Description

Cisco Systems, Inc. (CSCO) is a mega-cap technology company that develops, manufactures, and sells networking and communications hardware, software and services to the global IT industry. Over the years, Cisco has evolved into a true tech goliath, with an enormous installed base that DB estimates at over $250 billion, comprising ~840,00 customers, which affords it all the advantages of being an integrated tech platform and one-stop shop, along with tremendous global brand awareness and economies of scale. Yet, today, due to various recent industry and competitive trends, and uncertainty over technological innovation within the company, Cisco trades at a very inexpensive EV yield of 10.1%.

We think the market’s concerns are overdone: Cisco is still the dominant player in the enterprise, with a stable business generating lots of cash, and there are reasonable growth prospects for the company as it shifts its business model away from its legacy hardware business and towards new higher growth areas within software and services, a change that is occurring more quickly than the market thinks.

Bear Case 

The bear case against Cisco, however, is compelling. In the bear view, Cisco is an aging behemoth, losing market share in its core switches and routers markets to a host of smaller, nimbler competitors, who are leveraging disruptive new cloud-based networking software technologies to attack Cisco’s old-fashioned hardware franchise.

Cisco’s market share has declined across multiple categories in recent years. Indeed, in the current fiscal year, each of Cisco’s top 4 product categories, which make up over 80% of its product revenues, are shrinking at single digit rates. Ouch!

The bears argue that in today’s increasingly software- and cloud-based world, Cisco’s core business of switches, routers and hardware are a little like toasters. And if you are making toasters, there’s not much of a technology edge available; ultimately competition becomes a manufacturing efficiency game in which others enter the market and compete margins and returns on investment down to unattractive rates.

We think this is the wrong perspective for understanding Cisco.

Before getting into the business segments, we would observe that the scale and breadth of Cisco’s business allow for much more analysis than offered here. Each business segment is multi-billion dollar business on its own, and the company is changing so quickly several different analytical frameworks – old and new – can be used to understand it. The company is like an onion – there is layer after layer of detail for those who want to look deeper. But providing exhaustive and granular detail is not our purpose. We think that understanding a few of the big revenue pieces and dynamics of how the company’s product offering is changing will give a sense for why it’s a value stock today, but nevertheless is still a franchise worth owning at this price.

Business Segments

Switching

Cisco’s largest product segment, comprising ~40% of product revenues is network switches, a market in which it is the global leader, albeit a faltering one. Businesses use switches to connect devices to each other via a network, such as a local area network (LAN).  They might connect PCs, printers, servers and so forth. Switches essentially allow devices to communicate in an efficient way within a network. As bandwidth use has exploded in recent years due to new voice, data and other requirements, next generation 10GbE, and 40GbE high performance switches have been essential to efforts within enterprises to maintain network performance. 

According to IDC, the worldwide switch market has grown steadily over the past few years, including at a modest ~3%-4% rate in 2016 and early 2017, driven by strong international growth, and customer movement to higher speed (e.g.,10GbE) switches. Despite these reasonably favorable dynamics, Cisco has been unable to take advantage, with switch revenues shrinking along with market share, which was at ~56% in late 2016, down from ~59% a year earlier, and from ~75% in 2011. We’ll come back in a moment to this market share erosion.

NGN Routing

Cisco’s second largest product segment is routers, which make up ~22% of its product revenues. Routers allow networks themselves to communicate with one another and direct traffic among them. Routers can take raw information from a broadband signal (e.g., from a modem) and interpret it for different receivers, such as a computer or a phone, which might be on a subnetwork. Crucially, routers can be used to enhance the effectiveness of firewalls and network security.

The global market for routers has also grown, but more modestly than that for switches over the past few years, including ~1% during 2016. Cisco is the market leader for routers with a share of ~42% at the end of 2016, down from ~45% a year earlier, and down from greater than 60% in 2011. The company, while still a dominant participant in routers, is losing market share in this segment as well.

Software Defined Networking

What accounts for Cisco’s shrinking share of a growing market? Although switches and routers are Cisco’s bread and butter, in today’s tech world, such hardware is increasingly viewed as a generic off-the-shelf, “white-box,” commodity that can use merchant silicon and run open source software. Today’s networks are defined not by hardware, but by the software layer offered as a Software-as-a-Service (SaaS) product that defines the price/performance characteristics of the network.

Arista Networks is a good example of the threat to Cisco’s core business from software-driven, cloud networking competitors. Arista makes switches and routers that use silicon from Broadcom, but more important, offers proprietary “containerized” software to serve the networking needs of large cloud businesses like Facebook and Google.

Cisco recognizes that the world is changing, and is responding in kind by moving its business towards a service and software model delivered in the cloud. 

Collaboration

Collaboration, which is Cisco’s third largest product segment, making up ~11-12% of Cisco’s product revenues, offers a microcosm of this trend. Collaboration allows the integration of voice, video (e.g., videoconferencing), and data (e.g., web sharing), across applications such as blogs, chat, shared work spaces, etc., and across multiple devices, such as phones, PCs, tablets, etc. 

Collaboration revenues are shrinking modestly today, but within the segment there is a shift from revenues from sales of on-premise, endpoint hardware, such as phones, to recurring revenues from Application software sales, in this case conferencing software. An example of a SaaS Application hosted and delivered through the cloud is Cisco's Spark Board, a collaboration and meeting room software solution. In the most recent quarter, ~700 customers adopted this new solution.

In fiscal 2017, approximately 58% of Cisco’s Application revenues were software-based, and the company anticipates its Application business will grow at high single-digit rates, as the company continues pushing into software and the cloud. This type of shift to software has various implications for near-term and longer-term revenues across Cisco’s business segments.

Shift to Software Subscriptions, Growth in Deferred Revenues

Traditionally, when Cisco has made hardware sales, such as within its core markets for switches and routers, it has recognized revenues when a box left the warehouse, and the customer had a perpetual license for software associated with the device.

Under Cisco’s transition to software-as-a-service (SaaS) and cloud-delivery sales model, customers will pay a yearly licensing/subscription fee for software that is continually updated. While up-front revenues are smaller than under the previous model, under the new model they are recurring and more predictable as deferred revenues are recognized over time.

Cisco anticipates that over the next 3 years deferred revenues from software products sold as a subscription will grow at a 5%-10% CAGR. Moving to a SaaS model may cause a near-term revenue decline, as larger up-front revenues are replaced by smaller per year ongoing subscriptions, but over time this effect will be mitigated as the volume of subscriptions builds; in fiscal 2017 approximately 10% of product revenues were recurring, while in 2020 the company expects approximately 20% of product revenues will be recurring.

Cisco expects software to represent ~30% of revenues by FY 2020, up from ~22% in FY 2017. That is a significant change.

Security

Consider Security, which represents only ~5% of Cisco’s product revenues, but which is growing at near double digit rates. Several products within Security are driving this growth, including unified threat management, with growth of approximately 50%, and advanced threat and web security, both of which are growing at over 30%. Cisco’s strength in networking position it ideally to become more successful in Security, where it can offer a standalone, cloud-based software solution. In fiscal 2017, approximately 47% of Security revenues are represented by software sales; note that in the most recent quarter deferred revenue within Security grew 39%.

Service Revenues

Cisco is also moving its business towards Service Revenues, which increased this fiscal year across all segments, and are growing at single digit rates, today making up approximately 25% of Cisco’s revenues.

Advanced Services account for most of this growth, including Solution Support, with 51% revenue growth over past 2 years; Software Support, with 11% revenue growth over past 2 years; and Technology Advisory Services, with 4% revenue growth over past 2 years.

Aggregate Service Revenues are growing at an approximately 4-5% rate, which may increase due to additional focus on high growth security, cloud, and automation areas.

Service Revenue, consistent with the software subscription models it supports, is also trending toward recurring revenues. Today, ~30% of product + service revenues are recurring, and Cisco anticipates that figure will go to 37% by 2020.

Wireless and Data Center

Wireless and Data Center combine to make up approximately 9% and 7%, respectively, of Cisco’s product revenues. This fiscal year, Wireless is growing modestly, while Data Center has shrunk.  

The reason we combine Wireless and Data Center here is because Cisco’s core business of Switches and Routers combine with these business lines to form Cisco’s Infrastructure Platforms. This is where we may see the most pronounced shift to software over the next few years.

As the largest networking company in the world, Cisco is poised to benefit from the growth of the “Internet of Things” (IoT) and connected devices worldwide. IDC projects that the IoT endpoints will grow from14.9 billion in 2016, to 82 billion in 2025.

Infrastructure Platforms

Software revenues today make up only 14% of revenues in Infrastructure Platforms, but that is changing rapidly. Cisco anticipates that Deferred Revenues for Infrastructure Platforms will grow through 2020 at 20+% CAGRs.

There are a few key drivers. Cisco ONE software is a new portfolio of software products that spans the technology categories of data center and cloud, WAN, access, and security. Cisco Enterprise Agreement spans infrastructure, data center, security and collaboration portfolios. Digital Network Architecture is focused on centralized network management, in environments characterized by trends in mobile, IoT and the cloud.

M&A Activity Accelerates the Move to Software    

One mechanism Cisco employs to accelerate its push into software and services, and maintain their pace of innovation, is through a steady diet of acquisitions. Indeed, 80% of the company’s acquisitions over the past 4 years were of software businesses, and these have been successful. For instance, two of Cisco’s higher profile acquisitions in recent years, Meraki and Sourcefire, have both earned double digit returns. More recent highlights of this effort include a variety of firms.

Last month, Cisco announced the purchase of Observable Networks to complement its organic growth in Security. A few months ago, Cisco spent $610 million to acquire SD-WAN competitor Viptela. In January, Cisco announced it would purchase software data platform AppDynamics for $3.7 billion just before AppDynamics was to go public.

Cisco maintains a ~160 member dedicated integration staff, and prides itself on its ability to maintain 80% of acquired talent. This M&A activity provides the company access to new markets and accelerates the move towards software and services.

Brand

Cisco is a top global networking brand with strong name and brand recognition. It has a reliable product set, stable market position, and well-established customer support and service. Whatever you may think about the prospects for Cisco’s legacy hardware business, it continues to be a market leader in networking. The brand, and the company's technology know-how and experience, contribute to its franchise value, enabling the company to earn high returns on capital, generate cash flow and maintain stable margins.

Strong Returns on Assets and Capital

Cisco has a remarkably consistent ability to generate returns on its assets. This is reflected in its long-run (8 yr.) geometric average return on assets of 8.7%, which in our universe of tradeable stocks puts it in the 73rd percentile. Not bad for a $160bn company.

Cisco’s long-run ability to generate returns on capital is also impressive; it offers a compound return on capital of 11.7% over the past 8 years, placing it in the 68th percentile of our universe.

Cumulative Free Cash Flow to Assets

Cisco has been a cash flow machine for its owners. Over the past 8 years it has generated ~$85 billion in free cash flow, representing 71% of the assets on its balance sheet. When scaled by assets, this places the company in the 80th percentile of our investable universe.

High and Stable Margins

Cisco is able to maintain its margins through a variety of means, including accretive acquisitions, benefits of scale, pricing power across its product portfolio, and cost savings driven by the move to software and services. Below are Cisco’s gross margins for each of the last 8 years:

TTM 63.1%

2016 62.0%

2015 60.4%

2014 60.1%

2013 60.9%

2012 61.4%

2011 61.9%

2010 64.6% 

These are high and extremely stable margins, by any standard. We have an internal methodology that combines how high margins are with their stability (using a sharpe ratio approach) to compute overall margin strength/stability. We find Cisco is in the 87th percentile of all tradeable companies by our measure.

Financial Strength

The company has had strong free cash flow over the past 12 months, and has grown free cash flow in 5 of the past 7 years. In addition, free cash flow exceeded net income, which indicates that company is not using accruals, which would be an accounting red flag for us.

For the trailing twelve month period, Cisco generated 8.8% return on assets, and an 11.6% return on capital. Both figures are nearly identical to the long-run geometric averages cited above. The company has also paid down debt over the past 12 months. The company has grown its margins in each of past 3 years.

The today company holds approximately $68 billion in cash, with almost all of that total held overseas. The Trump administration has proposed a one-time 10% tax on all repatriated cash, so in the event that were to occur, Cisco could see significant value creation.

Return of Capital

Over the past year, Cisco has been a net repurchaser of stock. This is in keeping with a long term trend. Over the past 10 years, Cisco has devoted approximately half of its free cash flow to share repurchases. Since 2002, Cisco’s shareholder friendly use of free cash flow has enabled it to repurchase approximately 32% of its shares. Cisco has also grown its dividend at a 30% CAGR since 2011.

The below figures represent the percentage of free cash flow return to shareholders (through dividends and repurchases) over the past few years:

FY14 120% of FCF

FY15 73% of FCF

FY16 70% of FCF

FY17 ~70% of FCF

Conclusion

It is said that turning an aircraft carrier is a gradual process. Likewise within Cisco, change will not occur overnight, but from a multi-year perspective the company is on the cusp of a significant shift in its business model.

Cisco anticipates growing its software business at 12%-15% CAGRs through 2020. While Cisco is today primarily a hardware company, within the next 3 years it will become a software company, as software and service revenues will for the first time exceed those for hardware. The revenue mix will reflect this change, going from today’s predominantly perpetual software licenses, to predominantly subscriptions by 2020. These profound changes are masked by the company’s declining legacy business, leading to a shortsightedness by the market, which is focused only on the decline in Cisco’s core switch and router markets.

For this reason, the company is on sale today, with an EV yield of 10.1%, cheaper than > 90% of stocks we consider for investment. We believe Cisco represents good value at this price.

Catalyst

- Shift to software and services

- Growth in recurring revenues

- Growth of Applications and Security

- Continued return of FCF to shareholders