Initiation of Coverage Brief

19 October 2020

Key Points

  • Cisco is widely viewed to be in a position to take advantage of both the COVID pandemic eventually ending and Huawei rising security concerns, however, its infrastructure platforms (>50% of sales) declined ~3% per year from F13 to F20.
  • The company’s focus on Applications and Security matches well with our view that networking is moving to be dominated by software. SD-WAN is just the latest push by software into networking. Security should do well (it was the only segment to grow in the July quarter, up 10% YoY), driven by its Duo and Umbrella products.
  • Global internet penetration has grown from 25% in 2010 to 62% in 2020 (by Internet World Stats) and is projected to grow to 90% by 2030 (by Cybersecurity Ventures). Consensus projections are for 1% growth in industry revenues the next three years, down from +5% CAGR the last decade.
  • Networking market share changes tend to take time as multi-vendor enterprises are rare. Taking market share from Arista and Juniper is likely to be difficult, as Cisco is already the market leader (47% according to IDC).
  • The Catalyst 9000 has been strong (up double-digits last quarter), but enterprise campuses are now empty, and the focus is on remote access. Some customers are taking the opportunity to upgrade their empty campuses, however there could be a pause in Cat9k strength.
  • While the world is hoping for some type of recovery post-COVID, consensus estimates for Cisco’s October quarter are for a 10% revenue decline and a 16% EPS decline. Management’s guidance and tone is inline with these estimates. F1Q21 earnings are expected to be released on 12-Nov-2020.

Catalyst Monitor

  • Ethernet switches are historically the core product for Cisco. It has been losing share to the likes of Huawei for a few years; Cisco’s Ethernet switch share is down from 51% in C2Q19 to 47% in C2Q20. Tracking the Ethernet switch market gives investors a quick view into the health of the enterprise networking market and the relative strength of the individual market players. According to IDC, Arista had a 6% share in C2Q20 (down from 7%) and Huawei had 12% (up from 10%).
  • Security, which was up 10% in F4Q20, is a key initiative for Cisco. Cisco’s acquisitions in the security space are likely to continue and should give color around Cisco’s success in Security. The balance to the growth in Cisco’s Security segment is that it is still only 6% of revenue.
  • There has been significant attention on the Catalyst 9000. Its growth is still important to Cisco as it’s the amount of software Cisco sells with it. However, with enterprise campus efforts now taking a backseat to other networking concerns, we could see investors (and Cisco) look to other elements of the portfolio (like Webex).
  • Cisco’s software and services revenue is now over 50% of the total, and 78% of software is now sold as subscriptions. These trends should help keep the company’s gross margin up and it seems investors are focusing on Cisco’s top line trends. Consensus EBITDA margin is for declines from 37.5% in FY20, to 36.0% in FY21 and FY22, and 33.1% in FY23.
  • Like many in the networking space, SMB has been weak for Cisco. Large Enterprise and Federal have been strong. Expectations are for another YoY decline next quarter in overall revenue. SMB is unlikely to meaningfully recover until the COVID situation eases.

Our Insight

The Potential Opportunities

With COVID-19 changing nearly every business, Cisco has new potential opportunities that could accelerate its trajectory.

COVID-19 causing a pause, but growth should return possibly even stronger

While COVID is causing customers to pause, the longer-term impacts could be a positive for the networking industry. More remote workers, more remote video, and a more clouddriven business worldwide creates more demand for networking. Industry estimates continue to see growth for the medium term; datacenter networking is estimated to grow over 10% the next five years to over $40bn annually. As a leader in networking, Cisco should be able to grow with the market, but execution is important. Consensus expectations are for a 2% revenue decline in F21, followed by 4% growth in F22.

Applications and Security Groups could drive growth

Applications (11% of revenue) and Security (6%) have been seeing significant investment by Cisco. Apps and Security are outside the core hardware business, but leverage Cisco’s large install base of equipment. Moving toward more Applications and Security is critical to Cisco’s push for more subscriptions and recurring sales; moving away from product cycle driven revenue. Acquisitions in these areas should continue to supplement internal R&D efforts. In F4Q20, 51% of revenue was from software and services, which hit the company’s three-year target of 50% by F20. CEO Chuck Robbins said on the August earnings call that, “Security continues to be a top priority for our customers, particularly in this distributed digital world.”

As CPU’s continue to improve performance, more and more of the comm equipment industry will likely be driven by software. SD-WAN is a major element of Software Defined Networking (SDN). SDN provides agility, flexibility, and visibility for workloads that are now distributed across multiple clouds. Security is also becoming more software than hardware. Cisco has underperformed in network security over the years, but it still has a chance to be a leader in the space if it can leverage its dominance in networking hardware. This software taking over networking trend will likely continue for years. Note that the Cat9k comes with embedded software that can be upgraded for a price.

M&A could accelerate, possibly becoming more important to Cisco’s growth

Cisco has been buying up technology companies for decades, but this could accelerate as the pace of technology development continues to accelerate. COVID’s impacts have also made some R&D of less interest (e.g., campus) vs. others (e.g., remote access and security). In early 2016, CSCO acquired cloud based IoT SaaS company Jasper Technologies for $1.2 billion. In 2017, it was the much-discussed cloud monitor AppDynamics for over $3.2bn. In 2018, it was cloud contact center software maker BroadSoft for $2.2bn, SD-WAN provider Viptela for $500mn, and Duo Security for $2.4bn. In 2019, Cisco acquired silicon photonics maker Luxtera for high-performance networking optics.

Huawei concerns could provide upside to consensus expectations

Huawei passed Cisco in the service provider market in C2Q20; 36% vs. 33%. The lower prices of Huawei where effective but security concerns are starting to have a material impact. Extreme Networks cited a recent win at a SP where Huawei was just dropped from consideration. Cisco could regain the lead in SP as more SPs move away from Huawei and longer term start to replace installed Huawei equipment.

The Obstacles

Although there are numerous favorable tailwinds, there are also headwinds that must be navigated and overcome. The company has a long operating history, and there are a variety of externalities and issues that have been problematic, but nonetheless many believe that is the reality. Some of the highlighted obstacles include the following:

  • It is obvious, but external economic factors, elections, geopolitical issues, pandemics, etc. can all negatively impact demand for any product or service and Cisco is no different. On the August earnings call, the company said it would cut costs (more than $1 billion annualized) as COVID has impacted many customers. The company had its first yearly revenue decline in three years (down 5%). This could make for easy year / year comparisons, but COVID could also continue to have negative impacts.
  • Arista has effectively owned the cloud networking market for a few years and there have been expectations that Cisco will start to make some inroads when the cloud titans move from 100G to 400G. However, multi-vendor networks may be a luxury that a post-COVID world will not support. Microsoft Azure has been on a multi-vendor path, but Microsoft was pausing network purchases even before COVID hit the US. Altogether, this may cause Cisco’s window of opportunity to shrink, if not close completely. While Cisco grew its webscale business double-digits for the third quarter in a row, the revenue level is still not meaningful. The cloud titans will likely continue to be a challenge for Cisco.
  • Management changes can be a catalyst for a stock, sometimes positive sometimes negative. The announced retirement of CFO Kelly Kramer comes at a difficult time for Cisco; the company is having revenue challenges and is going to be cutting $1bn in expense over the next few quarters. Ms. Kramer plans to stay on until a successor is appointed.