Cisco Systems Is Like an Oil Tanker: Here's What Investors Need to Know
Have you heard the oil tanker analogy? An oil tanker can't turn on a dime, or it takes so many miles for an oil tanker to reverse course? This comparison is often made with large-cap companies going through a business transformation because the momentum of companies that are integrated with their customers' businesses is similar to an oil tanker carrying its 500,000 tons of cargo. Cisco's increasing subscription business brings it more in line with Oracle and Microsoft in stability, but has also pressured revenue growth. This pressure may be abating as deferred revenue continues to grow.
The digital tanker
Cisco fits the analogy perfectly. Its customers run their businesses on Cisco gear and software, and the integration is so tight, that when one moves, the other reacts. This is fine when the economy is strong. But when times are tough, customers try to squeeze vendors like Cisco to decrease equipment costs, putting pressure on Cisco's top-line growth. Cisco, in turn, combats this by offering more services to justify its pricing while offering shareholders dividends and share buybacks to support the stock price as top-line growth slows.
Emerging markets remain weak
When big changes do occur, the financial impact takes time to work through the quarterly results, and Cisco has felt the pressure of the global recession, which is alive and well outside the United States. While revenue in the U.S. grew 7%, countries like Brazil and Russia were down more than 25% from the prior year.
Subscription pricing pressures revenue growth but not bookings
On top of international weakness, Cisco has been seeing an increasing amount of deals structured with subscription pricing. Companies sign multi-year deals and receive favorable pricing in return. In the past, this has been the domain of software vendors, but as cloud computing becomes more prevalent, hardware vendors are offering this option as well. And why not? It helps them to better plan their businesses, and it nets out over time.
The downside of subscription pricing is that it causes revenue to be spread out over multiple years rather than causing a big revenue windfall at the time the contract is signed. Deferred revenue increases by the amount of the contract value, then makes its way onto the income statement as the bookings are recognized as revenue over time.
Microsoft and Oracle benefited greatly from pioneering subscription licenses
Tech giants Microsoft and later Oracle were early to embrace subscription pricing that allows companies to use as much technology as they need in any area of the business. This allows clients to respond quickly to business demands but creates confusion when it comes time to renew the licenses. If a client were to slip back from its enterprise license, the vendor would perform an equipment audit and could generate a much larger fee than the license fee. It locks a customer in and offers improved visibility for the vendor.
Many cloud computing deals are signed under these terms, and as Cisco is building up its deferred revenue balance with an increasing amount of large subscription deals, that deferred revenue balance will flow through to revenue and help the top line begin to grow again.
Revenue declines are abating
In the current quarter, Cisco's revenues declined 5.5% from the prior year. This looks terrible at the surface. But it's better than the 7.8% decline last quarter, and it looks to improve next quarter, when the company is expected to see a smaller decline of 1%-3%. The tanker is slowly turning.
Cash deployment has cushioned the blow of revenue declines
Even though revenue has been shrinking, the company has used the cash on its balance sheet to buy back massive amounts of shares and offer a dividend -- and even increased it in the most recent quarter, from $0.17 to $0.19. We had been critical of Cisco's massive buybacks since it was spending more on buybacks and dividends than it was generating in net income. However, if the top line is back on track for growth, this should right itself over time.
In this quarter, the company spent $2 billion to repurchase 90 million shares, which is actually down from the $4 billion spent last quarter. Despite the smaller buyback, the company beat its earnings hurdle and appears ready to resume revenue growth.
Large deals are an indicator that recovery continues
Perhaps the biggest highlight in the quarter was the number of large deals. Deals greater than $1 million were up 25% from the prior year, and deals greater than $5 million were up 50% year over year. General Motors even signed an enterprise license where it would have access to Cisco's product suite on demand. This enterprise licensing deal is similar to the ones offered by Microsoft that helped get its products into every nook and cranny of its customers' multi-national operations.
All in all, this was a fantastic quarter for Cisco, and the increase in deferred revenue implies that it may be the start of a trend rather than a one-off success.
Your cable company is scared, but you can get rich
You know cable's going away. But do you know how to profit? There's $2.2 trillion out there to be had. Currently, cable grabs a big piece of it. That won't last. And when cable falters, three companies are poised to benefit. Click here for their names. Hint: They're not Netflix, Google, and Apple.
The article Cisco Systems Is Like an Oil Tanker: Here's What Investors Need to Know originally appeared on Fool.com.David Eller has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. The Motley Fool owns shares of Microsoft and Oracle.. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright © 1995 - 2014 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.