Cisco Is Cheap But Fraught With Risks
Contributor since 2013 / 6911 Followers
Summary:
- Cisco’s growth initiatives include acquisitions, such as ThousandEyes and AppDynamics, and the successful Catalyst 9k product line.
- The company’s shift towards a recurring revenue model increases revenue predictability and resilience in a challenging climate.
- Competitive challenges and declining market share in the telecom equipment market pose risks to Cisco’s future performance.
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As Cisco Systems (NASDAQ:CSCO) approaches its upcoming earnings announcement, investors should carefully weigh the company’s growth initiatives, recurring revenue model, and potential risks and challenges. In this article, we will discuss Cisco’s capital allocation strategies, key acquisitions, and the Catalyst 9k product line’s impact on future growth. Additionally, we will examine the company’s shift towards a recurring revenue model and potential risks, including competitive challenges from Arista Networks and declining market share in the telecom equipment market.
Business Analysis
As we approach Cisco’s upcoming earnings, there are several key factors to consider for investors, which we will discuss in a more structured manner, addressing growth initiatives, the recurring revenue model, and potential risks and challenges.
First, let’s delve into Cisco’s growth initiatives. The company’s focus on future growth is demonstrated through its capital allocation, with priorities on maintaining dividends, buybacks, and mergers and acquisitions. Cisco has been successful in the hyperscale and AI markets, thanks to their Silicon One product, which offers efficient power consumption, a crucial aspect for hyperscalers. Additionally, Cisco’s acquisitions of ThousandEyes and AppDynamics have bolstered their position in the observability space, which is vital in a hybrid work environment.
Furthermore, the Catalyst 9k product line has been a significant success for Cisco. Instead of relying solely on its current success, the company plans to release the next generation on schedule, showcasing its commitment to innovation and staying ahead of competitors.
Moving on to the recurring revenue model, Cisco’s shift in this direction has altered the company’s outlook, providing increased visibility into future revenue growth and making it more resilient in challenging climates. The strong Recurring Performance Obligations (RPO) and sizable backlog increase predictability in Cisco’s forward performance.
Cisco has also been regaining market share in the enterprise sector, with expectations that this trend will continue as channel inventory issues are resolved. Gross margins have been improving and should continue to rise, with the company benefiting from stable pricing and lower freight costs.
However, investors must also be aware of potential risks and challenges. CDW’s weakness, one of the largest publicly-traded VARs in the US, may indicate broader IT spending trends, particularly in enterprise infrastructure. The underperformance in CDW’s solutions and services sectors could reflect greater large SMB spending caution, which might negatively impact Cisco’s enterprise-centric coverage.
Concerns also exist regarding Cisco’s underlying new order performance and potential customer frustrations with the complexity of their portfolio. Although backlog consumption is anticipated to be a tailwind through the remainder of FY23 and likely through 1H24, there is a risk that normalized orders and delivery may step down to low-single-digit growth in FY24.
Risks: Competitive Challenges
Over the past two decades, Arista Networks (ANET) has consistently challenged Cisco Systems as both companies vie for market share in the networking equipment industry. The current market landscape is complex, with slowing enterprise IT spending counterbalanced by strong demand from public cloud customers and further complicated by ongoing component shortages. However, the future prospects for these two companies are not equal, and based on our analysis, we believe Arista may be a better investment choice than Cisco at the moment.
We concur with consensus estimates from FactSet that Arista can sustain mid-teens growth for at least a few more years, as it continues to capture market share in data center switching. Despite concerns about slowing growth from the cloud, we still foresee double-digit growth ahead. Arista has successfully diversified its cloud customer base, reducing its reliance on Microsoft and Meta. We also expect Arista to gain more traction in the campus switching market, where it currently has under 2% market share. Arista’s substantial North American exposure acts as a buffer against foreign exchange headwinds.
In contrast, previous optimism for Cisco’s market share gains in the cloud market and increased revenue from software has diminished. Cisco’s share gains in the cloud have “stalled,” and its shift to a more software-based model has been slow. Additionally, we believe Cisco may be more susceptible to a macroeconomic slowdown than its peers.
For example, Cisco Systems may be more sensitive to macroeconomic slowdown than Arista Networks due to its larger market share, broader customer base, and greater reliance on hardware sales. As a global company with diverse products and customers, Cisco is exposed to various industries and sectors, making it more susceptible to economic fluctuations. In contrast, Arista focuses on high-performance data center and cloud networking solutions for a niche market, with a greater emphasis on software-based and subscription models, making it more resilient to economic downturns. Additionally, Arista’s concentrated presence in developed markets and its agility in innovation can further insulate it from macroeconomic slowdowns.
On the telecom side, Cisco’s recent decline in telecom equipment market share presents a significant risk for the company. According to MTN Consulting, the drop in market share was attributed to “lumpy customer capex” and improving supply chain issues. Cisco’s largest market, the U.S., experienced strong capital expenditure and a growing focus on 5G core, which the company has previously flagged as key to its growth in telco revenues. We believe this decline in market share raises concerns about Cisco’s ability to capitalize on these opportunities.
The competitive landscape adds to Cisco’s challenges, as other vendors like VMware (VMW) experienced surges in market share. The company must navigate this increasingly competitive environment while addressing the aforementioned market share decline. Cisco’s risks are further compounded by lingering supply chain issues, currency fluctuations, and regional deployment challenges, which have also impacted other vendors such as NEC, Airspan, and Casa Systems.
To mitigate these risks and regain its position in the telecom equipment market, Cisco needs to focus on strengthening its presence in the growing 5G core segment and resolving supply chain issues. By addressing the decline in market share and adapting to the evolving market conditions, Cisco can work towards reestablishing itself as a leading telecom equipment vendor and minimize the negative impacts on its business.
Financial & Valuation
Note: All data in this section are from FactSet
Cisco’s revenue growth has faced significant headwinds in recent years due to factors such as market share losses to competitors and supply chain constraints. The company experienced a 5.0% year-over-year (y/y) decline in revenue in FY 2020, followed by a meager 1% increase in 2021, and a 3.5% increase in 2022. In FY 2023, ending in July, revenue is expected to rebound with a 9.7% growth rate. However, concerns have arisen that this growth may be attributed to the drawdown of its backlog as supply chain issues normalize.
For FY 2024, revenue is anticipated to grow by 4.3%, reaching $59 billion, but this projection could be at risk as the macroeconomic environment weakens. In terms of earnings per share (EPS), FY 2023 is expected to reach $3.76, representing an 11.8% growth, while FY 2024 EPS is projected to grow by 7.5%, reaching $4.04. Given that EPS is highly dependent on revenue, we believe it is similarly at risk. In this context, Cisco’s low valuation appears reasonable. The company is trading at a forward 12-month consensus EPS multiple of 12x, which is toward the lower end of its 5-year range.
While some contrarian investors might view this as an attractive entry point, we prefer businesses that can compound at above-market rates in the long term. As a result, we maintain a neutral stance on Cisco and will continue to monitor the company until there are clear indications of improved competitiveness.
Conclusion
Cisco’s revenue growth has been constrained in recent years due to factors such as market share losses to competitors and supply chain issues. While the company’s growth initiatives and shift to a recurring revenue model offer promise, investors must also consider potential risks, including competitive challenges and declining market share in the telecom equipment market. Cisco’s current low valuation may be seen as an attractive entry point for some investors, but we prefer businesses that can compound at above-market rates in the long term. As a result, we maintain a neutral stance on Cisco stock and will continue to monitor the company until there are clear indications of improved competitiveness.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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