While Cisco Systems, Inc. (CSCO) is a high quality company, it currently appears to be richly valued.
- Strategy is to be "the" networking company rather than a maker of individual products.
- Shift to more of a software and subscription-based offering strategy improves revenue predictability.
- Customers exposed to high switching costs which increases CSCO product/service stickiness.
- Strong Balance Sheet and strong Free Cash Flow (~$12.4B, ~$12.9B, and ~$12.8B in FY2016 – FY2018).
- Using GAAP and FY2019 projected EPS, I am of the opinion CSCO is somewhat expensive.
- Analysis of multiple ‘Super Investor’ portfolios suggests I am not the only investor of the opinion CSCO is richly valued.
At the time, I viewed CSCO as being fairly valued despite CSCO’s PE of ~139; one-time charges grossly distorted CSCO’s FY2018 results. Look at page 49 of 141 in CSCO’s Annual Report and you will see CSCO reported Net Income of $0.11B on Revenue of $49.33B which was down from FY2017 Net Income of $9.609B on Revenue of $48.005B.
CSCO’s weak FY2018 results are because it recorded a provisional tax expense of $10.4B related to the enactment of the Tax Cuts and Job Act. This figure was comprised of $8.1B of U.S. transition tax, $1.2B of foreign withholding tax, and $1.1B re-measurement of net deferred tax assets and liabilities.
Were it not for this one-time charge, CSCO’s PE would have been within the historical PE range evidenced in the 2010 – 2017 timeframe (14.8, 15.6, 12.7, 12.2, 18.9, 14.5, 14.5, and 20).
At the time of my August 2018 CSCO article I included the following in my ‘Final Thoughts’:
‘One of the nice things about investing in a cash rich company such as CSCO (~$46.5B in cash and short-term investments as at FYE2018) is that it can make a methodical and calculated transition to more of a software-style focused company without having to be worried how a change of this magnitude will impact its financial stability.’
In addition to being a cash rich company which generates strong Free Cash Flow on an annual basis ($8.9B, $9.2B, $8.9B, $10.4B, $11.7B, $11B, $11.3B, $12.4B, $12.9B, and $12.8B in FY2009 – FY2018), CSCO appeals to me in that its customers would incur significant switching costs by changing vendors. It also possesses strong brand reputation with Information Technology (IT) professionals.
Based on my research, CSCO’s networking products are typically upgraded every 3 – 7 years. Changing network systems is a massive undertaking so, typically, a consumer is apt to retain the existing vendor so as to minimize disruption to its network.
Based on my experience, firms are risk adverse to making enterprise network changes especially if the existing network has kept business operations functional. I recently covered the Big 5 Canadian Banks in this article and I know that these banks still have systems that use COBOL software! Naturally, changes are being made but any change undergoes a rigorous review to assess risk/reward.
Changing network systems is a massive undertaking due to the need to migrate data and infrastructure hardware so the more critical the application, the greater the reluctance to make a change.
Despite the entry of new competitors over the years, CSCO has still managed to maintain gross margins in excess of 60%. Gross margin is typically just above 60% with FY2014 being the only year in the last 10 years in which it dropped below 60% (it was 58.9%).
A large percentage of CSCO’s core customer base continues to rely on its latest innovation and services
for their networking products. In my August 16, 2018 article I indicated that CSCO has been shifting to a subscription-based hardware, software, and services model wherein it offers 3, 5, or 7 year packages. This ties in its customers even further.
With a strategic push to selling new products on a subscription basis, CSCO is also endeavoring to adopt this business model to incumbent products.
In the 2018 Annual Report, CSCO’s Chairman and CEO stated (page 5 of 141):
‘As we integrate our products and services into architectures, we are selling more software and subscription-based offerings. These are designed to provide our customers with flexibility and continuous value, and at the same time they help us to shift our business model to more recurring revenue streams. In fiscal 2018, we delivered strong top-line growth and profitability, reporting our highest-ever revenue of $49.3 billion. Recurring offers accounted for 32% of our total revenue in fiscal 2018, and revenue from subscriptions was 54% of our software revenue. Our intention is to continue to drive recurring revenues by applying a subscription-based model to many of the new products we launch and ultimately across our entire portfolio.’
While I like the strategic transformation CSCO is undertaking and am of the opinion CSCO is a great company I still want to ensure that any new investment is being made at a fair value.
On this basis, let’s have a look at CSCO following its $12+/share price increase subsequent to its pre-Christmas 2018 low (~$40) to determine whether the current $52.59 as at the close of business on March 13, 2019 is reasonable.
Q2 2019 Financial Results
CSCO’s Q2 2019 results released February 13, 2019 can be accessed here.
CSCO has repeatedly acknowledged that it continues to operate in a challenging and highly competitive environment. Recognizing these challenges, CSCO made a strategic decision a few years ago to transition its business model to increased software subscriptions. On this basis, it is not surprising to see a 10 bps YoY increase in software subscriptions to the point where this now accounts for 65% of total software revenue.
I mentioned this in my previous article but bring it to your attention again…
Under new accounting standards, the timing of CSCO’s revenue is changing. Under the old accounting standard, a product sold for $100 would result in ~$75 of this revenue being recognized up front; the remaining $25 would be recognized over a period of 3 years.
Under the new accounting standard, more revenue will be recognized upfront thus boosting sales numbers. There will, however, still be ~10% - 11% of deferred revenue. This revenue recognition change will help make this company’s revenue slightly more predictable.
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Disclosure: I am long CSCO.
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