The best companies recognize when they need to change, and have a clear vision for executing that process. Cisco Systems (NASDAQ:CSCO) took another step towards becoming a leading cloud-based services provider when it acquired CloudLock for 293M in cash and equity. The Internet of Things phenomenon has facilitated a shift in how companies access, manage, store, and protect information. In response, CSCO has expanded into secular growth areas such as software, security, datacenter, and cloud. One particular area of focus is cloud security. CSCO purchased SourceFire Inc., a provider of security hardware and software, for $2.7 billion in 2013, and bough OpenDNS, a malware blocker, for $635 million in 2015. In the latest quarter, CSCO's security business grew 17%. With more and more companies decentralizing their operations, Cisco will continue to tilt its portfolio to cloud-based services through acquisitions. While many firms struggle to expand successfully into new, less familiar areas, Cisco has important advantages that will smooth out the process and increase the likelihood of success.
The latest addition to Cisco's software security portfolio, CloudLock, is a product of the firm's Security Everywhere Strategy, which is designed to provide greater visibility into multiple network areas (including enterprise, data center, cloud, and mobile) to protect against the growing threat of cybercrime. CouldLock's service allows corporate clients to "monitor their users and data that have migrated to outside servers run by cloud providers". What differentiates CloudLock is that it consolidates this process across multiple devices, and is therefore geared to serve a growing trend known as "Bring Your Own Device" (BYOD), where as fellow SA contributor L&F Capital Management explains, employers are increasingly allowing their workers to bring their own devices instead of providing the hardware and software themselves. BYOD allows for greater flexibility and reduces overhead, but many employers have resisted it because of the added difficulties of maintaining security. CloudLock, by allowing clients to limit access and file transfers across multiple devices, provides a solution.
While Cisco's acquisition-based growth model introduces a large element of execution risk, we are optimistic that most of the company's purchases will create value for shareholders. This is thanks to Cisco's deeply-embedded customer relationships that will smooth the transition to new growth areas. Cisco is the market leader in computer networking systems, with approximately 60% share of the Ethernet switches and routers markets. The company's massive installed base raises switch costs, as network engineers are most familiar with Cisco's products. And, as Morningstar explains, because customers are more concerned about minimizing network disruptions than switching to a cheaper but less proven vendor, customer relationships tend to be sticky. We believe Cisco's entrenched customer base will work to its advantage as it grows new business lines, as many of Cisco's clients in its legacy networking segment will retain CSCO for their cloud-based software needs. Furthermore, Cisco has the financial clout to carry out its growth plan. Thanks to pricing power and cost advantages from scale, CSCO is highly profitable (5-year median operating margin of 21.8% compared to an average of 3% for the peer group). Superior profitability allows CSCO to convert a significant portion of revenues into cash flow. Over the past five years, FCF as a percentage of sales has averaged approximately 23%, with very low volatility. Thus, CSCO has a sizeable cash position: cash and equivalents, at $63.5 billion, account for more than half of total assets. This has allowed Cisco to keep borrowing to minimum. In the latest quarter, the firm's D/E ratio was less than 0.40.
Cisco has a clear vision in mind for growth, and we are optimistic that the firm will be able to realize it without destroying shareholder value. CSCO's strong financial health will give it the freedom to pursue a number of high-growth opportunities, while the firm's entrenched customer base of loyal clients should ease the integration process.
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