We have been owners of Cisco (NASDAQ:CSCO) for a few years, but recently decided to sell due to what we believe is abundant evidence the company's competitive position is continuing to deteriorate. While on the surface it may seem like Cisco is doing well, we believe there are serious issues under the surface.
At first blush, it's hard to see many problems with Cisco. Revenue, operating income and free cash flow have all grown nicely over the past decade.
Data from Morningstar.com, figures in $M
Revenues have grown at an average annual rate of 6%, operating income at 4% and free cash flow at 5% over the past 10 years. At current prices, CSCO trades at a forward P/E of under 10, well below the market average of around 15. Additionally, it has become a popular dividend stock offering a dividend yield of over 3.5%.
Underneath the surface though cracks having been forming, and there are some worrying trends that have been taking shape.
Declining Gross Margins and Capital Efficiency
Over the last decade, Cisco's ROA and ROIC have steadily fallen.
Likewise, its gross margin has also seen a pronounced downward trend.
Basically Cisco's pricing power is being eroded and it requires ever more assets to grow or maintain sales levels. We believe that this is related to competitive pressures in the company's core network equipment franchise rather than any management or operational issues (which we will address later in the article).
Cisco's Eroding Competitive Position
Some of the threat to Cisco is, or at least should be, well known to those who follow the business. Large tech companies like Facebook (NASDAQ:FB), Microsoft (NASDAQ:MSFT), Amazon (NASDAQ:AMZN), and Google/Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) have increasingly turned to designing their own hardware and buying it directly from low-cost Asian manufacturers. This is colloquially referred to as "white-label" or "white-box" equipment. Originally, we did not view this as a large threat as a vast bulk of Cisco's customers did not have the scale and expertise to do something similar. But things look like they are starting to change for two reasons.
First, the move to the cloud may reduce the purchase of network equipment by small, midsize and even large corporations. For instance, Fortune 500 company XYZ may decide to move a portion of its computing operations that were previously done locally at the XYZ's data center into the cloud. So, XYZ purchases less networking hardware from Cisco because it has outsourced some of its operations to a cloud provider such as Microsoft. Meanwhile, Microsoft is using cheap white label networking equipment to support its cloud services rather than Cisco hardware.
Even if Microsoft uses (and it most certainly does) Cisco hardware, there is still an issue. Say 100 businesses move from local operations to the cloud with Microsoft. Previously, Cisco could get higher prices for its equipment as each company negotiating separate deals and none had the power individually to force CSCO to drop its prices. Now those 100 businesses' demand for networking hardware is basically being fulfilled by Microsoft. MSFT can simply go to CSCO and demand a good deal; otherwise, it'll use cheaper white label hardware.
No matter how you look at things, the move into the cloud is likely going to continue to have a profound effect on both the demand for Cisco's hardware, and more importantly, its pricing power.
Second, various networking companies have sprung up to package white label hardware and open source software into solutions that can be sold to companies that aren't in the "behemoth" category like Facebook or Amazon. Cumulus Networks might be the most well known of the newer entrants. The startup company was founded by ex-Cisco engineer JR Rivers. Furthermore, established IT companies like HP (NYSE:HPQ) are taking the opportunity to use white label hardware and open source software to undercut Cisco on price while offering full service support (something that has kept white label hardware previously relegated to only huge computing users). This is not to mention competition from other companies like Dell, Juniper (NYSE:JNPR), and Accton (OTC:ACCCY).
Additionally, network engineers are starting to rethink the way networks are built and managed. Previously, networking hardware and software were integrated in the same device, and each piece of network hardware was updated or changed individually. Enter Software Defined Networking, or SDN. There seems to be no universally agreed upon definition of what SDN specifically is, but at a high level, it is the removal of the management level of the network from each individual piece of hardware and to a centralized software suite. The threat to Cisco is that a large piece of its value add and justification for price premiums will be removed. With SDN cheaper, generic hardware will be able to be more readily substituted. Indeed, we've already seen Cisco's gross margin fall from 66% to 60%. What happens if network hardware margins continue falling to the level of gross margins on server hardware (where virtualization and centralized management have virtually wiped out the value-add part of the hardware business) which are in the neighborhood of 10% to 20%.
Yet, despite all these threats, Cisco has been able to increase profits. Does that mean its business is secure and the threats are overblown? Hardly.
The Real Reason Cisco's Profits Have Remained Strong
We believe the degree to which these threats have been hurting Cisco has been masked to some extent by operational improvements and cost-cutting measures. We are not saying that prudent cost-cutting measures are bad, and certainly, operational efficiency improvements should always be applauded by investors. What we are saying is that these moves have made CSCO appear more attractive and profitable than its underlying business momentum would suggest.
Cisco's management has made great strides in improving the business's operational efficiencies. Inventory turnover has increased markedly over the decade.
Additionally, it is doing a better job at translating sales to cash with its cash conversion cycle falling noticeably during the last decade.
Cisco has also benefited from cost cutting and better tax rates. For instance, its R&D spending has dropped by about two percentage points.
And the company's tax rate has dropped by around seven percentage points over the last decade.
There is a limit to how much Cisco can save in taxes, how much R&D spending can be reduced (and really with the threat of SDN on the horizon is reducing R&D spending really prudent?), and how many efficiencies management can wring out of the company.
We believe that over the coming years, the competitive threats on the horizon will start to impact Cisco's net income and free cash flow as management reaches the limit of operational and tax improvements. Cisco's stock is certainly cheap, but it may be cheap for a good reason. We decided the risk was too great and elected to move on to a better investment with a greater economic moat.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.