|Shares Out. (in M):||5,384||P/E||10.7x||12.2x|
|Market Cap (in M):||115,756||P/FCF||-||-|
|Net Debt (in M):||64,422||EBIT||13,700||11,500|
As a long time CSCO bull, we both favored and followed the company for years, and it saddens us to say that CSCO is now a compelling structural short (or at least reducing one’s positions). As the leader in a maturing industry that is now clearly commoditizing, the company will continue to lose share in its key markets (switching and routing) which comprises ~60% of revenues. The company is headed into a period where it will see continued anemic growth/declining revenues, and margins will deteriorate (its hard to maintain 60%+ gross margins as your products commoditize). Ultimately, CSCO will trade in-line with other large-cap technology hardware peers (i.e. HPQ, Dell pre-buyout) at ~4.5X EBITDA. Importantly, consensus assumes CSCO’s recent woes will be temporary and expect earnings to be flat next year (despite declining revenues) and a miraculous rebound in 2015, (when presumably emerging markets recover). We believe that CSCO is in the early innings of an long earnings decline, as competitive forces rise and the company’s competitive position erodes. We expect shares to trade <$15/share (vs. $21.50/share today) within the near term.
Since CSCO is a well-covered company (written up previously on VIC), we will not discuss in detail its business, its business model, or the networking equipment industry. (In fact, research coverage is very good for CSCO particularly with the presentation of pro-forma historical financials). Rather we will briefly focus on some of the key challenges CSCO is facing, and why we think the company’s earnings should decline in the future. Specifically, based on our conversations and research to date, we believe that switching (low and high end) and edge routing are particularly challenged as CSCO’s competition increases and as networking architectures shift to Software Defined Networking (“SDN”) over the next several years, which will disrupt the CSCO installed base / ecosystem and commoditize networking equipment.
For years, the mantra “no one gets fired for buying an IBM” was adequate to describe CSCO’s competitive advantages as the leader in networking equipment (technological innovation and R&D spend, and installed base and ecosystem of administrators trained and accustomed to CSCO standards, and reputation within IT purchasers as the “safe choice” with the lowest total cost of ownership). For many years, all of this was very true, particularly since network architectures naturally favored one standard/preferred vendor (compatibility issues, training of engineers, repeated certification standards, etc.) which CSCO monetized exceptionally well with premium pricing and high margin services contracts. That one vendor was CSCO, who had little competition and captured historical market shares of 60-70%+ in the switching and routing markets.
In fact, a few years ago, this well-known barrier to entry that allowed us to easily dismiss the emerging threats in enterprise switching and edge routing, when they first appeared. At the time, it was unclear how new entrants (HP, Huawei, ALU, etc.) in the switch/edge routing markets would impact CSCO. CSCO was introducing new products, reorganizing the company, and SDN was in its infancy. The strong secular tailwinds and the “Cisco Gold Standard” made for a compelling investment when CSCO was trading ~$15/share in 2011.
However, numerous conversations with tech executives and IT administrators today give us a different perception. (Btw, I don’t know any IT professionals today would say they wouldn’t get fired for purchasing an IBM server, except maybe those that retired 10 years ago.) We believe CSCO’s “moat” in these two key products (~50% of product revenues, ~60% of total revenues including services) is deteriorating (market share has already fallen ~10%) and that it will be hard for the company to retain the high margins and near monopoly position it’s historically exhibited. We believe we are seeing evidence of this in the company’s recent financial performance and the revised guidance.
CSCO has traditionally been a switch and routing company which comprises ~60% of the company’s revenues (estimated including services revenues). The switching industry is a mature industry that has grown slowly in the past several years. The switch market can be bifurcated into low-end switching (mostly used by small and mid-sized businesses) and higher end switching (for large enterprise and data centers). CSCO has been over serving the low end for years, and now most of these enterprises frankly don’t need premium switching products (diminished returns from technology – i.e. Moore’s law has moved faster than most small enterprises need) and many are beginning to outsource much of their IT needs.
HP entered the switching market and has been successful as a low-priced entrant. They have continued to gain share, and the battle for these small/mid-sized customers has only gotten more competitive as the years have passed and as acceptance of HP grows. According to many IT professionals, HP, which has existing relationships with many businesses (i.e. servers) offers much of the same assurances on product warranty/reliability/quality and the support staff that CSCO does. In addition, HP has now been in the market for several years and is establishing itself as a viable alternative with a track record (at discounted prices, usually bundled with server sales). Hence, CSCO is facing real competition at the low end of the switch market.
A similar story can be told in edge routing (vs. core routing). In the routing market, demand will continue to be driven by rising IP traffic, and core routers will likely be dominated by CSCO for a while (core routing is the least price sensitive, and requires high levels of sophistication and coding that caters to CSCO’s strengths and customer services). However, at the edge (lower capacity, less differentiated routers) CSCO is facing significant challenges as ALU/JNPR/(Huawei in emerging markets) continues to gain significant share. Some of this is because the carriers simply wanted more vendors and didn’t want to be reliant on CSCO, some of this is because competitors has offered as effective products or compete well in certain niches (ALU for fiber optic and mobile), and some is simply that carriers’ purchase decisions at the edge simply no longer feel the need to pay the premium for the CSCO products.
At the higher end of the switching market, which is primarily used by data centers and large enterprises that have large networks and significant data demands, CSCO has historically been dominant as these customers in this part of the market are particularly focused on reliability and compatibility with existing data center infrastructure. At this end, vendor switching is especially difficult and HP hasn’t made significant inroads. However, SDN, is rapidly growing in acceptance at data centers and in the next few years, we expect to more data center administrators to adopting SDN. Based on our diligence, SDN is going to gain acceptance and dramatically change the value of having one preferred vendor. (Basically, SDN adds an open technology software layer above the equipment to shuffle IP traffic – no longer is the traffic routing decisions made at the switch/router level, but at a meta-layer above the equipment. The result, is that the equipment is little more than a commoditized box and equipment vendor decisions will be interchangeable.) We believe this is a real threat to CSCO (and all equipment manufactures) as equipment (even at the high end of switching) essentially becomes a commodity. Though SDN is still in the early stages, most administrators we’ve spoken to admit CSCO compatibility will be far less relevant in the future. To compete, CSCO will have to be more of a software vendor (which they aren’t right now) and we don’t think will retain 60%+ gross margins on their equipment.
We view much of the recent weakness (-4% yoy product sales)/guidance (-8-12% yoy) reported by the company is an early warning sign of things to come. (The last time revenue declined like this was in the credit crisis. The macro environment is not strong, but it would be hard to assume all of this is macro related. And this is from a company which has historically generated high-single digit/mid teen revenue growth in a sector that should be growing rapidly). We think the “pause in demand” and “particular weakness in emerging markets” we think is a sign of the increase competition and price sensitivity to CSCO products. In addition, CSCO right now is going through product introductions in Switching and Routing that we understand to be have been bumpy and that CSCO currently has a pretty weak backlog.
We recognize that CSCO appears cheap on an absolute basis and on current earnings (its trading at 5.3x 2013 EBITDA, or 10.7X PE, 6.3X PE ex-cash, 7.8X PE ex-cash and tax-effected, depending on how you view the excess cash). However, we think CSCO’s revenue and earnings will decline and investors will re-rate the security. (Consensus, for some reason thinks earnings will be flat next year despite declining revenue and that both revenue and earnings rebound in 2015). We anticipate EBITDA down -13% to $13.8BN (6.0X EBITDA) next year and EPS of $1.76 (12.2X PE, 7.1X PE ex-cash, 8.9X PE ex-cash tax effected). We do not see how earnings rebound thereafter. Remember, margins for CSCO are 60%+, so it will be very hard for CSCO to find enough cost cuts to continuously offset share losses in switching and routing. Since we view earnings for CSCO in decline, we think the company should be valued like the other mature large cap technology hardware names and trade in-line with HP, INTC and Dell (pre-acquisition) at ~4.5X EBITDA. Based on our estimates, we think this implies a stock price below ~$15/share within the next several years. We recognize we would rather short a high multiple business in decline, but we feel that there are enough headwinds to CSCO’s future earnings that in this case it is worth consideration (or at least reducting one's position).
- Increased dividend / share repurchase - CSCO still generates significant cash and has a large excess cash balance (however, only $6BN of the company’s $48BN is domestic)
- SDN adoption takes a more modest pace
- CSCO can temporarily offset revenue losses with costs savings
- Share losses in switches and routing offset temporarily by growth other products - wireless, data center, etc. (however, these are typically lower margin products and CSCO has competition here too – Aruba is gaining share in wireless, etc.)
- Strong management team (i.e. Chambers)
- Successful new product launches
|Subject||Why I gave it a lousy rating|
|Entry||11/23/2013 11:13 AM|
I agree that CSCO is very well covered on the sell-side, and I don't have any keen analytical insights into the underlying technology transitions and what things look like 3-5 years from now. Anybody who claims to "know" is a fool (not accusing you of this...). Things move too fast, and veer off the "obvious" path in the technology vertical to have any high degree of certainty. Maybe SDN will be an issue, maybe CSCO will develop proprietary SDN algorithms that they code into ASICs that blow away performance available from a true software-only SDN solution. Whatever the case, the market and the sell-side have been wringing their hands over SDN risk for at least 18 months now, so it's baked into the stock.
The issue I have with your write-up is your selection of HPQ and DELL as the appropriate comps. The nexus you draw is simply that all three companies are in "large cap technology hardware". If I'm not mistaken, your basic thesis is that CSCO is primarily facing a margin issue due to commoditization of their core capabilities. Nowhere do I see you arguing that the IP communications industry is facing secular decline. I think that would be a really, really tough argument to make. HPQ and DELL are valued the way they are (were, in the case of DELL) because major portions of their business (PCs) are in secular decline. At the point in the PC industry lifecycle when the aggregate market was still growing, but white box manufacturers were grabbing big share (and HPQ and DELL were therefore facing margin pressure similar to what you're arguing CSCO is now facing), they were valued radically differently than they are now. Pulling numbers off Bloomberg, pre the 1998 meltdown and beginning of secular declines in PCs, HPQ didn't trade much below 8x EBITDA, and DELL didn't trade much below 10x EBITDA.
A much more appropriate group of comps would be other communications hardware companies. FFIV and JNPR, both of which have also announced big guidance shortfalls within the last couple of years, currently trade at an average of >8x EBITDA and >15x EPS. If I wanted to be nutty and throw some ridiculously highly valued communications hardware comps in, I'd use Ciena and Infinera, which trade at an average of >15x EBITDA and >40x EPS. Do I think the latter two are appropriate comps? No, but I don't think they're any less appropriate than HPQ and DELL.
I'm not sure whether you're right or wrong on whether CSCO is a short from here. In my view, Chambers has pulled fat rabbits out of the hat and proved naysayers wrong more times than just about any current sitting CEO in technology. Will he do it again this time? I don't know. Forward guidance was brutal, and maybe you're right that this is the time that they really do fumble the transition. Your target prices are based on a relative valn analysis, though, and I find your comp selection completely inappropriate.
|Subject||have you looked at EZCH?|
|Entry||11/27/2013 10:25 AM|
Cisco seems like somewhat of a tough short to me- it seems to be priced as a declining business and if the decline is slow (or if the company just treads water in a growing market) you could lose over time, especially if we ever get any change in the overseas cash repatriation tax issue. Maybe another way to say this is that I generally agree with what you wrote but at this price the magnitude and speed of the changes are critically important, and they seem uncertain to me.
However, if what you wrote is correct I think EZCH is an even better short than CSCO because it is critically dependent on Cisco's edge router sales and still carries a big valuation. In 2013 Cisco will be about 40% of EZCH's sales and over 50% of EZCH's gross margins given that its Cisco sales come at almost 100% GM as Marvell is actually making the chip and just paying EZCH royalties. I believe virtually all of EZCH's CSCO business is from edge routers. After two years of disappointing growth 2013 was a bounce-back year for EZCH as its Cisco busines returned to growth after a couple of strangely flattish years and JNPR, who is a customer of EZCH for its older generation edge routers but not for its newer models, had an inexplicable year of growth with what I suspect are last-time buys. However, 2014 looks like it could be a very tough year for EZCH as Cisco faces the headwinds you discuss here and Juniper is all but certain to reduce its purchases substantially. Obviously Cisco just gave disastrous guidance which bodes poorly for EZCH in the near term, and to the extent that Cisco loses edge router share to ALU and JNPR, who use internal silicon, EZCH in turn will lose share over time. Other than Cisco EZCH mainly supplies also-rans like Ericsson, Tellabs and ZTE although it does have some business with Huawei. Cisco always squeezes its suppliers, even more so in tough times. Cisco can credibly replace EZCH with either internal silicon (it still makes the NPUs for its more complex core routers internally) or with chips from BRCM or MRVL so they have the leverage here.
Somehow, EZCH still trades at 8x 2013 sales and Wall St. oddly expects it to grow 24% next year despite the issues with its two largest customers CSCO and JNPR. On a P/E basis the stock sort of appears reasonably at about 22x, but this is far from a trough semi multiple and EZCH's true profitabilty (especially to a potential acquirer) is overstated due to the fact that its R&D is subsidized by the Israeli government and it accrues a zero percent tax rate despite several years of profitability. EZCH is a cult stock, but the faith of the cult was severely shaken between 2011 and early 2013 and I'm not sure the blind devotion can stand another poor year relative to expectations.
|Subject||RE: RE: have you looked at EZCH?|
|Entry||11/27/2013 03:01 PM|
Katana, you mean MRVL, but yes. I think Marvell's NPU technology came from their Xelerated acquisition. BRCM also has announced an NPU that is theoretically competitive (the 880330, http://www.broadcom.com/press/release.php?id=s666869) developed from its Sandburst acquisition, but it is unclear if they've gotten any design traction.
If EZCH lost CSCO to MRVL or BRCM this thing is worth a slight premium to cash. I don't have any insight to if or when this will happen but it is an existential risk that would constrain the valuation in a rational world. At any rate, even without a major design loss there appears to be a lot of downside just from Cisco woes.
|Subject||RE: RE: have you looked at EZCH?|
|Entry||12/05/2013 01:51 PM|
I disagree with a few points on EZCH. Sales of CSCO's high end edge routers (the one's w/ EZCH inside) have done well... up 9% sequentially last quarter. The edge market ususally gets a mention in the CSCO calls and lately its been positive. Its a growing market that plays into the need to upgrade networks globally. Huawei has also done well, but they're also an EZCH customer.
There seems to be a massive differentiation between the EZCH platform and any other ASIC or merchant solution. They have a monopoly on the high-end merchant market. I suspect much of this is because of backward compatibility and functionality with the proprietary software developed by CSCO, Huawei, ZTE, etc. These sales have 4-5 years of in-fill orders, so expect years of ongoing sales from the current design wins (NP-4 and NP-5). To prove the point, EZCH revenue from Juniper actually grew last year even though they haven't had a design win at JNPR since 2009! To say the shares would drop to cash value if they lost a customer doesn't accountn for this long tail of profitable sales.
I don't think MRVL or BRCM are a threat to take share, they've never had a single design win. The bigger threat is for CSCO or Huawei to replace EZCH with an in house design. The suggestion of CSCO doing this crushed EZCH a few months ago. CSCO clearly stated this isn't the case on subsequent calls, but EZCH shares haven't recovered.
The thing that worries me about EZCH isn't any of the threats mentioned on this thread. Its whether their market share and margins can hold when they bring in the NPS in several years. SDNs will bring in different players. EZCH says they can compete, but its clearly a new game. On the plus side, the potential market is way bigger than the limited scale of high-end edge routers.
|Subject||RE: RE: RE: have you looked at EZCH?|
|Entry||12/05/2013 03:06 PM|
Box, thanks for the feedback. A few points
I agree that new edge routing products (specifically the ASR 9000 which is the highest dollar content EZCH product) have been a relative bright spot for Cisco, but if you listen to Cisco's calls the trend in ASR-9000 growth has been getting worse- 8/12 up 97%, 11/12 up 80%, 2/13 up 30%, 5/2013 up 40%, 8/2013 up 69% (and Cisco said the story is "about the edge", 11/13 up 20% while talking about overall poor service provider and edge orders. Against this I estimate EZCH's sales to Cisco have grown at a mere 16% CAGR between 2010, the first material year of Cisco sales, and 2013. Based on Cisco's comments and guidance I think there is a real chance EZCH has a flat to down year with Cisco in 2014 similar to 2011 as these kinds of slowdowns frequently result in inventory corrections for semi suppliers.
Maybe saying the shares would drop to cash value if they lost Cisco is an overstatement, and your point they would still get several years of Cisco sales if Cisco designed them out today is correct. But Cisco sales would shrink over time and if they lost/didn't have the top 3 customers in routers it would be difficult to see a future so the shares would likely get a bargain basement valuation. I think you are also right that BRCM and MRVL have not to date won any designs from EZCH but they are tough competitors and from recent company announcements they seem to be still at it.
On the subject of Juniper's unexpected growth in 2013, I think they were from what is called in the industry last time buys. Juniper might have notified its customers that the older routers that used EZCH's silicon were being discontinued so service providers who had not moved to the newest products placed a rush of orders before the deadline. I think in 2014 it is all but certain Juniper resumes its decline, possibly at an accelerated pace.
So when EZCH's largest customer just indicated revenue and orders would be down Y on Y with specific weakness in the products they serve and their second largest customer will decline, possibly substantially, I struggle to see how EZCH grows in 2014. That would be the third growth disappointment in the last 4 years.
I remember the hubbub around the new Cisco product that turned out to be unfounded. I think the stock did recover when Cisco said the product was only for high-end routers and not meant to replace EZCH, but the stock has sold off with the poor Cisco news. This underscores how the customer concentration with a customer who has the ability to replace EZCH with internal parts is an enormous risk factor and IMHO should accord a discount valuation. I would also observe that EZCH is down less than FNSR and CAVM since Cisco's earnings desipte both of those companies being far less concentrated with Cisco.
|Subject||RE: RE: RE: RE: have you looked at EZCH?|
|Entry||12/05/2013 05:20 PM|
Thanks for the discussion specialk.
Not sure I see why 2014 will be a down year based on CSCO's ASR growth pattern. The % gains have decreased, but they started from a low base. You may be right that 2014 is a flat year, I've seen strange things happen with inventory corrections in this space, but looking at those numbers I wouldn't bet on it. I do think overall EZCH revenue will be lumpy and the street will over-react to the weak quarters like they always do w/ EZCH.
Taking a step back, you have to have a negative view on overall edge router growth the next few years to short EZCH. All the market research firms, all the suppliers, and all the customers seem to suggesting otherwise. To be fair, some of the research firms have brought their growth numbers in, but the trend is still very much positive. Think about the pressure on networks from data traffic growth through the end of the decade.
For an EZCH short to work they have to lose CSCO, ZTE or Huawei to either an ASIC design, or someone like MRVL. All customers have signed up for the NP-4, which should be strong through 2015, with line card additions for another 3-4 years. EZCH management has suggested that CSCO and ZTE are on-board with the NP-5, which should reach peak sales in 2016. I don't see any of these customers leaving.
You may be right that JNPR sales are last time buys, but I haven't seen any indication this is the case. I do agree sales to JNPR will decline, but at a modest rate.
Bottom line, EZCH shares are already beaten down and expressing much of your negative outlook. There's better risk/reward here on the long side. The overall market is growing. They have locked in long-term deals with all the major customers. Valuation wise, its trading for 11x next years earnings ex-cash; with the NP-4 and NP-5 giving revenue visibility out a few years.