Saturday, December 14, 2013

Cisco's 2013 Financial Analyst Conference

Looking at the three key executive presentations at Cisco's Financial Analyst Conference, management made a case for why Cisco should emerge as the preferred IT provider for large global enterprises, even as their corporate customers face exponentially growing volumes of data, greater demands for analytics and decision making agility, and a rapidly evolving cloud-based computing environment. They make a pretty good case.

At the end of the CFO's presentation, however, it becomes clear that to get to this promised land, Cisco has to navigate a period of low or no growth in their core switching and router businesses, while they begin the most significant product line refresh in corporate history.  The 'core' Cisco business is projected to show revenue growth of 0-1% per annum over the next 3-5 years. This brought the projected revenue growth rate for the consolidated business over the next 3-5 years to 3-6%, which is down 1% from the top end of the prior projected range.  This is the point that wasn't taken well by analysts, who then felt that Cisco might not emerge as the preferred IT provider they aspire to be.

Some points that struck me in CEO John Chambers' slides:

  • CIOs are taking longer to make big commitments to new computing architectures from Cisco and other providers. This is similar to comments made by HP CEO Meg Whitman, and it jibes with IBM CEO Virginia Rommety's frustration with her sales force's inability to 'execute' or close sales on the usual schedules; 
  • Despite this nervousness and macroeconomic headwinds, Cisco has had 5 consecutive quarters of 8-10% growth in revenue from U.S. Enterprise customers.  For the recent 2013 fiscal year, U.S. revenues of $24.6 billion increased by 8.9% over the prior year. U.S. Commercial customer revenues over the same trailing five quarters increased 5-11%.  
  • Current growth areas are cloud computing, mobile, and video, as everyone agrees.  
  • Cisco's research and development budget and acquisitions will be directed to future growth areas in IT services, security, and collaboration.  
  • The key takeaway for me is the CEO's assertion that core routing and switching capabilities will be the foundation for the IT and business processes transformations that will create large, new addressable markets. Most analysts disagree with this assertion.  
Rob Lloyd, President of Development and Sales, made these points, among others:
  • For me these slides make a very important distinction about the different kinds of 'clouds' that will exist in the emerging computing environment, viz. public, or commodity, clouds like those provided by Amazon and others; private clouds, and virtual private clouds, both of which will feature highly developed security environments to protect corporate data.  Lloyd says that CIO decisions will be based on business agility (from the cloud provider and from the responsiveness of the environment), total cost of ownership, data sovereignty and trust and control. The latter two points are, in my opinion, going to be critical for a CIO and a board which will have to look at the risks associated with a move to the cloud. 
  • He has some interesting industry statistics on the components of data center spending:
    • Hardware accounts for more than thirty percent of data center infrastructure spending, despite its increasing commoditization;
    • People expenses account for 29 percent of the spend;
    • Software comprises 22 percent of data center costs;
    • Energy and facilities absorb 12 percent;
    • Disaster recovery (7 percent), Networking (10 percent), Storage (7 percent), Servers (11 percent), and Overhead (2 percent) make up the balance. 
  • Cisco's largest total addressable growth opportunities in 2017 will be in Saas (collaboration, security, and network operations), enabling cloud providers, and building private corporate clouds.  
The financial press suggested that Cisco might become the target of activist investors because of the stock's relative under performance relative to the 88% increase in HP, for example.  I'd find this company to be an unusual target for a few reasons. 
  • As we've said before, despite all the challenges in macro environment, pressures on pricing and reluctance of CIOs to make big commitments, and Cisco's continuing appetite for acquisitions, the company has a fortress balance sheet;
  • Cash from operations of $12.9 billion in fiscal year 2014 increased by 12% over the prior year, and free cash flow was $11.7 billion.
  • The company returned $6.1 billion to shareholders in fiscal year 2013 or 52 percent of its free cash flow, and it wisely changed the mix down to make the share buybacks a lower proportion than in the prior year.  
  • The proposal to divest the set top business picked up during the acquisition of Scientific-Atlanta has been floated, and it might improve profitability, if critics are right, but it's small potatoes in the scheme of things. In addition, the CEOs slides provides a justification for keeping the product line.  
  • If the stock gets below $18, it will be selling at about 9x adjusted fiscal 2014 EPS, which is about the level that HP hit before investor interest started to rise. What new value enhancing ideas would an 'activist' shareholder propose?  
  • The stock has a dividend yield in excess of 3%.  Assuming that the bottom doesn't fall out from under this company, an investor would get paid to wait for some revenue growth.
On the gross margin side, the product gross margin rate did dip below sixty percent in the last fiscal year, declining 1 percentage point to 59.1 percent.  Services margins held in at 65.7 percent, bringing the consolidated gross margin rate to 60.6 percent, a sixty basis point decline from the prior year.  

While pricing and an unfavorable product mix due to the product line changeovers took 360 basis points off the gross margin rate year-over-year, this was entirely offset by productivity gains of 3.7 percent.  In fact, the net erosion in the gross margin rate came from higher amortization of intangibles and an inventory adjustment from the acquisition of NDS.  Fundamentally, the company seems to be managing its manufacturing and procurement operations very well, and it is investing some of its cost-saving from staff reductions into getting design and production efficiencies.  

Analysts said that it wasn't an 'exciting' FAC from Cisco.  Maybe not, but this stock could have some legs in 2014: let's see.  I know that I have some tech head readers from the industry. Send me your thoughts.  

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