- Cisco's new alliance with Ericsson should enable both companies sell products as bundles, as well as develop new technologies to fend off white box manufacturers.
- Cisco wants to grow its high growth divisions fast. An acquisitions of Acano in the collaboration space looks on the cards.
- Cisco's service division is expected to grow strongly by 2020 due to the sheer size the Internet of Things market.
- Routing & Switching will not decline as much as Mr Market thinks.
Shares of Cisco (NASDAQ:CSCO) have recovered somewhat since the stock dropped more than $2 a share after the company announced its first quarter earnings for fiscal 2016 on the 13th of November. Although the company experienced strong growth in product sales which carried on the momentum of fiscal 2015 when it finished off the year with about 4% overall growth, guidance was low going forward citing only 0 to 2% growth in revenues and an EPS of $0.54 for the following quarter. Furthermore Mr Market didn't pay any heed to Cisco's higher profit margin which was reported at 63.2% which may have put an end to the company's declining gross margins (60.4% was the number in fiscal 2015). Nevertheless, the main reason why this tech giant is getting used to bearish commentary on wall-street is because its main divisions (switching & routing) could be on the decline.
The switching division's margins are under threat and although the division still grew at a nice 5% growth rate year on year, it still is not growing as quickly as the historic average. The routing division took a 8% growth rate hit in the last quarter which was primarily a result of soft carrier demand. When you combine the above mentioned divisions, you are looking at $5.8 billion in revenues which was 46% of the total quarter's take ($12.68 billion). If these areas slow down (in either margin or sales wise), a slump would undoubtedly affect the company's profitability. Cisco knows the current threats to its business it has to overcome which i believe it will. Let's discuss
Although Cisco has been very active on the acquisition front, I believe the recent Ericsson alliance will benefit the company especially in the areas in which it is struggling (switching and routers). Firstly Ericsson can help Cisco grow its sales by selling Cisco's products globally across Ericsson's markets and under Ericsson's umbrella which presently is over 180 countries. Secondly and more importantly, Cisco knows that the biggest threat to its business (in the near term) is the growth of white box manufacturers. Amazon, Google and Facebook are all using white box systems which is the main reason Cisco's growth in hardware products is definitely slowing. Therefore another objective of Cisco's new alliance with Ericsson is for both sets of engineers to work together and come up with SDN/NFV (Software defined networking/Network Functions Virtualization) solutions.
New technology would really help both companies here because at the moment competitors like Juniper Juniper Networks (NYSE:JNPR) are definitely gaining market share due to its products being cheaper and more customizable. What's the bottom line? Well Cisco needs to buy itself time with respect to its switching and routers divisions. If it can sell new hardware and technology as part of a package with Ericsson, added value may very well result in longevity with respect to sales growth. Nevertheless if white box manufacturers continue to gain traction, its still not all doom and gloom for Cisco. Other parts of its business are growing sharply and soon will be able to compensate for potential declines.
Collaboration for example was up 17% last quarter and Cisco has kept its foot on the pedal by stating its intent to buy Acano (for $700 million in cash) which specializes in infrastructure and conferencing products. The other high growth division in the company is data center products which grew by 24% on a rolling year basis to $859 million last quarter. The cloud is going to drive data center traffic aggressively going forward (see chart below) and Cisco wants to take advantage by selling software (Cisco IOS XR) to service providers which will decrease the cost burden but wont sacrifice performance of the customer's respective networks.
Furthermore I believe that Cisco's other divisions outside switches and routers ( Service, Wireless, Security) are all going strongly which should keep profits elevated. Service for example has profit margins near 70% and returned $2.8 billion in the last quarter. As Cisco sells more product going forward , one would feel that its service division has to increase. Furthermore the Internet of Things (IoT) initiative is projected to have 50 billion devices connected to the internet by 2020. Cisco's service division consists of a lot of recurring income which is why there seems to be less volatility in this divisions compared to product sales. If this division can get more traction, wall street I believe would really take to it because of the stability and predictable projected growth curve.
Markets Are Too Bearish On Cisco Stock - Conclusion
To sum up, I believe wall street is placing too much importance on the fact that Cisco routing and switching revenues are slowing down slightly. Many times network disruptions are more important to IT managers than reducing costs by buying cheaper switches or routers. Certification is another advantage Cisco has as engineers down through the years have used Cisco's technology as the "standard" in the industry. This undoubtedly gives the company a competitive advantage over its competitors which is why, at the very worst, I believe we will return to slow growth in routing and switching over time. Furthermore the company is definitely on the cheap side in this sector with a p/e ratio of 14.6 and dividend of just over 3%. There is ample cash on the company's balance sheet to keep supporting its dividend which the company has been growing aggressively since it was re-instated. The lower Cisco stock goes, the higher the dividend yield will grow which should bring in value investors and especially the ones looking for yield.