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.