Stable Margins And Rising Revenues, Cisco's Race To Be The Number 1 IT Company

| About: Cisco Systems, (CSCO)

Cisco Systems Inc. (NASDAQ:CSCO)

Cisco Systems, Inc. is the world's largest provider of communications equipment for service providers, enterprises, small/medium-sized businesses, and consumers worldwide. Across both service providers and enterprises, it has a dominant share in switches and routers. Switches provided for 32% of FY2012 total revenue and NGN Routing 18%.

Cisco is the overall leader in IP/Ethernet communications infrastructure, having significantly above-average operating profitability versus its industry peers. The collaboration segment consists primarily of tele-presence video conferencing solution and the web-based collaborative offerings (WebEx). The wireless segment provides wireless access points and associated equipment for enterprises. The security segment provides remote access, firewall, VPNs, intrusion prevention, web and email security and network security to enterprises and service providers.

The service segment provides technical support services, such as warranty and maintenance, and advanced services provide consulting and planning services. Breaking down the revenue by product and services, products provided for ~80% of the total 2012 revenue.

For reporting purposes, in fiscal year 2012, the company organized its business into three geographic segments: the Americas; Europe, Middle East, and Africa (EMEA) and Asia-Pacific, Japan, and China (APJC). The Americas, with 58% contributed largest revenue by any segment, are followed by 26% of EMEA and 16% of APJC.

Why We Like Cisco

We like this tech giant for the following reasons:

  1. Long-term topline growth of 5-7%.
  2. Stable/improving margins and increasing revenues.
  3. Well positioned to take advantage of growth in the data center.
  4. Best play in communication equipment.
  5. Potential dividend increases.
  6. Large net cash position.
  7. Commitment to return at least 50% free cash flow to investors.
  8. Recurring revenue to increase to 25% to 30% from current 22%.

Cisco's Analyst Day before year end was highlighted by a very positive tone and an aggressive endorsement of its rising revenues, growth targets, and margin stability as the company is rallying behind its strategic goal to become the leading global IT vendor in terms of growth & profitability. Cisco's confident CEO John Chambers made the case for Cisco's goal of transforming into the number one IT company by leveraging its $180 billion installed equipment base and technical know-how in hardware, software, services, & ASICs.

The company has distanced itself from the traditional networking competitors such as Huawei and Juniper Networks (NYSE:JNPR) and has stepped up the fight to compete with the companies that have traditionally occupied the number 1 IT company status such as Oracle (NYSE:ORCL), HP (NYSE:HPQ), Microsoft (NASDAQ:MSFT), SAP (NYSE:SAP), and IBM (NYSE:IBM). The market's transition to cloud computing provides Cisco a disruptive opportunity to displace the client-server era IT leaders and become the IT leader of the new cloud/mobility era.

Software and ASICs leading growth - Cisco's goal of transforming from the number 1 communication company to be the number 1 IT company comes with a greater focus on software and services. Cisco expects to double its software revenue in the next 3 to 5 years, to $12 billion from $6 billion now. The expected growth in software revenue includes the revenue generated by the company's last 10 acquisitions, 90% of which are cloud or software focused.

The company aims to grow the current services segment revenue of $10 billion at a double-digit CAGR of 10%. Its services strategy will focus on expanding the reach of Cisco's current offerings and moving into automation and analytics, consulting, and becoming a leader in industry-as-a-service, designing, building, and delivering industry solutions.

Cisco is introducing 6 to 8 ASICs over the next 5 quarters. This accelerated roadmap relative to Cisco's typical pace of 4 to 5 ASICs per year represent the company's increasing emphasis on ASICs as a differentiator in its vertically integrated strategy vs. the disaggregated SDN model.

The company expects recurring revenue, 22% of revenue, to increase to 25% to 30% over the next three to five years, driven by growing software portfolio and service revenue. Recurring revenue models are inherently less volatile and drive higher margins, if the company is able to execute its recurring revenue goal, it will prove to be very positive for the stock.

The company expects emerging market revenue growth to outpace Cisco's overall company growth target. Currently 20% of the revenue comes from emerging countries. Cisco expects revenue from emerging countries to grow at a 7% to 13% CAGR and to increase to 23 - 27% of total revenue over the next 3 to 5 years.

Margins - The company reaffirmed its 3-years gross margin guidance of 61% to 62% and raised its operating margin guidance to the high-20s from earlier forecasted mid-20s for the next 3 to 5 years. The company sent a strong message to investors of its ability to expand or at least maintain operating margin and manage gross margin.

For 1Q FY13, the company generated gross margin of 62.7% and for the past 12 quarters has maintained gross margin of 62% or more (4QFY12: 61.9%). During the same period, Cisco guided for gross margin of 61%-62% and always reported as guided or better.

According to a CS report, Cisco's competitive position appears to be improving in its most important product market, enterprise switching, particularly data center switching. On the other hand, the position of its key competitors, particularly HP, appears to be deteriorating. HP appears to be suffering significantly from employee departures both in terms of quality and quantity.

The company also increased its operating margin to the high-20s over the next three to five years, representing an improvement in both duration and magnitude. The company earlier guided operating margin to be in the low-to-mid 20s over the next three years. Over the last three years, the company has reported on average operating margin of 27.7%, ranging from low 24.5% to high 30.3%. Cisco's past performance suggests that the recent guidance is also achievable. Improvement in the company's ability to manage its operating expenses has resulted in higher operating margin guidance.

Buybacks and Dividends - The company reiterated its commitment to return half of its annual free cash flow to shareholders. Although dividends are becoming a significant portion of the mix, share repurchases are the large majority.

Acquisition Strategy - CEO John Chambers noted that over the company's history, mergers and acquisitions on average have added about 1% of annual revenue growth. As part of its growth story, Cisco continues to pursue acquisitions. The company increased its focus on M&A last year. However, Cisco stated that the recent NDS deal at $5 billion is a large one and does not see a new deal in the same range anytime soon.

Cisco's focus is on acquiring companies with cloud and software expertise, with 9 of Cisco's last 10 acquisitions fitting that strategy. The company pointed to the recent acquisition of Meraki, a leader in cloud-based networking, as an ideal acquisition in terms of size and product focus and said that expected future deals would be in this range. If Cisco is planning to be the leading IT player in support of growth in cloud, mobility, and video, we believe storage and big data will be the likely areas for acquisitions. The company maintains that its strategy in the storage market will be based on partnerships.

Acquisition of Meraki

In November, CSCO announced plans to acquire Meraki, an emerging player in the SMB WiFi Market, for $1.2 billion in cash and retention-based incentives. Meraki provides cloud-managed access solutions spanning WiFi, access switches, security appliances, and mobile device management. Cisco is expected to close the deal by the end of 2Q of FY 2013. Meraki has achieved an annual bookings run rate of close to $100 million.

Founded in 2006 by 3 MIT PhD candidates, Meraki's solutions have been deployed across 18,000 customers in 145 countries globally and in many vertical markets including education, healthcare, legal, technology, retail, industrial, and government. Meraki counts Google, DAG Ventures, and Sequoia Capital as investors. The company has over 20,000 customers, and its cloud manages 100,000s of devices. Cisco stated that Meraki would serve as the foundation for its new cloud networking group, based in San Francisco.

We think of Meraki's acquisition as a very smart, value-enhancing move by CSCO. Meraki fits well within the software-centric strategic M&A focus of Cisco. Meraki's acquisition brings to CSCO a cloud-based approach to networking and, we believe, should help CSCO to address the still very young, but looming shift toward software defined networking (SDN).

The acquisition is a strategic positive for CSCO for many reasons. It has the potential to increase CSCO's market share in the mid-market segment, where the company is lagging behind large enterprises. Meraki, for Cisco, represents a platform to a software rich and recurring revenue based cloud networking business, where a substantial part of the software and functionality reside in Cisco data centers and are delivered as software subscriptions. With this acquisition, Cisco will be able to better address the growing SMB market including and especially customers that have little to no IT departments.

Financial and Credit Analysis

Cisco gained 8.7% last year, outperforming Microsoft, Hewlett-Packard, Juniper Networks, and Alcatel-Lucent (ALU), which were up/down 2.9%, -45%, -3.6%, -11%, respectively.

CSCO is trading at a price/earnings ratio of 12.7 compared to the industry average of 28.6 and CSCO's own five years' average of 16.0, the company has a forward P/E of 9.4. In comparison HPQ is trading at a P/E of -2.2 and JNPR at 55.9. Cisco has a price/book ratio of 2.0 compared to the industry average of 2.1. Cisco has price/sales ratio of 2.3 and price/cash flow ratio of 9.1. The company has a dividend yield of 2.9%.

Cisco is trading at $19.65, with a 12-month median target of $22 and high target of $25, representing an upside potential of 12% and 27%, respectively.

CSCO has a debt/equity ratio of 0.31 compared to the industry average of 0.27, and HP's debt/equity ratio of 0.97. CSCO has current ratio of 3.38 compared to the industry average of 2.18, JNPR's current ratio of 2.63, and HPQ's current ratio of 1.09. CSCO's debt/EBITDA ratio of 1.41 is also better than the industry average of 1.59, JNPR debt/EBITDA ratio of 3.0 and HPQ's debt/EBITDA of -3.07. Similarly CSCO's EBITDA/interest ratio of 19.37 is also better than the industry average of 11.79, JNPR's EBITDA/interest ratio of 11.79, and HPQ's EBITDA/interest ratio of -10.59. Finally CSCO has a CFO/total debt ratio of 0.71 compared to the industry average of 0.69, JNPR's 0.73, and HPQ's 0.37. The majority of CSCO's debt matures by 2020 and the company's debt is of a high quality.

Moody's has a rating of A1 on CSCO's unsecured debt, compared to Baa1 for HPQ, and Baa2 for JNPR. Similarly Standard and Poor's has a rating of A+ for CSCO, compared to BBB rating of JNPR, and BBB+ of HPQ.

Source: Google Finance


We have a buy rating on Cisco. We believe Cisco is no longer just a networking company but is becoming a major data center player. The shift to more stable and recurring revenue will allow the company to return more cash to shareholders. The company has a dividend yield of 2.9%. Market share gains, the early days of margin improvement benefits, a solid cash story, and predictable earnings through a rising mix of recurring revenue should support multiple expansion. The company's cost management program is still young and there is room for margin improvement.

The company recently announced that it will return at least 50% of annual free cash flow to investors in the form of share repurchases and dividends. With its switching and data center products, the company remains well positioned to take advantage of growth in the data center. Over the next three to five years, the company expects to double its software revenue, grow services revenue at a double-digit CAGR of 10%, and increase recurring revenue from 22% to 25-30%. Lastly, Cisco continues to perform well even in a tough environment as evident from stable margins.

Risks to our analysis

The company's revenues and growth are increasingly correlated with the trends in the global economy and any sharp decline in the global economy can have a negative impact on Cisco's earnings. A slowdown in the economic growth can also lead to a cut in spending by corporations, which might make it difficult for Cisco to achieve its own and consensus estimates. The company generates the majority of its revenue from traditional LAN switches and enterprise routers. As new low cost competitors move into these segments, they can use price as a primary means to compete, which could threaten Cisco's margins if the company fails to lower its own costs.

Have a good day!

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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