Few companies in the IT sector inspire as much confidence in shareholders as Cisco Systems Inc. (CSCO), the leading supplier of software and data networking. The firm produces everything from routers to switches, and offers clients network-management software designed specifically for data communication amongst distant networks. It is one of the most traded companies among investment gurus, and currently enjoys the backing of John Hussman (Trades, Portfolio), Ronald Muhlenkamp (Trades, Portfolio), and Louis Moore Bacon (Trades, Portfolio). So, let’s take a look at this industry giant and see why it might be a stock worth purchasing for 2014.
Scale Advantages and High Switching Costs
The main advantage of being such an important player in the IT world is that customers are willing to endure higher prices in exchange for continued service. In other word, high switching costs give Cisco a huge advantage over rivals and possible new entrants. Clients are reluctant to change for two main reasons: first, IT system managers prefer to avoid disruptions rather than reduce costs, and are thus willing to stick with Cisco even when other, cheaper options are available. Second, the firm’s certification is considered an industry standard, and thus Cisco products enjoy a reputation few can match (if any).
Hence, IT managers are bound to continue working with the same company, since certified employees are easier to find, and training costs can thus be minimized. Overall, the advantage for employers is quite evident, as are the preferences of IT managers. This generates a durable competitive advantage for Cisco, particularly in the switches and routers sectors, which are its core markets.
Not Fearing the Competition
In the routers segment for example, Cisco has a clear advantage over rival Hewlett-Packard Co. (HPQ), and controls around 50% of the global market in carrier routers. This huge market share guarantees most customers will stay loyal, since the elevated switching costs make a change to another provider unreasonable. Furthermore, the company has not let clients down, making the movement of data, video and voice traffic efficient and speedy. Telecom providers for example clearly favor Cisco for long distance data transfers, despite recent attempts by Huawei and Alcatel-Lucent (ALU) to capture some market share.
Services for Wider Margins
Cisco is particularly strong in North America, yet its global presence is staggering. The firm's wide portfolio and extensive reach into corporations and their IT sectors is impressive, and management’s newest service and product integration strategy is smart. Services are particularly lucrative, as the recent figures demonstrate: service revenue has actually grown faster than product revenue. Apart from being a more stable stream of income, gross margins in the services sector are in the upper 60s, and thus far above the industry average. Cisco’s solid performance in this area has already been demonstrated over the past few years, and the firm’s success is bound to endure.
Apart from a solid business model, large size, wide customer base and significant economic moat, Cisco has an impressive balance sheet. The firm generates a huge amount of free cash flow and has little debt and an operating margin above the 20% mark. Shareholders will definitely like the 337% return on invested capital the stock has to offer, and the 3% annual dividend yield rate is also attractive. And to make things even more compelling, Cisco is currently trading at 12.1 times its trailing earnings, meaning shares are available at a 40% price discount relative to industry peers’ average. Since the outlook is rosy, and the conditions for entry are given, I feel very bullish regarding this stock’s future.
Disclosure: Patricio Kehoe holds no position in any stocks mentioned.