Cisco Systems (NASDAQ: CSCO) has transformed itself from a hardware-focused networking company into a software and services powerhouse. Yet the market still treats CSCO like a low-growth cyclical stock, presenting a compelling value opportunity for investors.
The Evolution of Cisco’s Business Model
Founded in 1984, Cisco built its reputation as the dominant supplier of routers and switches that form the backbone of corporate networks and the internet.
This hardware focus made revenues highly cyclical, rising and falling with economic and capital spending cycles. As a result, Cisco often traded at discounted valuations compared to high-flying software stocks.
However, over the last decade, Cisco has dramatically shifted its business mix towards software and services. The company now generates over 40% of revenues from software and subscriptions. Major drivers include:
Growing Security Segment
Cisco has built a substantial security software business through both R&D and acquisitions. Its security offerings now span network, cloud, endpoints, and more. According to IDC, Cisco was the #2 enterprise security company by 2021 revenues.
Cisco’s Webex video conferencing and team collaboration tools have seen surging adoption since the pandemic. Webex now has over 600 million monthly active users. Subscription revenues for these cloud-delivered apps are recurring and high margin.
Transition to Software-Defined Networking
Even Cisco’s core networking products are now software-defined, with advanced features powered by software rather than hardware upgrades. This shift leads to more predictable revenues.
The Splunk Deal: Accelerating the Software Transformation
Cisco aims to accelerate its software transition with the proposed $20 billion acquisition of machine data analytics leader Splunk. The deal is expected to close in first half 2023.
Splunk will mesh well with Cisco’s security segment. Splunk’s data analytics tools help organizations monitor threats and events across their technology footprint. According to Gartner, Splunk is a leader in the security information and event management (SIEM) market.
After integration, Cisco expects to provide more AI-powered cybersecurity solutions on a massive global scale. By combining forces, the companies can provide end-to-end visibility and threat protection across networks, endpoints, clouds, and applications.
The Splunk deal also provides direct financial benefits. It’s expected to be immediately cash flow accretive for Cisco while boosting gross margins and growth rates. Once integrated, Splunk will contribute over $4 billion in high-margin recurring revenues.
Overall, Splunk stands to give Cisco’s business mix an even stronger software focus. Cisco estimates its recurring revenue will exceed $30 billion after the acquisition, making up over 50% of total revenues.
Valuation Remains Discounted Despite Progress
Despite this multi-year business transformation, Cisco’s stock continues to trade at a low valuation typical of hardware companies. CSCO has a forward P/E of just 12x and trades at 11x free cash flow.
Yet when looking under the hood, Cisco’s fundamentals and growth dynamics increasingly resemble a software stock:
- 44% of revenues are now recurring subscriptions rather than lumpy hardware sales
- Gross margins have expanded beyond 60%, supported by higher software mix
- Management is guiding for 5-7% YoY revenue growth in 2023
- The Splunk deal will be immediately accretive while accelerating software revenues
- Cisco has a rock-solid balance sheet with $19 billion in cash to fund growth
In short, Cisco is executing a software company playbook but retains the valuation of an old-world hardware firm. Once Mr. Market recognizes Cisco’s evolution, substantial multiple expansion seems likely.
Cisco Systems has fundamentally transformed over the past decade from its networking hardware roots into a recurring revenue-driven software provider. However, the market’s perception remains stuck in the past.
The pending Splunk deal looks set to serve as the final capstone on Cisco’s software pivot. As a result, CSCO stock remains one of the most undervalued in tech. Shares trade at just 12x P/E and 11x cash flow despite an increasingly attractive growth profile.
As Cisco’s transformation becomes undeniable in 2023, the stock deserves significant multiple expansion. For investors, CSCO represents a unique opportunity to buy a high-quality software growth company at a value price. The next decade looks bright as “hardware Cisco” finally becomes “software Cisco” in the market’s eyes.