Cisco Systems Inc. (CSCO, Financial) is the world’s leading supplier of Internet protocol (IP) based networking and other related services. It provides to communications and information technology service providers, companies, commercial users and individuals different products such as routers, switches and access equipment along with network-management software. The company designs, manufactures and sells IP-based products and services and has recently entered newer markets such as web-based collaboration and video conferencing.
Since 2012 Cisco recategorized its products into seven categories: Switches, Next-Generation Network (NGN) Routers, Collaboration, Service Provider Video, Wireless, Security, Data Center and Other Products. This last segment includes Linksys home networking products and other networking products, as well as new emerging technologies.
It works through three geographic segments: The Americas, representing 58% of total revenue as of last quarter’s report, Europe, Middle East and Africa (EMEA), generating 26% and Asia Pacific, Japan and China (PJC), representing 16% of total revenue, for the same period.
Results for second-quarter fiscal 2014 showed above estimated earnings per share of 42 cents. Revenues, despite having decreased 7.8% year over year and 7.4% sequentially to $11.2 billion, were still above forecasts. The revenue decrease was sequential across all geographies: Americas declined 11.7%, EMEA, 1.3% and APJC segment 2.0%. Revenue is likely to remain unstable as the company withdraws from low-margin set-top box hardware business and migrates towards a new software-based content delivery offering, remodeling its service provider video business to a to a cloud-based recurring revenue model based largely on its 2012 acquisition of NDS.
Cisco is a strong player and reported a decent second-quarter results with both the top and bottom lines surpassing estimations. Moreover, analysts think the increase in dividend indicates the company is heading toward strong future growth, and recent launch of three large platforms across its switching and routing platform, has a crucial importance for the company’s software-defined networking.
Recent Developments and Acquisitions
There is no doubt Cisco is a leader within the data networking market. With scale advantages and meaningful customer switching costs, Cisco enjoys competitive advantages and a strong competitive position among the industry, with a substantial market share advantage over its major competitor Hewlett-Packard Company (HPQ, Financial). Although Alcatel-Lucent (ALU, Financial) and Huawei Technologies Co. Ltd have recently gained some presence within the global market, Cisco still maintains more than 50% global market share in carrier routers. Furthermore, the fact that customers are reluctant to change vendors adds an extra competitive advantage; IT managers prefer to minimize network disruptions rather than cut costs and choose Cisco-certified employees to minimize training costs and risk.
The company’s focus on wireless carriers has increased as it acquired Intucell, BroadHop, Cognitive Security, Cariden, ClearAccess and Ubiquisis. These acquisitions are likely as well to improve software and service capabilities and help diversify the firm’s revenue streams, mitigating the cyclicality associated with hardware sales.
The growth in data demand due to the proliferation of smartphones has made Cisco’s wireless carrier segment surge, and the introduction of high-speed LTE networks is expected to accelerate that growth. Therefore, it is probable networking solutions will gain importance for Cisco in the coming years, and moreover this new focus is likely to help the company to increase share in the edge routing segment, currently lead by competitors Alcatel-Lucent (ALU, Financial) and Juniper Networks Inc. (JNPR).
Cisco’s strategy is to develop a more integrated operations and network management system in order to reduce overall operating cost for its primary clients. Given this intention, Cisco has recently acquired leading intelligent fiber security solutions company Sourcefire, seeking to increase its security market share. Sourcefire is expected to help the firm develop a unified security strategy for all large organizations while providing it direct access to other open source technologies such as ClamAV and Razorback and strengthening customer base.
New Approaches
The company is also driving its attention toward corporate software and technology services, as to meet the growing demand for software-defined networking (SDN) solutions. This approach to networking in which control moves from hardware to a software application called a controller, allows administrators to regulate and direct network traffic from a centralized hub, minimizing the use of different expensive routers and switches while increasing the flexibility of the infrastructure and reducing costs for companies. This lower cost technology is likely to be rapidly adopted by different companies, and thus enable Cisco to improve the overall margin profile of the company while making the organization leaner and more efficient.
A market adjacencies program has been announced by the company’s management recently. Through this initiative, Cisco expects to use core competencies supplemented by acquisitions to exploit opportunities in more than 30 adjacent markets. The company expects to enable secure energy management on electrical grids from the transmission to the consumption stage, teaming up with different companies, utilities and standards authorities. In addition the ongoing restructuring policy points to lower costs by hiring workforce at lower-cost locations, especially in India and China, with a positive impact on profitability.
Cisco announced its recent innovations in video technology with new experiences and formats, simplifying video processing infrastructures and reducing costs in video processing value chains. Cisco is expanding its Videoscape TV service delivery platform with Virtualized Video Processing and evolving to AnyRes to support full-frame rate 4K content and the High Efficiency Video Coding (HEVC) standard for both real time and on-demand. As a result, agility will be increased and a more exciting user experience will be developed. Moreover, Cisco and Sony Corporation (SNE) will team up to demonstrate the live delivery of full-frame rate 4K 60P content, from New York City to Las Vegas, on display for NAB show attendees. Mike Fasulo, president for Sony Electronics, said, "Collaborating with Cisco in this industry first demo of live 4K distribution over a cable backbone proves that 4K is ready for primary TV consumption."
Competition and Industry’s Setbacks
Competition in this industry is intense, and Cisco as well as many other companies face increasing rivalry. Moreover, the increased adoption of private and public clouds could mean it will have to face a gradually concentrated base of sophisticated customers with lower switching costs. The company has a conservative guidance strategy, reactive to an inconsistent global macroeconomic environment and weak performance in emerging markets.
The recent negative publicity Cisco has been receiving from China is presenting some problems, as it was recently claimed by Chinese media that the U.S. used equipment made by Cisco to spy on China. These accusations added to the company’s already troubled position in China a new setback. In addition, stiff competition resulted in peers pricing pressures, forcing Cisco to offer discounts and deals in response. Hewlett-Packard Company (HPQ, Financial)’s ProCurve has been for some time retained customers with a deal-by-deal basis, offering significant discounts for exchanging Cisco products. The HP-3Com combination poses additional threat to Cisco as 3Com has a strong position in China, meaning stiff competition, prices pressure and constricted margins.
Bottom Line
Cisco reported on Feb. 12, 2014, fiscal second quarter earnings of $0.47 per share, which beat the consensus of analysts' estimates by a penny. However the overall performance of the company remained rather weak with earnings behind estimations across all geographical regions. Moreover, an additional 7% revenue drop is expected by analysts by the end of the current quarter due to macroeconomic headwinds in the emerging markets. However the company has decided to invest $1 billion in cloud computing service, allowing Cisco to compete directly with mayor rivals such as Amazon.com Inc. (AMZN, Financial), Google Inc. (GOOG, Financial), and Microsoft Corporation (MSFT, Financial), among others. Moreover, company’s share of the Ethernet switch market has held relatively steady despite competition, and UCS servers continue to gain traction, expanding its footprint through its customers' data centers.
Cisco enhances shareholders distributing profits in the form of cash dividends and share repurchases. This makes the company an interesting choice for investors focusing on receiving significant returns, distributed through increasing dividend payouts and share repurchase programs. Still, analysts think growth potential seems rather limited and the recent shock from Spherix Incorporated (SPEX)’s sue for patent infringement is raising some questions regarding Cisco’s future performance.
Cloud computing will force Cisco to sell into a more concentrated group of sophisticated customers over time, which could lead to gross margin deterioration, revenue pressure, and an increased risk of technological disruption.
Disclosure: Damian Illia holds no position in any of the stocks mentioned.
