Source, 11th July 2018, Courtesy of Cisco Systems, Inc. Unauthorized use not permitted
Q4 2018 earnings will provide some important updates about the transformation that Cisco (CSCO) has initiated three years ago. Although I am too often wrong for my taste, I expect the results to confirm that, considering its scale and initiatives, the company is successfully transforming.
After decades of growth and dominance, Cisco has been losing market share in its core businesses over the last few years. In addition to aggressive competitors, the shifting of the consumption model for networking and security products and services has forced the company to evolve to a subscription based software oriented company.
Last quarter, the company has shown some improvement. Q4 2018 earnings will provide further insight into the transformation journey, especially in the security and network areas.
Security is growing, but at which pace ?
The security segment is being attacked by Palo Alto (PANW), an aggressive competitor that privileges growth over profits. By growing its revenues at 47% CAGR over the last five years, Palo Alto has been taking market shares and is overtaking Cisco as market leader. This paradigm should continue as Palo Alto has recently issued $1.5B of convertible debt to finance its growth.
Cisco has indicated last quarter that the security segment would grow. That's the least Cisco should do in a security market that is growing at about 7% CAGR. Therefore, Cisco growth rate for its security segment will be a decisive parameter to look at during the Q4 2018 earnings and beyond. At less than 7%, Cisco will keep on losing market shares.
Considering Cisco transformation and the related accounting of deferred revenues, the revenue growth will have to be assessed in relation to the deferred revenues.
On the operational side, I will pay attention to any announcement regarding the integration and automation of security solutions within the Cisco ecosystem as these concepts are shaping the IT security industry. With its important installed base, Cisco is in a good position to integrate all security (and network) components into one consistent solution.
Checkpoint (CHKP) and Fortinet (FTNT), two major pure security players, will report two weeks before Cisco and I will judge Cisco security performance in perspective with the results of these two companies.
The core networking business is not more protected than the security segment. In addition to the white box concerns, Arista (ANET), a network company founded by ex-Cisco employees, is rapidly taking market shares to Cisco in the cloud data center area.
I am pretty sure that the management will not directly address these topics, but, considering their importance, I would bet that analysts will raise some questions about it during the Q&A session.
At this occasion, the management should talk about the ongoing activities with the web scale data centers and provide an update on the partnership with Google (GOGL) to provide a hybrid cloud solution.
On the campus side, the adoption rate of the Catalyst 9000 will constitute an important update. Not so much for the cash it will bring - it's always good to sell boxes at 60%+ margins - but more importantly, for the installed base these devices provide to accelerate the software and subscription transition.
As a reference, 5,800 customers had purchased this switch by Q3 2018, up from 3,100 the quarter before. This quarter and the next ones should rapidly grow as the Catalyst 9000 constitute the natural replacement of the aging previous generation access switches in the campus. Moreover, Cisco is not facing aggressive competitors in this networking segment.
In addition, I will pay attention to some other less crucial information, but still important. Any announcement on the innovation for intent based networking and infrastructure platform, some update related to the decline of routers with service providers, and some information about the integration progress of Viptela in the SD-Wan area will help assessing the success of the transformation.
From a higher perspective, during the conference call Q3 2018, the management has provided the following guidance for Q4 2018:
We expect revenue growth to be in the range of 4% to 6% year-over-year. We anticipate the non-GAAP gross margin rate to be in the range of 63% to 64%. The non-GAAP operating margin rate is expected to be in the range of 29.5% to 30.5%, and the non-GAAP tax provision rate is expected to be 21%. Non-GAAP earnings per share is expected to range from $0.68 to $0.70.
Evaluating these results will only make sense in the context of the considerations I have listed above.
Updates on service and subscription revenues together with the outlook for Q1 2019 will provide some additional food for thoughts regarding the transition.
Cisco is in the typical situation of a dominant mature company facing the conjunction of rising aggressive competition and an evolution of its business model.
The company has taken the steps to transform itself into a subscription based software oriented company instead of a network vendor that sells boxes.
The company is taking advantage of its scale and installed base in order to push and cross sell its new solutions and successfully transform.
The coming earnings will provide valuable information to confirm the success I forecast for the turnaround. As I am a shareholder, I hope that the coming earnings results will not prove me wrong.
Disclosure: I am/we are long CSCO. 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.