Cisco's Growth Depends on Software and Services

Cisco Systems , dominant in the networking hardware market, doesn't expect much growth from its core markets over the next few years. The company expects to generate about $25 billion in revenue this year from switching, wireless, and routing, a bit more than half of its total revenue, but annual growth over the next 3-5 years will only be 2%-4%, according to Cisco's guidance.

However, the rest of Cisco's business is expected to grow at a faster rate, driving total revenue growth of 3%-6% annually over the next 3-5 years. That may not seem like much, but each percentage point of growth will add about $500 million of revenue to Cisco's total.

This growth will be driven in part by software and services, both of which are growing faster than the core hardware business. While Cisco has traditionally been known primarily as a hardware company, things are changing at the networking giant.

Selling solutions, not boxesHardware is certainly going to remain the core part of Cisco's business. In fact, the data center segment, which is one of the company's fastest growing segments, is built around Cisco's UCS servers.

But software is becoming an increasingly important source of revenue for Cisco. In fiscal 2012, software generated $6 billion of Cisco's revenue, about 13% of the total. In fiscal 2015, Cisco expects software revenue to reach $9 billion, or roughly 18% of its total expected revenue. And over the next 3-5 years, software revenue will grow at an annual rate of 10%-15%, according to Cisco's guidance. At the high end of that range, software would account for over 27% of Cisco's revenue by 2020.

Cisco's services business, which includes things like product support, migration assistance, and operations management, has also grown to become a major source of revenue. In fiscal 2015, services will bring in $11 billion of revenue, and Cisco expects this to grow at an annual rate of 4%-7% annually over the next 3-5 years. Software and services, which today collectively represent about 41% of Cisco's total revenue, could grow to more than half of Cisco's revenue by 2020.

Cisco's strategy is to sell integrated solutions, involving hardware, software, and services, in its core markets as well as in its fast-growing businesses like data centers and security. This is very similar to IBM's strategy, and Cisco's aim is to become more of an IT company than simply a networking hardware company.

Winning the security marketSecurity has grown into a $2 billion business for Cisco, in part because of various acquisitions over the past few years. Cisco is currently the leader in the security appliance market, which grew by 8.6% during the fourth quarter, according to IDC, but competitors like Check Point are quickly gaining ground. Security appliances account for a large portion of Cisco's security revenue.

In line with Cisco's strategy, the company's security business is shifting toward software and recurring revenue. Software, along with security services, allows Cisco to offer integrated security solutions that smaller, more specialized competitors can't match. Over the next 3-5 years, Cisco expects its security business to grow by 10%-15% annually, potentially doubling in size by 2020.

More security acquisitions will almost certainly be part of the plan, and these will likely skew toward software. Already this year, Cisco acquired OpenDNS, a cloud security software vendor, as well as a few other software companies in areas outside of security. An analyst for UBS recently put out a research note suggesting the average large enterprise has more than 54 different security vendors, and this creates a massive opportunity for Cisco to replace a significant number of those vendors with an integrated security solution.

Becoming a software and services companyCisco has been transforming itself into an IT company, and software and services will be major drivers of growth for the company going forward. Cisco is following a very similar path to the one IBM has followed for many years, and if Cisco can execute, many years of profitable growth could be ahead. Understanding the needs of clients and providing integrated solutions will be the key to Cisco's strategy.

Because software tends to carry higher margins than hardware, Cisco expects to grow its non-GAAP earnings at a faster rate than revenue over the next 3-5 years. While Cisco has guided for 3%-6% annual revenue growth, non-GAAP EPS is expected to grow by a faster 5%-7% annually, potentially increasing by 40% by 2020.

With shares of Cisco trading at just 12.5 times trailing-12-month GAAP earnings, after backing out the tens of billions of dollars of net cash on the company's balance sheet, mid-to-high single-digit growth is more than enough to make Cisco's stock look cheap. And a 3% dividend yield, with plenty of room for dividend growth in the future, doesn't hurt either.

The article Cisco's Growth Depends on Software and Services originally appeared on Fool.com.

Timothy Green owns shares of Cisco Systems and International Business Machines. The Motley Fool recommends Check Point Software Technologies and Cisco Systems. 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.