A frustrating reality of tech investing is that there's really no competition between growth and value; absent growth, value seldom ever matters enough to move a stock. That's a problem for San Jose, Calif.-based Cisco Systems, Inc. (Nasdaq:CSCO), as this leading networking company is not looking at particularly robust growth anytime soon. Making matters worse, investors worry that threats like software-defined networking (SDN) and cloud service platforms will erode the company's hardware business at an even faster rate.
Cisco shares look undervalued if the company can grow its cash flow at all, but investors now seem to regard that as a big “if.” This could be a bit too negative a position, but investors considering Cisco need to have a lot of patience to realize the value that may remain here.
SDN Is Coming, But Timing, Magnitude Are Unknown
Software-defined networking threatens to undermine the switching business that has long provided Cisco with a large chunk of its revenue -- around 30% at last count. Palo Alto, Calif.-based Hewlett-Packard Co. (NYSE:HPQ) and Juniper Networks, Inc. (Nasdaq:JNPR) of Sunnyvale, Calif., barely offer a serious threat to Cisco in switching, but the switch to SDN could undermine a lot of the value that Cisco has built in this business.
Software-defined networking features a centralized controller with a complete view of an entire network and knowledge of all paths and capabilities, allowing it to best route traffic through the network as conditions change. This allows a network operator to use cheaper, less sophisticated “white box” switches as the centralized control plane takes away the need for smart switches that recognize and manage different types of packets.
The threat, then, is that the SDN offerings of companies like Palo Alto-based VMware Inc. (Nasdaq:VMW) and Microsoft Corp. (Nasdaq:MSFT) of Redmond, Wash., will seriously undermine the value of Cisco's switches. So far the implementations of SDN have been limited and it's not always as easy as advertised to swap out a network of smart switches for more commoditized switches. Over time, though, there is a real risk that SDN controller offerings from VMware and others will shrink the market for Cisco's high-value switches.
Cisco isn't standing around waiting for this to happen. The company is developing its own SDN capabilities and is also pushing its “Application-Centric Infrastructure” that unsurprisingly maintains a role for Cisco hardware.
Can Cisco Put Its Cash To Good Use?
Unlike Armonk, N.Y.-based International Business Machines Corp. (NYSE:IBM) and Santa Clara, Calif.-based Oracle Corp. (Nasdaq:ORCL), Cisco doesn't have a particularly good history of value-added M&A. The company's expensive forays into video haven't really added value and it's unclear that its Sourcefire acquisition will maintain the company's leadership in the face of entrenched competitors or new players in the security space. Likewise, the company hasn't always done a good job of identifying oncoming threats, such as Seattle-based F5 Networks, Inc. (Nasdaq:FFIV) in application delivery controllers (ADCs) and heading them off through acquisition or competitive response.
As tech companies mature, skillful M&A becomes more and more important. Referring back to IBM and Oracle, a large percentage of the most competitive businesses there were acquisitions. Developing multiple successful business is beyond the capabilities of most companies and Cisco needs to be better about identifying key acquisition targets to maintain its relevance in the changing IT hardware and software markets. To be fair, this is not a Cisco-exclusive problem, as neither Juniper nor Hewlett-Packard have really distinguished themselves with good M&A. It's also important for companies to recognize when it's time to exit a business. IBM is perhaps the best example of this, as the company has been willing to sell off major businesses (personal computers and x86 servers, for instance) once it became clear that the growth of the market and the company's position were no longer good enough to earn acceptable returns.
Not Enough Growth In A Growth-Hungry Market
By most reasonable measures, Cisco is not an expensive stock. The company's margins and return on capital argue for better multiples to sales, EBITDA and book value than the market currently gives the stock. Unfortunately, that's just not how tech typically works; revenue growth has a disproportionate influence over tech stock multiples and current estimates are calling for just a 1% revenue CAGR between fiscal 2013 and fiscal 2016.
Going forward, expect Cisco to see some negative impact from SDN and a shift toward cloud infrastructure services but it should still still post low single-digit growth. Free cash flow (FCF) growth should be negligible, though, as Cisco should see margin/FCF de-leverage. Even with minimal growth, though, a discounted cash flow model suggests a fair value in the high $20s.
The Bottom Line
It's going to take time for Cisco shares to deliver on the potential suggested by a discounted cash flow model. There's a risk that the company's revenue and FCF come in even lower. Right now there's a great deal of pessimism regarding Cisco's ability to compete and grow. That pessimism could pass but it'll take some time, making CSCO a tough stock to recommend. The value seems to be there, but the Street's fears will have to put to rest first.
Disclosure: as of the time of writing, the author owned shares of EMC, the majority owner of VMware.