Description

As a long time CSCO bull, we both favored and followed the company for years, and it saddens us to say that CSCO is now a compelling structural short (or at least reducing one’s positions).   As the leader in a maturing industry that is now clearly commoditizing, the company will continue to lose share in its key markets (switching and routing) which comprises ~60% of revenues.  The company is headed into a period where it will see continued anemic growth/declining revenues, and margins will deteriorate (its hard to maintain 60%+ gross margins as your products commoditize).  Ultimately, CSCO will trade in-line with other large-cap technology hardware peers (i.e. HPQ, Dell pre-buyout) at ~4.5X EBITDA.  Importantly, consensus assumes CSCO’s recent woes will be temporary and expect earnings to be flat next year (despite declining revenues) and a miraculous rebound in 2015, (when presumably emerging markets recover).  We believe that CSCO is in the early innings of an long earnings decline, as competitive forces rise and the company’s competitive position erodes.   We expect shares to trade <$15/share (vs. $21.50/share today) within the near term. 

Since CSCO is a well-covered company (written up previously on VIC), we will not discuss in detail its business, its business model, or the networking equipment industry.  (In fact, research coverage is very good for CSCO particularly with the presentation of pro-forma historical financials).  Rather we will briefly focus on some of the key challenges CSCO is facing, and why we think the company’s earnings should decline in the future.  Specifically, based on our conversations and research to date, we believe that switching (low and high end) and edge routing are particularly challenged as CSCO’s competition increases and as networking architectures shift to Software Defined Networking (“SDN”) over the next several years, which will disrupt the CSCO installed base / ecosystem and commoditize networking equipment.  

For years, the mantra “no one gets fired for buying an IBM” was adequate to describe CSCO’s competitive advantages as the leader in networking equipment  (technological innovation and R&D spend, and installed base and ecosystem of administrators trained and accustomed to CSCO standards, and reputation within IT purchasers as the “safe choice” with the lowest total cost of ownership).  For many years, all of this was very true, particularly since network architectures naturally favored one standard/preferred vendor (compatibility issues, training of engineers, repeated certification standards, etc.) which CSCO monetized exceptionally well with premium pricing and high margin services contracts. That one vendor was CSCO, who had little competition and captured historical market shares of 60-70%+ in the switching and routing markets.  

In fact, a few years ago, this well-known barrier to entry that allowed us to easily dismiss the emerging threats in enterprise switching and edge routing, when they first appeared.  At the time, it was unclear how new entrants (HP, Huawei, ALU, etc.) in the switch/edge routing markets would impact CSCO.   CSCO was introducing new products, reorganizing the company, and SDN was in its infancy.  The strong secular tailwinds and the “Cisco Gold Standard” made for a compelling investment when CSCO was trading ~$15/share in 2011. 

However, numerous conversations with tech executives and IT administrators today give us a different perception.  (Btw, I don’t know any IT professionals today would say they wouldn’t get fired for purchasing an IBM server, except maybe those that retired 10 years ago.)  We believe CSCO’s “moat” in these two key products (~50% of product revenues, ~60% of total revenues including services) is deteriorating (market share has already fallen ~10%) and that it will be hard for the company to retain the high margins and near monopoly position it’s historically exhibited.  We believe we are seeing evidence of this in the company’s recent financial performance and the revised guidance. 

CSCO has traditionally been a switch and routing company which comprises ~60% of the company’s revenues (estimated including services revenues).  The switching industry is a mature industry that has grown slowly in the past several years.  The switch market can be bifurcated into low-end switching (mostly used by small and mid-sized businesses) and higher end switching (for large enterprise and data centers).  CSCO has been over serving the low end for years, and now most of these enterprises frankly don’t need premium switching products (diminished returns from technology – i.e. Moore’s law has moved faster than most small enterprises need) and many are beginning to outsource much of their IT needs. 

HP entered the switching market and has been successful as a low-priced entrant.  They have continued to gain share, and the battle for these small/mid-sized customers has only gotten more competitive as the years have passed and as acceptance of HP grows.  According to many IT professionals, HP, which has existing relationships with many businesses (i.e. servers) offers much of the same assurances on product warranty/reliability/quality and the support staff that CSCO does.  In addition, HP has now been in the market for several years and is establishing itself as a viable alternative with a track record (at discounted prices, usually bundled with server sales).  Hence, CSCO is facing real competition at the low end of the switch market.    

A similar story can be told in edge routing (vs. core routing).  In the routing market, demand will continue to be driven by rising IP traffic, and core routers will likely be dominated by CSCO for a while (core routing is the least price sensitive, and requires high levels of sophistication and coding that caters to CSCO’s strengths and customer services).  However, at the edge (lower capacity, less differentiated routers) CSCO is facing significant challenges as ALU/JNPR/(Huawei in emerging markets) continues to gain significant share.  Some of this is because the carriers simply wanted more vendors and didn’t want to be reliant on CSCO, some of this is because competitors has offered as effective products or compete well in certain niches (ALU  for fiber optic and mobile), and some is simply that carriers’ purchase decisions at the edge simply no longer feel the need to pay the premium for the CSCO products.

At the higher end of the switching market, which is primarily used by data centers and large enterprises that have large networks and significant data demands, CSCO has historically been dominant as these customers in this part of the market are particularly focused on reliability and compatibility with existing data center infrastructure.  At this end, vendor switching is especially difficult and HP hasn’t made significant inroads.  However, SDN, is rapidly growing in acceptance at data centers and in the next few years, we expect to more data center administrators to adopting SDN.  Based on our diligence, SDN is going to gain acceptance and dramatically change the value of having one preferred vendor.  (Basically, SDN adds an open technology software layer above the equipment to shuffle IP traffic – no longer is the traffic routing decisions made at the switch/router level, but at a meta-layer above the equipment. The result, is that the equipment is little more than a commoditized box and equipment vendor decisions will be interchangeable.) We believe this is a real threat to CSCO (and all equipment manufactures) as equipment (even at the high end of switching) essentially becomes a commodity.  Though SDN is still in the early stages, most administrators we’ve spoken to admit CSCO compatibility will be far less relevant in the future.   To compete, CSCO will have to be more of a software vendor (which they aren’t right now) and we don’t think will retain 60%+ gross margins on their equipment.

We view much of the recent weakness (-4% yoy product sales)/guidance (-8-12% yoy) reported by the company is an early warning sign of things to come.  (The last time revenue declined like this was in the credit crisis.  The macro environment is not strong, but it would be hard to assume all of this is macro related.  And this is from a company which has historically generated high-single digit/mid teen revenue growth in a sector that should be growing rapidly).  We think the “pause in demand” and “particular weakness in emerging markets” we think is a sign of the increase competition and price sensitivity to CSCO products.  In addition, CSCO right now is going through product introductions in Switching and Routing that we understand to be  have been bumpy and that CSCO currently has a pretty weak backlog.

We recognize that CSCO appears cheap on an absolute basis and on current earnings (its trading at 5.3x 2013 EBITDA, or 10.7X PE, 6.3X PE ex-cash, 7.8X PE ex-cash and tax-effected, depending on how you view the excess cash).  However, we think CSCO’s revenue and earnings will decline and investors will re-rate the security.  (Consensus, for some reason thinks earnings will be flat next year despite declining revenue and that both revenue and earnings rebound in 2015).  We anticipate EBITDA down -13% to $13.8BN (6.0X EBITDA) next year and EPS of $1.76 (12.2X PE, 7.1X PE ex-cash, 8.9X PE ex-cash tax effected).  We do not see how earnings rebound thereafter.  Remember, margins for CSCO are 60%+, so it will be very hard for CSCO to find enough cost cuts to continuously offset share losses in switching and routing.  Since we view earnings for CSCO in decline, we think the company should be valued like the other mature large cap technology hardware names and trade in-line with HP, INTC and Dell (pre-acquisition) at ~4.5X EBITDA.   Based on our estimates, we think this implies a stock price below ~$15/share within the next several years.   We recognize we would rather short a high multiple business in decline, but we feel that there are enough headwinds to CSCO’s future earnings that in this case it is worth consideration (or at least reducting one's position).

Risks:

-          Increased dividend / share repurchase - CSCO still generates significant cash and has a large excess cash balance (however, only $6BN of the company’s $48BN is domestic)

-          SDN adoption takes a more modest pace

-          CSCO can temporarily offset revenue losses with costs savings

-          Share losses in switches and routing offset temporarily by growth other products - wireless, data center, etc. (however, these are typically lower margin products and CSCO has competition here too – Aruba is gaining share in wireless, etc.)

-          Strong management team (i.e. Chambers)

-          Successful new product launches

Catalyst