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Why Cisco Systems, Inc. (CSCO) Stock Will Pay Off in the Long-Term

CSCO stock is evolving, but the final destination should be profitable

By James Brumley, InvestorPlace Feature Writer

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While most stocks remain in the midst of the post-Trump rally, not every name has remained on that bullish train. Cisco Systems, Inc. (NASDAQ:CSCO) is one of those few exceptions. Although CSCO stock got November started on a bullish foot, once the company unveiled its fiscal Q1 numbers on Nov. 17, the selling has been brisk. Cisco stock fell 5% that day, and since then, it has continued to lose ground.

It wasn’t exactly the first quarter results, however, that did the bulk of the deed. It was the company’s lackluster Q2 outlook (and beyond) that was the concern for owners of CSCO stock. In short, the maker of networking hardware is facing a top-line and bottom-line headwind.

Yet, as Cisco CEO Chuck Robbins commented in the aftermath of the Q1 report, “You have to look at it over time, and not just quarter to quarter.”

He’s got a valid point. The question is, what’s Cisco going to look like in time, once it completes its paradigm shift? Perhaps more important, what might send CSCO lower should the transition not flow well?

CSCO Changing Business Model

CSCO is well established as a networking equipment name. Indeed, the company’s moniker became synonymous with networking in the late 90s, and although it has been dinged up a bit, Cisco stock has held onto that crown ever since. Outright sales of hardware was its business model.

As technology has changed though (and as competition caught up), CSCO is being forced to adapt. Hardware means less, and software means more.

This shift is readily evident in last quarter’s revenue mix. Product revenue was down 1%, while service revenue grew 7% on a year-over-year basis. Switching revenue — the company’s bread and butter — was off 7%. Conversely, deferred product revenue related to recurring and subscription-based business grew 48%.

That’s largely by design. As Robbins said of the prior quarter’s numbers,

“We’ve continued to have very good core execution in whatever the environment is, and also to shift to more of a software and subscription model. We had another quarter with deferred growing nicely, it was up 48%, at almost $4 billion. And we continue to see fantastic growth in the security business … We are pleased with the continued transition to a software recurring model. For example, the Cisco One business was a point-and-a-half of growth, and that moved into a ratable model last quarter, which would have previously been a one-time sale. And then there’s the strength in security, and our collaboration and next-gen data center businesses.”

One of the side effects of a recurring revenue model is reliable revenue, which in turn allows for a reliable dividend.

And, the company has started to respect the appeal of payouts. The Cisco dividend has grown from six cents per share per quarter in 2011 to 26 cents per share of CSCO stock now. That translates into a healthy dividend yield of 3.5%, which is on par with stocks more commonly categorized as “value” names … an idea yours truly posed in the middle of November.

Potential Pitfalls for Cisco

While it’s a necessary step in the right direction as virtualization and software becomes a better, cheaper alternative to hardware, this transition won’t necessarily be an easy one.

The biggest stumbling block for Cisco stock is the simple fact that the company doesn’t have as firm of a hold on the new market that it did on the old one.

Brocade Communications Systems, Inc. (NASDAQ:BRCD) is one of those names that has positioned itself well in the modern era of networking. Its 5600 vRouter is the gold standard in software-based routers.

Meanwhile, though Robbins cheered the growth of the company’s security services, and that’s an even more crowded field. Palo Alto Networks Inc (NYSE:PANW), Fortinet Inc (NASDAQ:FTNT) and FireEye Inc (NASDAQ:FEYE) are just a handful of the companies already in the security business, and with a significant head start on CSCO.

Still, with $71 billion in the bank, it’s tough to think Cisco can’t buy its way out of any problem it may find itself facing in the foreseeable future.

Bottom Line for Cisco Stock

Although it’s likely to be a long, frustrating adjustment, it is an adjustment CSCO stock is equipped to handle. The question is, are owners of Cisco stock equipped to handle the adjustment? It could take a long while for CSCO to become the recurring revenue machine it’s aiming to be.

It may also require something of an adjustment in the valuation-perception of Cisco stock.

The good news is that CSCO stock is presently valued at a trailing price-to-earnings ratio of 14.1 and a forward-looking price-to-earnings ratio of 11.8. That’s in line with the market’s typical multiple for a value stock. The bad news is, the market may not be ready to view Cisco stock in that way, punishing it for slowing growth … despite the growing stream of reliable revenue.

Still, for the true long-termer and fan of income, CSCO could end up being a pleasant surprise.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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Article printed from InvestorPlace Media, https://investorplace.com/2016/12/cisco-systems-inc-csco-stock-will-pay-off-long-term/.

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