Why Cisco’s Stock Is Worth $32

Over the last few years, IT hardware manufacturers have observed a slowdown in product sales due to low global demand. This trend is expected to continue through the rest of 2016, with global IT spend likely to decline by around 0.5% to $3.49 trillion in 2016, according to a Gartner estimate. ^[1] Networking giant Cisco (NASDAQ:CSCO) has not been immune to this change, and has reported revenue declines across multiple product lines over the years. Cisco’s core hardware product sales – including network switches and routers – have witnessed limited growth since 2011, as shown in the table below. Both of these revenue streams combined formed roughly 60% of Cisco’s product revenues last year. On the other hand, new product lines such as Data Center products, network security solutions and Wireless products have grown significantly in the same period.

According to our estimates, Network Services and Network Switches both make up roughly a fifth of our $160 billion valuation for Cisco. The Routing segment makes up around 11% of Cisco’s valuation, and other market segments including Network Security, Data Center and Wireless segments combined make up roughly 15% of our valuation for Cisco. Below we take a look at key growth drivers for Cisco and why we maintain a $32 price estimate for Cisco’s stock.

Cisco’s Year-To-Date Performance

Keeping up the trend from previous years, Network Switches and Routing revenues through the first three quarters of 2016 have been roughly flat over the comparable prior year period. Additionally, Collaboration, Data Center products and Wireless revenues have also witnessed limited growth as shown below. Service Provider Video revenues have fallen by 19% year-over-year primarily due to the the company selling of the SP
Video CPE business in November last year. On a positive note, spinning off this business has led to a significant improvement in the company-wide product gross margins. Moreover, On the other hand, Network Security solutions and Services revenues have continued to grow at a steady pace.

Cisco’s combined Product gross margin in 2016 thus far has improved by almost 3 percentage points to over 63%, while its Services gross margin has improved by 140 basis points over previous year levels to 65.7%. There are two key reasons for an improvement in both product and services gross margins this year. Firstly, the company’s business is transitioning to a more software and SaaS based solutions, which typically have higher margins compared to hardware products. ^[2] Secondly, Cisco sold off its low-margin SP Video CPE business in order to improve its overall profitability.

Robust Long-Term Outlook

In the long run, we forecast network switches and routing revenues to grow at a steady 2% – broadly in line with the industry-wide growth. Much of the top line growth for products is likely to come from fast-growing revenues streams such as Collaboration, Wireless products and Network Security revenue streams.

Collaboration revenues are likely to be driven by the need by global businesses to connect across geographies. The huge demand for conferencing software solutions in addition to software-based instant-messaging (such as Cisco WebEx), business messaging (Cisco Spark), Telepresence and communication gateways software products should help drive revenue growth.

The rapid proliferation of wireless devices in recent years has impacted the work environment as well as people’s work habits, making Wi-Fi an absolute necessity in the office as well as public space. Over the last three years, the wireless LAN market has grown at less than 10% a year, which is much higher than the overall computer hardware and infrastructure market. Cisco has reported a 15% annual growth in Wireless product revenues in the same period with a strong outlook for future growth.

Another fast growing revenue stream for Cisco has been Network Security, with a 9% annual growth in revenues from 2011 through 2015 as shown in the table above. Over the years, it has become an increasingly important component of networks as enterprises look to safely share data between geographically separate individuals and teams. Cisco’s expertise in network and data center security includes advanced threat protection, web and email security, access and policy, unified threat management and managed services, while the company sells equipment like Virtual Private Networks (VPNs) and firewalls.

In addition to the fast growing product lines, Cisco’s services could continue to drive much of the company’s top line growth given the increasing mix of service and subscription-based solutions on offer. A services-based business model is typified by the steady, recession-proof revenues that it brings in from customers due to past contracts and a wide-aggregated customer base. Post-sales services and subscription based revenues are more beneficial to Cisco since they are annually recurring revenues, compared to the lumpy demand caused by product life cycles extending for multiple years.

You can modify the interactive charts in this note to gauge how a change in network security, wireless, collaboration revenues or gross margins can have on our price estimate for Cisco.

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1. Gartner Says Worldwide IT Spending Is Forecast to Decline 0.5 Percent in 2016, Gartner Press Release, April 2016 [↩]
2. Cisco Q4 FY 2016 Earnings Call Transcript, Seeking Alpha, August 2016 [↩]