Cisco Pulling an IBM? Reasonable Strategy But Starting Point Is Different

As noted on my Blog from October 24th “Tucci Says No to Networking; Chambers Says Yes to Software”, Cisco is becoming more serious in its pursuit to transform its business model to become less dependent on traditional networking hardware products (e.g. Ethernet Switches, Routers etc…) and more dependent on recurring revenues from higher margin software and services.  CEO John Chambers and the Cisco Board finally concluded that reinvigorating revenue growth to the glory days of Cisco’s past as a means of reversing Cisco’s declining price earnings multiple that has taken place over the prior 12 years was not going to work.  Paying a healthy dividend and improving earnings growth/visibility even during economic downturns was a better formula for shareholder returns and relative valuation metrics to other large mature technology companies.

While I agree with Cisco’s new strategy and give credit to Cisco for finally pursuing this course of action, Cisco is entering this transformation with very high gross and operating margins. Thus, while many hope Cisco can “pull and IBM” over the next several years in transforming its business to more software and services, IBM started its transformation from an easier starting point in terms of profitability margins.   This high starting ground for Cisco, reflective of still very high margins in its traditional networking hardware platforms that are subject to longer term margin pressure, will make Cisco’s transformation a lot more challenging than IBM’s in my view.  It is also likely to lead to more aggressive and larger acquisitions in the software industry in the next two years.  NDS and Meraki, the two largest software-like acquisitions in 2012 so far, are likely to be just the start of things to come at Cisco.

Cisco Hitting Recent 5%-7% Growth Target, But Helped by Acquisitions

Chambers no longer talks about the 30%-50% revenue growth goal that was the Cisco growth mantra up until the tech bubble crash in 2000 or the 12%-17% growth target that followed post the tech bubble recovery in 2004 but rather a more subdued 5%-7% growth that followed post the recovery from the 2008 financial bubble collapse.  Cisco has been living up to this new target with average revenue growth of 6% in the past eight quarters.  Even this more modest goal has not been a layup for Cisco, however, as organic revenue growth excluding acquisitions in the most recent quarter and guidance for the next quarter is below 5%.

With Revenue Growth Elusive, Pursue Earnings Visibility and Dividends

With strong organic revenue growth proving to be elusive for Cisco given increased competition from niche start-ups in various product categories (e.g. F5 in Layer 4-7, Palo Alto in Security, Arista in Switching etc…), price competition from broad large IT companies like Huawei and HP and the potential for a new business model disruption to its hardware centric business from the emerging Software Defined Networking architecture, Cisco altered course to pursue an “IBM like” model of high margin recurring revenues from software and services and an increasing dividend payout.  This increasing focus on software and services was very prevalent on Cisco’s earnings call last week as evident from this quote from John Chambers:

“…we are focusing very aggressively, even though it takes a couple of years to do it, much more software, much more recurring revenue…”   

I think John is being a bit optimistic that this business model transformation will only take a couple of years, but it is certainly clear that this is the new direction for Cisco.  This software, services and recurring revenue strategy is also very evident when one looks at the acquisitions Cisco has made so far in 2012.   In 2012, Cisco has announced 8 acquisitions with only one being in classic hardware (e.g. Lightwire for development of lower cost transceiver modules within Switching and Routing platforms), while all the other companies were primarily software companies.  In particular, the two largest deals of the year, NDS Group ($5B purchase price) and Meraki ($1.2B purchase price) were predominantly software-based businesses with gross margins above Cisco’s corporate gross margin in the 60% range.

Cisco Will Be Challenged To Achieve IBM’s EPS Growth Rate and Visibility

Besides concluding that strong organic revenue growth was unlikely given failed attempts in the past decade, Cisco likely looked at the success IBM has had over the past decade in reducing its earnings volatility during downturns in the global economy and how that has led to a superior stock performance and improved valuation vs. Cisco.  In particular, IBM has shown only about 3% revenue CAGR over the past decade, but its operating income has grown at about a 30% CAGR and EPS CAGR of about 23%.   Over the same period, Cisco has shown stronger revenue CAGR of about 11%, buts much weaker operating income CAGR of 8% and EPS CAGR of 13%.  More impressively, IBM never had a down year in EPS over the past decade, even during the “great recession” of 2009.  Cisco on the other hand, had two years where earnings fell with a 20% decline in fiscal 2009 and a 14% decline in fiscal 2011.

While Cisco’s revelation that a business model around strong revenue growth was not achievable and pursuing a more stable, higher margin, recurring revenue model with higher dividends was more favorable for its shareholders there is one major difference between when IBM started its transformation and where Cisco is today.  Namely, IBM’s gross margin and operating margin a decade ago were in the high 30s and between 8%-9% respectively.  By focusing on software and services via acquisitions and organic development, IBM was able to increase its GAAP gross and operating margin to about 47% and 19% respectively.  Cisco on other hand is starting its business transformation from a very high margin structure with GAAP gross and operating margin of about 60% and 22% respectively.   Cisco still derives well over 50% of revenues from networking hardware platforms and enjoys extremely high margins of over 60% on these platforms.  The ability to transform its business model to more software and services will only be achieved if Cisco can preserve profit margins on traditional networking platforms.  This is likely to be challenging in my view as traditional networking products will likely to continue to experience margin compression over time given the ongoing trends of Software Defined Networking, increased availability of networking merchant silicon making lower cost networking platforms more prevalent and continued pricing pressure from large IT players from China like Huawei.   With such a challenging goal, I believe Cisco will seek to achieve its transformation via a more aggressive acquisition pace in the software area and a networking hardware sales approach that seeks to maximize the leverage of its installed base to delay as much as possible the likely margin pressure in traditional networking products.

 

SDN Permeates Ethernet Expo Conference in NYC

I attended the Lightreading Ethernet Expo Conference held in NY this week. While technical topics at this annual conference like 100G, Ethernet based wireless backhaul, small cells, Carrier Ethernet 2.0 etc.… were all prominent, I was fascinated to see how much Software Defined Networking (SDN) permeated the presentations and discussion as compared to the conference a year ago.  With the first Open Networking Summit taken place only about a year ago in October 2011 at Stanford University, it is spectacular to see in the course of only one year how much discussion in both the networking industry and investment community SDN now comprises vs. the actual level of SDN network deployment and revenues.

My current observations regarding the pace of the SDN deployment and the impact to the investment community are as follows:

–       SDN Is Unstoppable:  SDN is unstoppable and will be disruptive across Cloud, Carrier and Enterprise Networks, likely in that order.  There are too many smart people and disruptive companies within the technology industry working to make this happen.  Early high visibility adopters like Google and the recent significant increase in VC funding into the SDN area are also adding to this momentum.

–       The Pace of SDN Deployments Will Not Match the Current “Hype”: The pace of truly open SDN deployment via agreed upon OpenFlow standards will likely be slower relative to the current level of industry and Wall Street “hype”.  This is not, however, unusual for a new disruptive technology like SDN.  A simple example is key features that are required in the Carrier community like MPLS, IPv6 and VLAN Stacking still need to be broadly developed and tested across the vendor community.  In addition, open standards around the Northbound Interface for APIs from the Controller Layer to the Orchestration and Feature Layer are not yet fully specified.

–       Risk To Proprietary Northbound Interface Implementations High: I think there is material risk to a truly open standards approach on the northbound controller interface.  I believe early adopters/innovators in the cloud operator and/or vendor community will drive pre-standard implementations of the northbound interface to facilitate a competitive and time to market advantage over the competition.  The standards work right now seems more focused on controller to data plan standards work (and rightfully so) given the magnitude of work that needs to be done in that area.  To me this raises the question, will SDN see a couple of leading operating systems around the control layer through early leadership in the northbound interface that will lead to only a couple of dominant winners like we see today in server virtualization (e.g. VMW) or Smartphones (Apple and Android operating systems that drive application development)?   When I posed this question to the carriers at the Ethernet Expo conference, they all were cognizant of the risk, but felt that the SDN northbound interface will not follow the server virtualization or smartphone model. The carriers point to the standards process in place to avoid this risk.  Even so, a cloud provider like Google or a leading SDN controller company’s desire to differentiate itself through a more rapid feature deployment via a time to market advantage of the northbound interface could be very tempting.

–       The Window For Early Exits for VCs Is Narrow:  There is a short window for early exits for VCs in their SDN portfolio companies. While there have some nice early exits in 2012 for SDN companies (i.e. Nicira), I think the window will be short for such exits as actual SDN revenues and deployments will be minimal in 2012 and 2013.   My advice to companies and VCs in the SDN market, is don’t be greedy if your exit strategy is to sell the company.  The iron will not always be hot as it is now and don’t let investment bankers fill your head about lofty valuations just because of the VMWare/Nicira deal.  Facebook announced the acquisition of Instagram for over $1B in April of this year.  Do you think Instagram would sell today for over $1B????

–       Valuation Impact to Publicly Traded Networking Companies Is Semi-Permanent:  Even though the migration to SDN will be gradual over the next 3 years, the negative impact to valuation metrics for publicly traded hardware based networking companies is likely to remain.   SDN will take time to penetrate carrier and Enterprise networks, but as I said earlier it is unstoppable.  Investors looking at companies like Cisco, Juniper, F5, Brocade etc.… will constantly have the overhang of what SDN will do to the business models of these companies over the next 3-5 years.  A case in point at the Ethernet Expo conference in NY this week was the presentation from AT&T.  AT&T clearly articulated that their vision of an SDN based network of the future will not only utilize standard, low cost and high volume Ethernet Switches, Storage and Servers, but also the ability to eliminate the deployment of application specific appliances (e.g. DPI, Firewall, Load Balancing, SBC, CDN etc.…).  AT&T envisions these specific network appliances being replaced by virtual appliances written by independent software vendors.  Thus, SDN not only creates an overhang on Switch/Router companies but also network specific appliance companies.   We are likely to see the successful networking companies transform themselves by quickly endorsing the SDN model and selling features as software/virtual appliances rather than hardware with their embedded features.   The challenge they will face is start-ups are being funded to break into the virtual appliance/software model given the technology discontinuity created by SDN.

Has Apple Stock Peaked? Probably So

Apple stock has experienced a decline of about 18% from its all time high on September 19th.  This rapid decline in the stock price in the last few weeks has many asking the question “has the stock peaked?”  A historical view of other $500B+ market capitalization companies and the analysis of some simple investing basics suggest that the stock probably has peaked in my view.

It Is Difficult To Hit And Remain A $500B+ Market Cap

Lets start with a historical perspective of companies that reached a market capitalization of $500B.  U.S. listed companies other than Apple that I found searching through various public sources that approached or exceeded a market capitalization of $500B were Cisco, Microsoft, Exxon Mobil, PetroChina and GE.   Cisco. GE and Microsoft reached their peaks in market cap during the peak of the stock market bubble in 2000 while PetroChina and Exxon Mobil hit their peaks during the Energy boom peak in October of 2007.  In all these cases, however, sustaining stock price appreciation post a $500B market capitalization proved to be impossible.  Take a look at the respective stock charts of these five companies below taken from Yahoo Finance.

Apple’s Entry Into the $500B+ Market Cap Club Most Impressive

What is unique about Apple breaking the $500B market cap barrier and reaching a market capitalization in mid September at about $650B is that it achieved this level of company value without a stock market bubble providing wind in its back via an excessive price earnings multiple.  At its peak, Apple’s forward PE ratio was about 13.3, generally in line or slightly lower than the overall market at the time and not high from an absolute basis historically given the average forward PE ratio of the S&P500 since 1976 is about 13x.  What is also impressive is Apple achieved the $500B+ market cap level primarily organically without large stock based acquisitions adding to the value of the company.  Apple achieved the $500B+ market cap level via its own success of dislocating markets leading to market share gains in multiple markets, namely, the purchase of music, PCs, smartphones and the newly created tablet market.  In doing so, Apple extracted significant value from other tech companies in the process, namely, Sony, Microsoft, Nokia, Motorola, HP, Dell and others.  So, in a sense, Apple breaking the $500B market cap barrier was the most impressive in my view.

While achieving the $500B+ market cap valuation was achieved in the most impressive manner, the prior five examples show its still challenging for companies to grow market capitalization post $500B.  I remember during the 2000 Cisco analyst day when CEO John Chambers was asked how Cisco could continue to grow 30%-50% given its size.  John answered back that the size of a company should not dictate its growth rate. Well the rest was history after that for Cisco.  The size of a company and its market capitalization does matter in terms of future growth and market cap appreciation. Companies simply get too big to grow at historical rates and mature.

A Look At The Trend In Company Fundamentals, Sentiment and Valuation

Now lets look at some simple investment concepts outside of the law of large numbers to see how the stock may fair in the future.  The three simple questions I look at regarding any stock are:

  1. Fundamentals: Are the fundamentals accelerating or decelerating?
    1. Revenue Growth
    2. Margin Profile
    3. Market Share
  2. Sentiment: Is the stock over-owned or under-owned and is it loved/hated by the sell-side analysts
  3. Valuation: Is the stock expensive or inexpensive relative to the market and peers

Fundamentals Decelerating

While Apple still has good fundamentals, the fundamentals are now decelerating rather than accelerating.  Revenue growth is slowing and margins have peaked and are now contracting.  The simultaneous combination of slowing revenue growth and contracting margins occurred in June 2012 quarter.  In particular, Apple’s past results and future analyst projections show revenue growth rates of 66%, 45%, 29% and 18% respectively for fiscal 2011, 2012, 2013 and 2014.  Apple has also seen its gross and operating margin decline from its peak level in the March 2012 quarter of 47.4% and 39.3% to 40.0% and 30.4% respectively in the most recent September 2012 quarter.   In the case of margins, analysts are expecting Apple’s margins to rise again in future quarters.  This will be important for the stock, as the lack of margin recovery will lead to further analyst earning estimate reductions.  Finally, according to IDC, Apple’s market share in the Smartphone market has fallen from its peak of 23% in 1Q12 to 14.9% in 3Q12. While some might suggest this is due to supply chain issues and a late launch of the iPhone 5 in 3Q, the enormous market share gain of the Android operating system over the same period is concerning for Apple stock. Android share of the smartphone market went from 52.8% in 1Q12 to 75% in 3Q12.

Apple Is Running Out of Massive New Markets To Dislocate

The amazing achievement regarding margins by Apple, is that it has achieved an operating margin of 30%+ as a consumer electronics company.   This phenomenal achievement was accomplished by a very sticky ecosystem and a pedigree of innovation that allowed for premium pricing and many successful products in the consumer electronics industry.  The question now is whether this innovation will continue at the same pace.  I think it will probably not as evidenced by the recent new product introduction of the iPad Mini, which I view as an incremental product, not a breakthrough product like the iPod, iPhone or original iPad.  Apple is running out of large markets that it can dislocate with its products.  The iPod dislocated the Walkman, iTunes dislocated and Compact Disk market and the way we purchased music, the iPhone dislocated the cell phone market and the iPad created a whole new market while partially dislocating the traditional PC market.  The latest innovation from Apple, namely the iPad Mini, is an incremental product not a new market disruption.  Its success will likely cannibalize parts of the iPod and iPad markets. And does not offer any major market disruption.

Will Apple Disrupt the TV Market?

Some have suggested that the next big thing for Apple will be the TV market as Apple will sometime in the future enter the actual physical TV market which is about $80B in annual sales globally.  While this could be a new large market for Apple to disrupt and be a new catalyst for the stock, I would highlight a couple of key points that may not make the TV market as easy to disrupt as other markets.  First of all, profit margins in the TV market are razor thin and well below Apple’s margin.  It is also not clear to me how Apple can leverage its ecosystem to charge a premium price for TVs like they do in the tablet and smartphone markets.  TVs also take more significant shelf space than tablets and smartphones. Apple stores are not as well suited for selling a broad range of TVs as they are for selling smaller consumer electronic devices.  Finally, TVs have much longer replacement cycles of about 7-10 years vs. smartphones of about 2 years and PCs of about 4-5 years.  Thus, its not clear to me that Apple will be as successful in entering the TV market as it was in entering its other markets. I also any disruption in the TV market by Apple is likely to be in the form of an adjunct product (e.g. an enhanced version of the current Apple TV product) that can leverage the current Apple ecosystem and add to it enhanced ways of obtaining, navigating and watching video content rather than Apple selling stand alone TVs.

An Over-Owned and Loved Stock

After reviewing the fundamentals, lets look at the sentiment on the stock. Since the stock has fallen 18% over the past month or so, sentiment is clearly not as strong as it was back the summer. However, Apple is still a broadly owned stock by institutions and given its relative market cap to the S&P 500 and to NASDAQ in particular.  According to Yahoo Finance there are 50 sell side analysts that rate Apple as Buy/Strong Buy with only 4 that rate the stock as Hold and 2 that rate the stock as Sell/Underperform.  This suggests that if Apple stumbles further in future quarters, the sell side analysts are more likely to downgrade the stock than upgrade given the significantly higher number of analysts that are recommending the stock vs. those who are not recommending it.  It also suggests institutional investors will be concerned in owning the stock if they do not view it as outperforming the overall market going forward.  Note, that Apple has missed 2 of the past four quarters either in terms of revenues, EPS and/or projected guidance vs. street expectations.  If this downward momentum continues, we can start to see the street become less positive on the stock, which will limit upward momentum in the stock in the near/intermediate term.

At Least Apple Shares Are Not Expensive

The one thing Apple has going in its favor that will limit downside to the shares is its current valuation.  Based on consensus EPS estimates for fiscal 2013 ending September 2013, Apple is trading at a forward PE ratio of 11.2x on fiscal 2013 EPS.  That compares to the forward PE ratio of about 13.7x for the S&P 500 and 14.1x for the NASDAQ 100.  Thus, Apple is not an expensive stock by any means and if current estimates are not reduced in future quarters, the stock is probably not going to decline much from here.  On the other hand, if gross and operating margins do not recover for Apple to prior levels as most analysts have embedded in their models, earnings estimates will be reduced and the stock will see more downside.

Netting It All Out- Apple Likely Peaked

In my view Apple has likely peaked as its market cap is above the precarious $500B+ level while fundamentals are no longer accelerating and the stock is over-owned by institutional investors and loved by the sell side analysts.  Its current below market valuation in terms of forward PE ratio, however, keeps the stock from being a short at current levels unless margins continue to disappoint in the future.  Successful dislocations of new markets could be the catalyst to drive Apple to all time highs.  The iPad Mini is not such a product in my view as its an extension of the existing iPod/iPad products.  Time will tell if Apple can continue to dislocate new markets. If not, the stock could be entering a maturity phase which will not likely allow the stock to hit new all time highs in the future.

 

Matt Bross To Juniper? I Really Doubt It

Light Reading reported yesterday that Matt Bross, the CTO of Huawei, has left Huawei and is likely heading to Juniper.  The timing of such speculation is very interesting as Juniper executive Stephan Dyckerhoff, EVP of the Platforms Systems Division, announced last week he was leaving Juniper in the near future to pursue a career in venture capital.  Some have taken the Light Reading report and Stephan’s departure as perhaps endorsing the press report that Matt Bross is in-fact heading to Juniper.

I personally think Matt Bross is not going to Juniper.  I think Matt Bross would not be a good cultural fit with the Juniper culture and his joining Juniper would be more detrimental than helpful.  I also think it would be difficult for Juniper to parade around the former CTO of China based Huawei to its top customers as a new senior executive of the company.  The more I think about this speculation, the more I conclude it makes very little sense and Juniper’s management team and board will hopefully see it the same way.