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Cisco spent $14.5 billion on R&D to achieve $3.4 billion net revenue increase
Tue, 6/14/11 - 5:53pm    View comments

Mark SueCiscoToday, RBC Capital Markets Managing Director - Mark Sue made the following alarming observation (at least in my opinion):

"Cisco's revenue growth had been consistently ahead of growth in R&D expenses from FY04 until FY08. However, starting in FY09, R&D expenses have continued to grow while revenue growth has slowed. From 2008 to 2011, Cisco spent a total of $14.5B in R&D and achieved a net revenue increase from 2008 to 2011 of $3.4B (or just +3% CAGR)."

Cisco's R&D Expense Growth vs. Revenue Growth

Cisco's R&D Expense Growth vs. Revenue Growth

Also today, Sue made the following additional observations about Cisco:

Switching market competition is making growth difficult for Cisco

"Cisco went on a long and costly crusade while not protecting its home turf of switching (30%) and routing (17%). Ethernet switching had a strong year in 2010 with ~28% growth, according to IDC. In 4Q10, 10Gig Ethernet led the way with ~57% YoY growth in revenues, more than 1.1M in ports shipments and a ~30% YoY increase in Gigabit Ethernet revenues. Cisco benefited from market recovery/growth and maintained its leading market share position of ~66% in switching.

"However, the switching market experienced a slowdown in the first quarter of 2011 with worldwide Ethernet switching declining -9% YoY. 10Gig Ethernet remained strong at ~16% YoY growth from data center deployments, shipping 1.35M ports, but at a lower price per port of more than -20% compared to the December quarter. The weakness was seen on the Gigabit Ethernet side, which decreased ~13% YoY. Cisco's market share declined to ~64% of the total Ethernet switching market, driven by the weakness in Gigabit Ethernet. It's our view that the switching market will be challenged for some time and for established vendors such as Cisco, it may be difficult to regain share throughout the year.

"If competition intensifies in switching, Cisco may do tactical things to defend its market share such as cut prices, expand margins, and bundle its wares. We've seen a lot of these actions already and Cisco often may offer extended payment terms to customers to win the deal with buy now with no payment till later options. Some of this is evident in Cisco's DSOs which about two years ago were 27 but now stand at 37 days.

"Our analysis shows an increasing correlation between technology products in the maturation cycle, in Cisco's case switching and routing and global GDP. There are years when the growth rate of these segments can increase sharply but it may be more related to the growth in the particular region where the product is sold rather than a sub-cycle related to a new product."

GDP vs. Cisco's Core Businesses (Calendar quarters)

GDP vs. Cisco's Core Businesses (Calendar quarters)

Where can Cisco's stock price go? (How about down to $13 or even $11 per share)

"If Cisco takes drastic actions, increases accountability and refocuses back to what it does best, we do see the stock eventually rebounding. Near term, there's just too much going on, a lot of the good executives may be departing and the company may now be in the unfamiliar position of restructuring to fix its problems. Divesting is not easy particularly when you paid top dollar to acquire some of these lower margin assets. For its part, Cisco has a war chest of $43B in cash but approximately $39B is held overseas. The company also has debt of $17B. At the moment the cash is earning ~1.5%. Without meaningful action and clarity of outcome, investors may resort to an EV/Sales multiple of 1X forward revenues implying a price of $13.

"Overall port growth may remain strong in our view yet with pricing declines in certain segments of desktop and stackable switching declining over -20% YoY, Cisco may need to lower prices to maintain its current footprint to drive future upgrades. Our bear case scenario which assumes revenues in CY12 of $44B (+2% YoY), overall gross margins of 56% and operating margins of 20% (factoring in the cost savings initiative of $1B) gets us to potential trough earnings of $1.30. Normalize these earnings for stock based compensation and its closer to a worst case EPS of $1.05, apply a P/E of 10X can result in a stock price of ~$11."

Cisco's Preoccupation with Telepresence and UCS

"Cisco may have pushed too deeply into existing markets and in the process hurt many partnerships by over focusing on telepresence and UCS. Collaboration has been growing near +40% YoY over the past three quarters and UCS has grown tremendously over the past few quarters (+31% in F3Q11) and is now at an order run rate of $900M. However during the process, many of Cisco's partnerships deteriorated and began to collectively work against Cisco. Many of Cisco's partners in collaboration are now in partnership with its main competitor, Polycom. Key Polycom allies now include HP, IBM, Microsoft, Juniper and others."

Is a Massive Cisco Stock Buy Back Possible?

"Cisco may continue to buy back shares as the stock price is at the lowest level since the recent financial crisis. Cisco currently has $11.7B remaining on its stock repurchase program and has already repurchased $5.3B of stock in the first nine months of this fiscal year. What may make it difficult to increase its repurchase rate is the fact that Cisco only has $4.6B of its total cash balance of $43.4B held domestically and a dividend commitment of ~$1.3B annually. However, Cisco can pay a repatriation tax on the cash held overseas to use for repurchases although we find it unlikely. Cisco does generate a healthy amount of cash and may use some of the cash from operations (~$10B in last four quarters) to fund its financial activities. If Cisco took all its domestic cash and spent it all on a massive buyback, it would add two pennies to the consensus July quarter earnings of $0.38."

Cisco Cash Used for Share Repurchases

Cisco Cash Used for Share Repurchases

Cisco's Gross Margins, Where Will They Settle?

"Gross margins for Cisco peaked at 70.8% and have steadily declined to 62.4% before bouncing to 63.9% last quarter from the benefit of nonrecurring items. Near-term, Cisco has guided for gross margins near 62% for the July quarter. The best way for Cisco to improve gross margins is to get rid of its low margin businesses; easy to do but a little complicated in the case of Cisco. In our estimate, gross margins for the UCS segment may be near the mid 30%s but is expected to improve with volume over time. Certain segments such as home networking (competitor NETGEAR has GMs of ~32%) may not really recover considering it's just the nature of that particular business.

"Rank order Cisco's business segments and we believe gross margins on certain products are near 85% (high end router line cards for example) all the way down to low 30%s (certain set top boxes). Switching gross margins typically, we believe, were previously in the high 60%s but have steadily declined over time to our estimate of low 60%s. Value engineering and component cost reduction are many things Cisco can do to enhance its gross margins but the gravitational pull of pricing may make it increasingly challenging to maintain overall corporate gross margins in the low 60%s, in our view. Footprint at enterprises and service provider customers are very important and Cisco, from what we've noted, is tackling competition with price.

"In our dialogue with a broad range of competitors, the common theme it seems is that it may actually be easier to gain share from Cisco vs. even a year ago. Cisco is losing share in application networking to F5, in security to Checkpoint and Fortinet, in switching to Juniper and HP, in Edge Routing to Alcatel-Lucent, in wireless to Aruba, in CMTS to Arris, in set top boxes to Samsung, in WAN optimization to Riverbed, and the list goes on. It wasn't always like this and Cisco had accelerating revenues, gained share, and made life miserable for competitors all while holding on to impressive gross margins. It's a different company now and we think catching up in technology where leapfrogging is required to stem market share loss, may prove to be difficult undertaking for Cisco."

Cisco's Historical Gross Margins

Cisco's Historical Gross Margins

Pruning Cisco's Portfolio for Future Growth

"Cisco's strategic acquisitions have fuelled most of its growth over the past 10 years and its portfolio of business units subsequently expanded over that time period. Some acquisitions were good for Cisco but others were not as lucrative as once thought. However, in this process, Cisco did not proactively prune its lagging product lines and it ultimately may have led to its margin compression. Cisco is in the evaluation process of its business lines and has already shut down its Flip camera business but it's our view that there may be others that need to be either sold or shut down all together. Also during this transition period, Cisco must also actively search for new growth acquisitions that are accretive to earnings and strategic fit with the other business units.

"A portfolio approach to product management implies having many segments in various parts of the life cycle and Cisco used to be very artful in funding new technologies by harvesting others. Too much attention went into Telepresence and UCS and not into the other segments which not only have become rapid growth markets but have become strategic to the networks as well. It's happened before at Cisco when anything Service Provider related received the predominant share of resources at the company. Routing provided a source of stability for Cisco for many years and Cisco's now been in a switching 'transition' for over three years now, implying more active pruning for non-strategic segments may have been required. Our view is also that portfolio leverage needs to be protected but should also run across business groups and customer segments so that Cisco avoids the mistake of becoming a large holding company."

Cisco's End to End Architecture Solution is Out of Date

"In the past, network complexity was enough for IT organizations to adopt an end to end architecture solution for their enterprise networks and Cisco was the vendor of choice. However, as the network has evolved and competitors have become more specialized and technologically forward, IT organizations began to build their networks with best of breed solutions. Because of this structural shift, systems integrators like IBM, HP and DELL have benefitted from being a supplier of best of breed products and customers benefit from being able to pay one bill. Large tech companies typically end up being major service integrators and most of these companies now have service revenues at over 20% of total revenues."

Services Revenues % (Calendar Quarters)

Services Revenues % (Calendar Quarters)

More key observations about Cisco made by Mark Sue today:

  1. "Cisco may be preoccupied with re-org and restructuring and not on reclaiming lost market share, expanding its product development and improving its financial model.

    "Large cap tech companies, our study shows, display decreases in R&D efficiency and their organizational structures may further hamper the ability to innovate. Despite the stock trading at a discount valuation of 8X CY12 consensus EPS, the multiple may compress even further. With our view of commoditization of the switch market, Cisco's margins may move lower dragging down forward earnings. Rating is now Underperform. New CY12 EPS of $1.65 compares to the consensus of $1.79. GAAP earnings may be closer to $1.35."

  2. "The root cause of many of the challenges facing Cisco today were driving towards an unrealistic growth target of 12-17%, assuming a layered bureaucratic structure, and moving into the entrenched server market.

  3. "The last concern had the unfortunate result of creating enemies out of Cisco's once trusted tech allies. Many of these concerns are already behind us but we believe not enough drastic and necessary actions have been taken and Cisco is now in the situation of losing wallet share with customers."

  4. "Over the past three years, Cisco has lost over $73B in market value.

    "Restructuring can sometimes create a false sense of productivity and may not address the heart of the matter and for Cisco; driving network complexity during a period of technology standardization is resulting in share loss. Nokia, Motorola, Nortel, Alcatel-Lucent and Ericsson have gone through long and difficult restructuring periods."

  5. "Cisco erred by underestimating the response from competitors in its big bold move into the $48B server market, dominated by IBM, HP and Dell.

    "They are now aggressively responding to grab Cisco's once lucrative switching market estimated at $18B."

  6. "It may be a lengthy 'transition' period in our view and the shrinking revenues and margins may keep growth investors on the sidelines.

    "Normalize earnings ex-stock based comp and Cisco's CY12 P/E may be near 11X vs. Apple's P/E also at 11X pointing to little relative value. Cisco's $43B in cash if in the U.S. would be a tremendous asset but stuck overseas, it's not doing much for the company."

What's your take, do you agree with Mark Sue's observations about Cisco?

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