes, the tablet tale, the miserable Windows Vista update and the heavily advertised but easily forgotten Zune music player give investors pause.

That may be why the stock has languished despite the company’s impressive financial performance. “There are almost two stories with Microsoft -- a positive one about the business and a negative one about the stock,” says Allen.

Citigroup analyst Walter Pritchard, who rates the stock a buy, thinks the market is underestimating how well Microsoft might fare in tablets. Besides, at the current price of $24.67, the stock is mouthwateringly cheap, trading at just 8.6 times the average analyst estimate of $2.87 per share for the year that ends next June. Plus, the stock yields 2.6% (all prices and related data are as of August 18).

Investors are less enthusiastic about Cisco. Sandeep Shyamsukha, an analyst at Auriga USA, an institutional brokerage firm, says he expects revenues to grow modestly but profit margins to shrink. The problem? Cisco, still the dominant player in business-to-business communications technology, branched into a variety of ancillary -- and sometimes unrelated -- businesses, from cable boxes to flip cameras. Along the way, analysts say, Cisco lost its focus, allowing upstart rivals to nip away at its core business. The company recently ditched the flip-camera operation and launched restructuring that will eliminate some 6,500 jobs.

But don’t write off Cisco yet. For starters, the company is stilling on $44.6 billion in cash. Not only does it remain the dominant player in its business, providing technology services for 85% of the Fortune 500 companies, it has managed to grow and profit in nearly every environment. Plus, Cisco’s cost-cutting moves are designed to save the company $1 billion in the current fiscal year, which ends next July.

Cisco’s shares rose sharply after the company delivered better-than-expected results for the quarter that ended July 31 and CEO John Chambers reported “solid progress” in Cisco’s turnaround efforts. Still, revenues for that quarter rose just 3.3% from the same period in 2010, and Cisco forecasted sales growth of just 1% to 4% for the current quarter, which ends in October. That’s a far cry from the 27% year-over-year revenue growth in the October 2010 quarter. For the July 2011 year, Cisco reported sales of $43.2 billion and earnings of $1.62 per share, up from $40.0 billion and $1.60, respectively, from the previous year.

On a price-earnings basis, Cisco is about as cheap as Microsoft. At $15.01, Cisco sells at 8.7 times estimated earnings of $1.72 per share for the fiscal year that ends next July. But its dividend, which Cisco began paying this year, isn’t as rich; the stock yields 1.6%. Consumer crusader Ralph Nader, a longtime Cisco shareholder, is pushing the company to hike the regular dividend and make a one-time special distribution, while many analysts say they want to see how well Cisco executes its restructuring plan before they start recommending the stock. For now, Shyamsukha suggests that investors stay on the sidelines. “There are better investment options out there,” he says.

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