Cisco Systems Inc. (CSCO, Financial), is one of the all-time big names in the router, switch and overall networking equipment industry, and 2014 faces it with a big transition. While the company’s shares are undervalued, the firm’s market position is really strong in its principal categories. Cisco has strong cash generation, ($2.6 billion in free cash flow), $30 billion net cash position, and attractive valuation provide additional support. And it stands firmly to sustain throughout the year in both market share and operating margins.
Cisco’s moat comes from its core markets, switching and routing. It enjoys scale advantage and customer costs advantages. Its routers and switches are a non-official standard among data centers, offices, the overall business segment and even houses (LAN and WAN). The great majority of businesses have their networks built on Cisco structures, and prefer Cisco-certified professionals to work on them. On the other end of the line, professionals seek Cisco’s certifications to get work from nearly any office. Telecom and cable service providers also use Cisco’s routers to move data across long distances. In this segment, the company still has 50% of the market share, widely surpassing that of its biggest competitors Huawei and Alcatel-Lucent (ALU).
Advantages and Market Share
Cisco’s switches and routers represent 75% of the company’s revenue. The rest comes from smaller businesses like enterprise wireless, security and data center, which are expected to generate 5% annualized revenue growth over the next five years.
Since the company has a deep reach into offices, businesses, service providers' IT environments, and a broad services and products portfolio. Cisco’s services segment has been one of the strongest in the company’s portfolio. Services revenue grew faster over the last five years than any other component of the company’s portfolio, and with less volatility. We expect the company’s management to integrate both products and services going forward.
An advantage the company has in the carrier routing industry comes from customer switching costs (most services providers rely on Cisco’s products to move data, text, voice and video through long distances to millions of subscribers). And, since it’s a small, but crucial, part of the business, customers are willing to pay only Cisco for premium products and services to ensure a quality, secure and uninterrupted network, rather than switching costs and trying a non-proven competitor. As a result of those causes, the carrier routing industry has become quite a duopoly, between Cisco (45% to 50%) and Juniper (half Cisco’s market share).
Besides that described above, Cisco has the advantage of being an unspoken standard for commercial and government customers. These customers are reluctant to change their whole network to try a new brand. They prime good uninterrupted service over cost, while they still seek for Cisco-certified technicians to minimize training costs and risks, maximize network benefits and minimize disruptions.
The company’s dominance on layer 2-3 switches provides big R&D costs scale advantages. Its main competitor Hewlett-Packard (HPQ, Financial) has 9% of the market share (second largest), and is still behind Cisco who sold $14.5 billion worth of switches in its latest fiscal year, while HP couldn’t reach $2 billion. Cisco spent more than HP’s revenue on R&D for switches (nearly $5.5 billion).
Cisco could leverage its strength in switches and routers and manage to construct a broad portfolio of smaller businesses in new segments, from wireless enterprise networking, to web-based collaboration and enterprise video conferencing. Though these businesses aren’t nearly as competitive as routers and switches, the whole portfolio generates from 50% to 55% of gross margin boasting to more than $14 billion and covering a good number of great businesses.
New Policies from a Very Experienced Management
John Chambers has been with Cisco since 1991, its CEO since 1995, and chairman since 1996. Dennis Powell, former CFO, gave way to Frank Calderoni in 2008. Calderoni is a finance veteran and former CFO of SanDisk (SNDK, Financial) and QLogic (QLGC, Financial). Gary Moore, former director of the company’s service businesses, is COO and president.
This team is one of the most experienced in the industry, and it shows. Since 2011, the management focuses on cutting costs of overly bureaucratic structure and underperforming non-core businesses. The company could maintain its high market share and accelerated revenue growth. The sales and engineering teams were realigned and the management could cut $1 billion in operating costs.
The company has a high free cash flow, that could be used either to gain more acquisitions or to return a portion to its shareholders.
Margin and Ratios
| Â | CISCO | Industry Median | History |
| Operating Margin | 23.00 | 3.9 | Â |
| Net Margin | 20.5 | 3.1 | 23.1 |
| ROE | 16.9 | 5.7 | Â |
| ROA | 9.9 | 2.9 | Â |
| ROC | 337.00 | 11.4 | 348.2 |
| EPS Growth | 11.8 | 2.2 | Â |
- As we can see on the chart its dividend yield is reaching a three-year high.
- While the P/E ratio is reaching a year low of 11.01
- The net margin percentage is 20.5, near the company’s historical high and over HP’s 4.6 and Juniper’s 4.6, the biggest competition the firm has.
- Its P/S ratio is down at 2.5, not even a point above from the historical low of 1.84.
Conclusion
Overall, the company has high competitivity capacity and a good foreseeable future as the company still sustains the bigger portion of the market share. And since cuts and realignments are being made since 2011, from the management we expect the company to maintain or drop very few points of growth and market share over the next five years.
Disclosure: Damian Ilia holds no position in any stocks mentioned.
