Cisco FY4Q19: Subscription Nears The End of The Beginning

The Important

  • Cisco now classifies 70% of software revenue as subscription
  • This includes a wide scope of licensing arrangements
  • Cisco has struggled hard over many years and done well
  • But this is just the beginning
  • The future belongs to the networking company that transforms to ratable, subscription, services.
  • This will maximize financial outcomes
  • This will become the basis of competition with disruption opportunities along the way

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Discussion

Analysis of Cisco’s FY4Q19 earnings disclosures rightly focuses on the dramatic decline in China revenues in response to trade tensions, the broader weakness in APAC (bohcay modeling), the weakness in SP / uncertainty as to when investment in 5G Enterprise services will provide Cisco an uplift, the opportunity for share gains in the transition to 400G, and a conservative FY1Q20 guidance. All important quarterly / annual analysis issues.

If we look longer term, one prominent aspect of Cisco’s strategy is its transition to software subscriptions. Cisco reported in FY4Q19 that subscriptions now represent 70% of software revenues. Cisco classifies a range of software licensing approaches as subscriptions, including ratable security services, SaaS, and term licenses, presumably including Enterprise License Agreements, which Cisco has leaned on heavily in recent years.

This begs the question, do all these approaches classified as subscription deliver on the goals Cisco has: do they provide stickiness, do they flatten out bumps in the road, do they maintain competitive advantage?

I view the answer to these questions in two parts:

  • What type of subscriptions should networking companies be offering?
  • What is the right mix of software and equipment for a company like Cisco?

What type of subscriptions?

If you’ve been following this blog, you know I have a strong bias towards service subscriptions, the kind of subscriptions that provide ongoing value like advanced security subscriptions do, the type that are ratable, and should be automatically renewed unless the customer notifies of intention to cancel. That’s hard for some to imagine, but this is where business general managers and product managers have to really spend some creative cycles with their customers. Someone is going to disrupt the industry by working out how to leverage the cloud to change the game in networking. We have already seen glimpses of what is to come with companies like Meraki  and SD-WAN solutions , but there is surely much more to come:

If you believe this, then as Cisco approaches 100% of software from subscription, we have reached the end of the beginning. The phase where the industry, specifically Cisco, trained customers to purchase software in a different way. What is the next phase? Truly leveraging the subscription paradigm to change the experience of operating a network, to replace today’s OPEX, with less expensive subscription services that do more efficiently, optimally, and timely, what is being done today; to develop new value propositions and capabilities.

Right Mix of Software and Equipment

As noted in our quick back-of-the-napkin analysis of Cisco’s FY3Q19 data, Cisco’s product revenue is still dominated by the Infrastructure Platforms category, and that category is still highly correlated with total product revenue and total product and service revenue. In short, the Infrastructure Platforms category still has a significant influence on Cisco Revenue dynamics, despite the good work Cisco has done with acquisitions and new offers such as the Cat9K.

This point was born out somewhat in FY4Q19, where Infrastructure revenue growth on a dollar basis was $49 million less than last year, where as Applications and Security increased $43 million more than last year. Applications and Security has a much higher growth rate than Infrastructure, but on a significantly smaller base, so in dollar terms, Infrastructure revenue still dominates outcomes for Cisco.

Cisco FY4Q19 by categiory

Note: Includes Divested SP Video Software Solutions (SPVSS)


Figure 1. Cisco Revenues by Category, FY4Q17-FY4Q19. Source: Cisco Systems.

One answer to this problem is to shrink the Infrastructure Platform category. Not a good strategy, and not that likely while the Cat9K, and other Enterprise portfolio products are in a refresh cycle.

What else is left?

Well you don’t really convert software running on equipment to the type of subscription services I am talking about above without a significant amount of R&D investment. That would take vision, leadership, and courage. It is also hard to do when you are trying to keep a large installed base happy. That said, the Cat9K advanced subscriptions are interesting directionally.

Cisco probably needs to do the type of transformational acquisition that it typically is not comfortable with, an existing large software / SaaS company. Assuming Cisco can not get comfortable with that approach, then it will need to double down on smaller acquisitions, and maybe even at a faster rate than it has been doing so far.

Infrastructure Platform revenue is still 78% of product revenue, and has been hovering at that level for some time. Cisco needs to bring that ratio way down if it really wants to change its revenue dynamics. I should note, that software / services may have more of an impact on margins than revenue, so if that is the case, there is much goodness in what has already been achieved by Cisco. But margins is one game, and revenue dynamics / total cash flow, and EPS are others.

Conclusion

There is a high probability that the way networking companies are thinking about subscription offerings today is just a step towards a richer future of subscription services that radically change the experience of operating a network, becoming the basis of competition, and providing the opportunity for disruption. Cisco can not declare victory at 70%+ of software being subscription as currently defined. They need to keep pushing forward into this new world of Network-as-a-Subscription Service, and I suspect they will.

Cisco’s product revenue is still dominated by Infrastructure Platforms. They need to push the accelerator on a strategy that changes their revenue mix, if they really want to transform their revenue dynamics.

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