image March 2016 image April 2016

Cisco Systems Rides Again
A legacy enterprise software vendor willing to evolve

As usual, the world of technology refuses to stand still. The emergence of the public cloud as a legitimate platform for hosting core I.T. functions has raised concerns regarding whether, in the future, the typical enterprise hosts any I.T. assets! This belief is reflected in extreme valuation dispersion among so-called legacy suppliers, typically priced at sub-15x cash earnings, and their new economy counterparts, typically priced in excess of 5x sales with little focus on earnings. Like previous I.T. paradigm shifts there will be losers, but the market has in our view cast its ‘loser’ net too wide.

Companies such as Microsoft, energised and liberated by a new CEO, are unleashing the power of their installed base and vast developer network to transition to a cloud based operating environment. NetApp, a leading enterprise storage vendor, whilst earlier in this transition is similarly empowered by new leadership. Sitting between these two is the focus of today’s feature, Cisco Systems, also dominant in its core markets, yet its shares remain discounted by the suspicion of imminent disruption. Yes the public cloud is real, but it will not be defined by a single vendor. We expect that the demand for choice and best of breed solutions, provides opportunities for both new entrants and the legacy vendors willing to evolve.

Cisco Systems, a top 10 position in the Antipodes Global funds, has mapped both the highs and lows of global stock market sentiment over the past 15 years. Having briefly been the world’s most valuable company in 2000, with a market value exceeding US$500bn, the shares declined 90% by the middle of 2002. Fast forward 14 years to 2016 and, by stock market standards, Cisco remains a shadow of its former self, despite having demonstrated years of stable margins and cash-flow generation. Lacking the eye popping growth rates it demonstrated as one of the 1990’s four horseman of the internet , Cisco today is priced at 12.5x earnings, while retaining a fortress-like balance sheet with more than 30% of the market capitalisation covered by cash.

The key debate around Cisco centres on the sustainability of its networking profit pool as the world gradually transitions to software defined networking and use of the so-called “public cloud”. It’s well known that to date Cisco has failed to gain share at public cloud vendors such as Amazon, and the market thus imputes Amazon’s success as Cisco’s failure. Our discussion with various corporates though, reveals a more nuanced view of the cloud and Cisco’s role. Whilst some corporate workloads will inevitably end up in the public cloud, many are embarking on a hybrid approach of on premise, private and public cloud infrastructure needs. In many cases, for reasons of security and cost, private cloud solutions are a more logical solution. Here we think Cisco continues to be well positioned, evidenced by sales growth targeting this area exceeding 100% p.a. over the past six quarters.

Software defined networking (SDN) is similarly held out as cause for concern over Cisco’s future. The idea of taking network intelligence out of the hardware and moving to software to enable easier control and provisioning of network assets is now an inevitable trend. Not surprisingly, Cisco leads the way in terms of market share in this domain, leveraging a rich I.P. portfolio. Much of Cisco’s ability to have maintained high margins over the years is a reflection of its reach within the I.T. networking community. Cisco created the industry-standard networking qualification and continues to train thousands of “Cisco certified” engineers each year. Although this training is typically based on open industry standards, familiarity with Cisco equipment and protocols reinforces its “brand” as the default option for enterprise networking solutions.

Cisco’s new internally appointed CEO, Chuck Robbins, takes the reigns of a very good business that has the potential to become a great business. Long-time CEO, John Chambers, has moved into the role of Executive Chairman, equivalent to Cisco’s cultural attaché, travelling hither and yon forging relationships with key decision makers and selling Cisco’s vision of a digitized future. Evidence of these efforts can be seen in Cisco’s recent Chinese results. Whilst other technology companies in the early months of 2016 reported weak trends, Cisco’s Chinese business accelerated to represent its fastest growing geography rising 64% yoy. In fact, overall performance in the BRICM (Brazil, Russia, India, China and Mexico) region was more than commendable, rising 17% yoy, again at a time when few companies are reporting positive trends in these locales.

Also, whilst the company continues to make small technology oriented acquisitions, Cisco’s attitude to capital allocation has become much more proactive with a commitment to return more than half of future free cash-flow to shareholders. Importantly, at Cisco’s current valuation, share repurchase are highly accretive and the recent dividend raise leaves the shares yielding in excess of 4%. We take these actions as a sign of confidence in the future of the business, at a time when the market remains sceptical. We see the prospect for modest top-line growth ahead, improving operational control and margins and a more rational capital allocation plan. In short, we see multiple positives from our investment in this world class business.