Should Investors Be Worried About Cisco's Weak Outlook?

Networking hardware giant Cisco Systems (NASDAQ: CSCO) held its annual financial-analyst conference late last month, providing an update on its strategy and financial outlook. Software and services were two focal points, with Cisco talking up its push to produce more than half of its revenue from those areas by 2020. Software revenue is expected to grow by 12% to 15% annually over the next few years, expanding from an estimated $11 billion in fiscal 2017.

Overall growth won't be as impressive. Cisco expects revenue to grow by just 1% to 3% over the next 3-to-5 years, well below its previous outlook calling for 3% to 6% growth. Margins are expected to be stable, with earnings per share (EPS) expanding by a mid-single-digit percentage annually, driven, in part, by share buybacks.

With shares of Cisco up more than 80% over the past five years, should investors be worried about this weak outlook?

The shift to subscriptions

The growth of software and services revenue isn't the only shift happening at Cisco. Within the software business, revenue is shifting toward subscriptions. While subscription-software revenue was the minority in 2014 compared to revenue generated by perpetual software licenses, it's expected to account for the majority of software revenue by 2020.

This will be driven by the growth of software-as-a-service (Saas) and hybrid-software sales, both of which are subscription-based and delivered via the cloud. These products account for just 22% of Cisco's software revenue, while 36% comes from system software. System-software sales are tied to hardware, provide a perpetual license, and immediately translate into revenue. Subscription sales, on the other hand, produce revenue over the lifetime of the subscription.

Cisco expects SaaS and hybrid-software revenue to grow, and for system-software revenue to shrink over the next few years as it moves customers into subscription products. The downside of this in the near term is a revenue-growth slowdown, since perpetual revenue that would have been recognized immediately is now being spread out over time.

Cisco estimates that around $2 billion would have been recognized as revenue from fiscal 2015 through fiscal 2017 had it not been for this shift to subscriptions. Over the next few years, this effect will accelerate as Cisco ramps up its subscription push. The company sees this shift negatively impacting overall revenue growth by 2% to 3% annually through 2020, accounting for the entirety of its outlook reduction.

Once this shift to subscriptions has played out, the negative impact will disappear. If Cisco is still seeing sluggish revenue growth at that point, investors would have a good reason to be concerned. But right now, this looks like a temporary issue.

A cheap valuation

Even with shares of Cisco soaring over the past five years, the stock is still inexpensive relative to the market. A growth slowdown would be a major problem for an overheated stock with lofty expectations built in, but Cisco is already priced for sluggish growth.

Backing out the $35 billion of net cash and investments on the balance sheet, Cisco stock trades for just 10 times the average analyst estimate for adjusted 2017 earnings. It won't take much earnings growth at all to justify that valuation, and the stock should do well over the next few years if Cisco hits its target of mid-single-digit earnings growth.

Cisco is going through two transitions at once. The company is shifting toward software and services, reducing its reliance on hardware sales, while simultaneously moving away from perpetual licenses and toward subscriptions. The net effect of these shifts over the next few years will be sluggish growth, but Cisco should come out the other side a stronger, more software-heavy company with the potential to grow earnings at a faster rate.

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Timothy Green owns shares of Cisco Systems. The Motley Fool recommends Cisco Systems. The Motley Fool has a disclosure policy.