Cisco Systems (CSCO) posted fourth-quarter results that beat Wall Street's expectations late Wednesday, but a more interesting tale was the update on its transition efforts from a stodgy, old hardware company to one that relies on software and recurring subscription sales.
If Cisco can nail this transition, it stands to reap the long-term benefits of stable, recurring revenues and fatter gross profit margins, given the lower production costs associated with software compared with hardware. Can Cisco do it? And, if so, how long will it take?
The answer to the first question is a definitive yes, according to market and industry experts. But as for the second question, well, that is far more circumspect.
In trotting out its quarterly results, Cisco pointed to some pieces of evidence of the progress in transitioning from a hardware company to software and subscriptions. For starters, software and recurring revenues comprised 28% of total fourth-quarter sales, which stood at $12.6 billion. The same time a year ago, it accounted for 25% of total sales.
"The transition was started long ago, but it didn't shift into high gear until [Cisco CEO] Chuck Robbins took the reins last year. Cisco is fundamentally a hardware company. The future demands a very different twist to that hardware, however," Glenn O'Donnell, vice president and research director for Forrester Research, told Real Money. "[Venture capitalist] Marc Andreesen famously stated, 'Software is eating the world,' and it certainly is eating this hardware world. Hardware is not dead, but hardware that cannot be adapted easily with software is indeed dead."
Other data that point to Cisco's progress on its transition includes its product-related deferred revenue that is tied to its software subscription business. That was up 33% in the fourth quarter, compared with a year ago. And when you add the category of its total contract value business, in which it has not yet recognized revenue for customers who will be billed on a monthly basis, the figure rises to 43% in the fourth quarter vs. a year ago, Robbins said during the earnings conference call.
Although Cisco has clearly shown it is making headway on its transition, how far is it aiming to go before it knows it has accomplished its goal?
O'Donnell notes Cisco already has a lot of software products, but the interesting twist is how the company wants to move all this to a software as a service (SaaS) cloud model. Robbins has stated the goal is to have 100% of its software on SaaS, O'Donnell said.
"I applaud this move to SaaS. Customers will love it. Cisco will love it. Investors will love it (later) because the recurring revenue model of SaaS makes revenue more predictable. In the short term, it will prove disruptive and probably have a negative impact on earnings. Long term, this is a very good move," O'Donnell said.
In sizing up Cisco's ability to successfully make its hardware-to-software-and-subscription transition, Jack Mohr, director of research for Jim Cramer's Action Alerts PLUS portfolio, which holds Cisco shares, told Real Money he is confident the networking behemoth can pull it off.
"Yes, because it has an incredible hybrid architecture (ACI), which weaves its hardware with software and creates a hosting pad, which enables innovation, facilitates integration and accelerates adoption," Mohr said. He added this allows the company to "upgrade existing enterprise customers seamlessly and intelligently."
O'Donnell also believes Cisco will ultimately prevail in its transition, though it will not be easy.
"Normally, I'd say it is a pipe dream for a company like this to make such a radical transition. Cisco has significant inertia -- with contracts, customers, its own people, and most importantly with the overall mindset. It's impossible to change things so dramatically," O'Donnell said. "However, Chuck has demonstrated impressive progress only in his first year. I'm surprised by the magnitude of changes he's already made. ... In short, yes, I am now confident in its success. It will not be easy at all, but Chuck seems to be the right leader to pull it off."
It's a tricky transition, however. Cisco needs to keep its core business humming, while simultaneously shifting its operations to a software and subscription model. As a Goldman Sachs research note points out, the company is tweaking its business toward higher margins at the expense of top-line growth.
Cisco has missed its revenue growth target of 3% to 6% over the past three quarters, the Goldman analysts wrote, but it has also exceeded its operating margin target of 30% during the last four quarters. Goldman rates the shares a Neutral with a price target of $32.
During the conference call, Robbins said he would not ignore Cisco's core business in favor of another.
Both Mohr and O'Donnell noted it remains to be seen how long it will take Cisco to achieve its transition goals, but on the earnings call Robbins described the process as still being in the early stages.
Acquisitions will be a key element of speeding up this transition; its previous buyouts of Cliqr and Jasper Technologies have helped. Yet there could be obstacles along the way.
"Some of Cisco's important products are potential pitfalls," O'Donnell said. "In this software-defined everything world, software-defined networking (SDN) is central to its success. Plenty of SDN platforms now exist, including Cisco's. While it has successfully crushed its hardware competition, SDN is a different game with different rules. VMware (VMW) has proven successful and open standards are showing good progress. If Cisco fumbles this ball, it will be big trouble."
Cisco indeed has competition in making this transition, as its competitors have done so and some are currently in this phase. In an industry where speed to market, new features and functions, or introducing a new concept, can make or break of a company, Mohr noted that Cisco's transition pace is aggressive yet thoughtful.
"It is not attempting to grow faster than its technological capabilities, rather it is building out its differentiation first and then growing second," Mohr said. "It is already a step ahead of its mega-cap enterprise networking equipment peers and is giving up price competition on the legacy business in order to focus investments aggressively toward current and future growth areas as mentioned."
