Cisco’s Transition Is Still a Work In Progress

Cisco (NASDAQ: CSCO), as I have previously written, is facing numerous growth headwinds, as its premier networking hardware is becoming more commoditized. The company recently reported its fiscal fourth quarter results, and there were some scary-looking numbers embedded in the release, as well as rather pessimistic guidance numbers.

However, Cisco is still by far the biggest brand in networking, with roughly 33% market share, according to Synergy Research Group. Moreover, management also had useful explanations behind the numbers  as the company shifts from hardware to a bundled service and subscription offering. Here are the main concerns, as well as how management intends to cope with industry change.

Core switching and routing

Perhaps the scariest number Cisco posted was a 9% year-over-year decrease in its main switching and routing platforms, which, combined, account for nearly half of Cisco's revenue. That segment is under siege by upstart Arista Networks (NYSE: ANET), Juniper Networks (NYSE: JNPR) and, to a lesser extent, Ubiquiti Networks (NASDAQ: UBNT). These companies, especially Arista and Ubiquiti, have business models that are built around lower costs and simplicity, as opposed to Cisco's model, which has mainly revolved around its proprietary (read: expensive) hardware.

Both Arista and Ubiquiti, along with routing rival Juniper Networks, reported impressive growth last quarter, while Cisco posted declines, suggesting those companies are taking market share, at least in certain segments.

However, when a company switches to a subscription model, as Cisco is, that will initially hurt recognized revenue and earnings numbers, and Cisco is still in the early innings of this transition.

In return for a recurring fee, Cisco is trying to assemble an all-encompassing offering that adds advanced features such as security, analytics, and automation capabilities -- the core needs of enterprises today -- on top of its advanced custom hardware. Basically, adding advanced bells and whistles beyond hardware, all under the Cisco umbrella.

New features

For instance, Cisco recently released its new Catalyst 9000 Switches, which have lots of functionality in the software layer, including intuitive threat detection, and optimization for mobility and the Internet of Things. Customers have the choice to operate on a subscription model and buy certain features, as opposed to a one-time license that businesses would upgrade every five to seven years.

Cisco also touted 38% growth in its data center ACI platform, a software-defined networking system, which increases simplicity and scalability across data centers and cloud. Management also highlighted adoption of its hyperconvergence software, which allows companies to manage compute, networking, and storage functions across an entire network all from a single interface. After the earnings announcement, Cisco bought out Springpath, its hyperconvergence software vendor (and which it previously invested in), for $320 million.

New model

As a result of this change, Cisco saw its deferred product revenue increase 50% year-over-year to over $5 billion. Deferred revenue includes subscriptions that have been billed, but which are recognized over time. This stands in contrast to the overall 4% decline in recognized revenue. Management also claimed that 31% of revenue is "recurring," up four points from a year ago. As more of the business switches to subscription, that will hurt recognized revenue initially, as new subscription customers are only "renting" as opposed to "buying" the whole product for a longer term.

In light of the change, the company also announced it will be changing the way it reports its segments going forward. Instead of breaking out each segment by hardware category (switches, routers, wireless, etc.), the company will now divide its segments into platforms such as Infrastructure Platform, Applications, Security, Services, and Other in fiscal year 2018. That shows the company is moving toward a new model based on platform functions, not products.

Outlook unclear

In light of the transition, it is unclear exactly if the company is losing market share, or merely switching existing customers to a subscription model. Either way, it looks as though growth is still challenged in the near-term. That doesn't mean Cisco can't generated lots of cash flow – it can.  It's just Cisco is likely going to have to work very hard -- and, as Springpath and other recent acquisitions show, spend lots of money -- in order to keep its comprehensive platform ahead of the pack. That seems to be working on maintaining Cisco's leading position in networking, but for investors hoping for growth, they will have to wait longer, if it happens at all.

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Billy Duberstein owns shares of Ubiquiti Networks. The Motley Fool owns shares of and recommends Arista Networks and Ubiquiti Networks. The Motley Fool recommends Cisco Systems. The Motley Fool has a disclosure policy.