Cisco Moves To Virtualize Network Servicing

| About: Cisco Systems, (CSCO)

Cisco's (NASDAQ:CSCO) CEO John Chambers recently laid out the company's strategy for the coming years that aims to transform the business from a router and server developer to a software and service company. This change will come through an increase of software revenues from $6 billion to $12 billion in the next five years. By then, Cisco will be earning a quarter of its revenues from software, as opposed to about one-fifth it earns currently, after which the software revenues are expected to grow at an annual rate of around 6%. Although Cisco has been trying to reposition itself as a software and service company over the last couple of years this is the first time that a clear plan in this regard has come forward.

However, this shift is not going to be as fundamental as that of IBM's (NYSE:IBM) as Cisco will continue to operate with its partners such as Accenture. The IP connections are already growing and Cisco's leadership in that market does give it an advantage. More importantly, as the world moves towards "internet of everything", there are very few global companies that can provide utility scale services for high-end network technologies and Cisco is one of them. Currently, Cisco and IBM are working on the futuristic home for urban population, the "smart-cities," in Madsar City, Abu Dhabi and Songdo, South Korea. This is one area where Cisco will try to focus on providing services related to new and innovative technologies.

In the meantime, Cisco's market cap has recently reached $105 billion making it the 26th largest company of the world. However, that is still about half the size of IBM's cap of $219 billion. But the interesting point here is that IBM has $12.2 billion in cash (as on 30th Sep) reserves while Cisco has more than three times that amount. It is sitting on a pile of $45 billion (as on 27th Oct), in spite of the string of acquisitions it has done recently - ten in 2012 alone.

In the last two weeks of November, the company has taken over three firms, most notably cloud networking startup Meraki Inc for $1.2 billion cash. Meraki had been planning for an IPO but with the IPO market difficult and U.S. investment banks currently very skittish after the Facebook and Zynga IPOs, made Cisco's "very significant offer" a much more attractive exit strategy for CEO and co-founder Sanjit Biswas for his investors. Meraki initially started as a research project by three MIT grads and is now 330 people strong and has attracted an impressive clientele for its cloud-controlled networking systems from MIT and Stanford University to Peet's Coffee.

Cisco's acquisitions have highlighted its strategy to move deeper into software. Almost all of its 2012 acquisitions - nine out of ten - have been of software/cloud companies. In its previous quarterly results, despite the poor performance of routing and switching operations, Cisco beat both profit and revenue estimates by posting $2.6 billion and $11.9 billion in quarterly profits and revenues, both growing by 11% and 6% respectively. The positive results were partly attributed to the 12% increase in service (read software) revenues.

Cisco currently dominates the global layer 2/3 Ethernet switch market with 62.2% share. Its closest rival is the directionless Hewlett-Packard (NYSE:HPQ) with 9.3% of the market. But, routing is not Cisco's story anymore, it is their hard charge in the server market which has their Universal Computing System (UCS) growing at a 40% rate year-over-year in the third quarter with a 56% rise in revenue. Not only is UCS a hit, it's pulling blade server market share away from H-P and IBM quickly. Cisco has moved from less than 2% of the x86 blade server market - which according to Gartner makes up 91% of the total blade server market - in the U.S. to more than 22% in the three years since its release.

The Meraki acquisition along with others gives Cisco a cloud-based management system to build on top of their easier to administer physical networking solutions. Other acquisitions at this point made with that mountain of cash will be to acquire a server business for itself. Data center giant Rackspace (NYSE:RAX) - market cap is $9.8 billion - is a natural move.

For its second quarter of fiscal 2013, Cisco expects revenues to grow by up to 5.5% to $12.1 billion. At this point that estimate looks conservative and it wouldn't be surprising if Cisco manages to beat the analysts' forecasts again, which would be the eighth time in a row. Moreover, it does so while trading at a non-premium multiple of just 12.8. But, with $45 billion in the bank Cisco will continue to go on the acquisition offensive while also jettisoning low-margin home networking maker Linksys, which it has hired Barclay's to handle the sale of.








































With its faster than expected growth in blade servers, piles of cash and a good track record of making astute acquisitions - unlike its chief server rival H-P - while also trading at a value multiple make Cisco an attractive stock right now. We liked their prospects earlier in the year and this aggressive move to acquire Meraki only improves that opinion.

Disclosure: I 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.

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