Cisco Highly Differentiated. Law of Large Numbers Still Looms

With the Cisco’s FY4Q earnings call scheduled for next week, August 14th, some quick back of the napkin analysis on Cisco’s progress through FY3Q, towards transforming its business model. Will follow up with more analysis after the earnings call. Please note, this analysis is based purely on data made public by Cisco and does not take into account qualitative statements made by management.

The Important

  • There are many different ways to judge transformation
  • In this report, we focus narrowly on the issue of revenue composition and dynamics
  • Amongst its peers, Cisco leverages its M&A muscle better than anyone
  • Cisco has successfully leveraged its M&A muscle to create two categories of revenue that have much different dynamics than its core business: Security and Applications
  • Despite the success Cisco has had, it is hard to escape the law of big numbers, which still looms over Cisco’s transformation

M&A as Strategic Lever

There are a few obvious ways that Cisco is highly differentiated from its major North American competitors, Arista Networks and Juniper Networks:

  • Sales-driven culture with strong channel dominance
  • Highest investment in R&D on a $ basis (assumption)
  • Breadth of installed base
  • Strength of M&A experience and capability

It is the last of these which is of special interest to transformation. Organic transformation is hard. Extremely hard. Statistically doomed to fail, most of the time. There are many reasons for this. See:

Any high-percentage(1) transformation effort is therefore going to have a large inorganic strategy element and/or a complete separation of the new business from the existing business. In the networking industry, there is no company better at acquisitions than Cisco, notwithstanding there are and will be misadventures. Cisco is of interest to investors not just as a networking play, but an overall IT/tech bell-weather.

So Cisco is the best when it comes to M&A, and M&A is an extremely important lever for transformation.

How has Cisco Done?

Cisco has done well. Cisco turned around its Security business, growing revenue from $485 million in FY1Q16 to $707 million in FY3Q19, at a compound rate of 2.7% per quarter, and the Application business from $1.1 billion in FY1Q16 to $1.4 billion in FY3Q16, at a compound rate of 1.7% per quarter. In contrast, the Infrastructure platform category grew from $7.48 billion in FY1Q16 to $7.55B in FY3Q19 at a compound rate of 0.1% per quarter (Infrastructure business was at $7.6B in FY1Q19). Perhaps worse still, if not for the Cat 9K refresh and other portfolio enhancements, the Infrastructure Platform category may have declined at a compound rate of -0.9% per quarter (bohcay LLC model).

Even with the good performance of Security and Applications, Cisco’s Infrastructure Platform business still represents 78% of product revenue. Without the Cat 9K refresh, perhaps Infrastructure would have declined to 75% of product revenue, still a large percentage.

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Figure 1. Cisco Revenue composition estimate without CAT 9K refresh

The good news for Cisco, as shown in Figure 2. is that revenue streams like Security have arguably less seasonality than the Infrastructure business, and may have even less as subscription business grows. Same for the Applications business. The dampening of security seasonality seams more apparent in the last 4 quarters than the 4 quarters before that (just eyeballing it), so the trend appears to be improving for Cisco. This could simply be a function of more consistent growth, so the long-run seasonality pattern may not be revealing itself just yet.

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Figure 2. Cisco Product Revenue Trends by Category, FY1Q16-FY3Q19

Cisco has done well to build two revenue categories that are growing faster than the core business, appear to have less seasonality than the core business, and have the potential to have a higher rate of subscription model attach than the core business (as traditionally delivered, there are some changes occurring in the core business as well). But the core Infrastructure business is still 78% of total product revenue, and perhaps only as low as 75% if we model out the Cat 9K refresh / consider the trajectory of the Infrastructure Platform business prior to the Cat 9K.

There is still a high correlation between Infrastructure Platform revenue and Total Product Revenue, as well as between Infrastructure Platform Revenue and Total Product and Service Revenue. Which means the overall seasonality and cyclicality of Cisco’s total business may remain highly correlated to its core business, the Infrastructure business; a correlation that may remain for many years to come.

This is where the conversation turns to should Cisco structure its business as two different stock offerings, have a tracking stock for the growing business areas, divest, create subsidiaries, and other strategic options. That is a complex issue for a different day. What can be implied just based on the above quick/back-of-the-napkin analysis is if Cisco wants to continue with the Infrastructure, Security, and Applications categories under one P&L, Cisco should probably consider doubling down on the software and services acquisition front. I don’t mean to imply Cisco is never looking for good acquisition matches, I am confident it always is. I just mean to imply, it probably has to be even busier than it already has been, if it wants to move the needle on its transformation in the next few years. Cisco has the M&A capacity to do so, if there are appealing assets to be bought.

For full charts and analysis, purchase the Cisco Transformation Analysis report at this link.

(1) High-percentage meaning a statistical probability of succeeding. That does not mean it is impossible to do transformation organically, it just means that it is hard, statistically likely to fail, and should probably not be undertaken unless there is a compelling reason and a talented leadership team 100%+ aligned and committed to the transformation.

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