A changing strategy has the potential to catalyze Cisco Systems' (CSCO, Financial) stock price. Its move toward a subscription-based business model is gradually increasing recurring revenue. This could lead to lower costs as well as a more reliable income stream. The company’s growth potential in areas such as cybersecurity and in international markets also remains high.
Competition, though, is increasing. This could suppress margins in the near term. With a large cash pile, further acquisitions could provide the business with the means to capitalize on fast-growing areas and overcome competitive threats.
Cisco’s stock price has risen 46% in the last year. This is ahead of 17% growth for the S&P 500. Given its future prospects, further outperformance could be ahead.
Changing business model
Cisco’s shift to a subscription-based business model has boosted its recurring revenue. It now makes up 32% of the company’s total sales, which is one percentage point higher than in the same period of the previous year. Customers are increasingly choosing to subscribe to the company’s products on a monthly basis, which eliminates the upfront capital costs that were previously required.
Subscriptions provide a relatively predictable revenue stream for Cisco and also offer cross-selling opportunities for its range of products and services. It also easier for the company to market upgraded products to existing customers, while the cost of customer acquisitions could fall over the medium term.
The company has also been successful in its first attempt to sell a subscription software package on top of a core networking product. Its Catalyst 9000 switches have been the fastest-ramping products it has ever built. This suggests there is scope for future switching and router products to be sold within the same recurring revenue model.
Growth potential
With security continuing to be the biggest concern for the company’s customers, it remains a top priority. Cisco is seeking to simplify its customer offering in this segment through products that work together and share analytics. It has an advantage over many of its rivals in winning new customers in the cybersecurity segment. Its legacy as a provider of networking equipment such as switches and routers means it can bundle its security solutions together with existing products.
The acquisition of Duo has the potential to grow the company’s security segment. Its expertise in two-factor authentication could lead to higher demand for its services since the majority of data breaches are due to weak passwords. Alongside Cisco’s network, end point and cloud security platform, Duo could further enhance the company’s current offering.
The company also has growth potential in international markets like India. Its software division could capitalize on the gradual digitization that is taking place across the country, where a focus on smaller companies could present opportunities for new customer acquisition. According to Cisco, 70% of smaller companies in India currently operate offline. Its Smart Platform is helping them to get online at a relatively low cost. Over the next three years, it is projecting to triple its smaller company customer base in India.
Potential risks
The company’s gross margin declined across its product and service segments in the most recent quarter. The total gross margin was 80 basis points lower versus the prior-year quarter at 62.9%. This was due to lower margin deals as well as a negative product mix in certain regions. Increasing competition could keep margins pegged back, with companies such as Arista Networks (ANET, Financial) and Huawei adopting aggressive pricing strategies. Arista believes its switches could replace traditional routers when combined with cloud-based networking solutions, so it could become an increasing threat to Cisco’s financial outlook.
The company’s strong cash position could help it to adapt to changes in technology as well as faster-growth areas. Following the repatriation of $67 billion of overseas money, the company now has a cash balance of over $46 billion. While some of this amount may be used for share repurchases and dividends, a large portion could be used to fund acquisitions. Smaller companies that have an innovative product or service, or that provide a complementary offering to an existing product, could be obvious targets for Cisco’s large cash pile. This could help it to overcome increasing competition in a fast-moving technology industry.
Outlook
The company’s decision to focus on a subscription-based business model could reduce costs and increase the reliability of its income streams. It may also prove to be popular among customers, with it reducing upfront costs.
Growth potential in international markets such as India and in cybersecurity is high, with the company’s cash balance providing it with the capacity to capitalize on fast-growing segments.
Although competition is increasing and the company’s stock price has risen in the last year, it continues to have investment appeal. Further outperformance of the S&P 500 could be ahead.
