How Does Cisco Make Money?

Earlier this week I found Dow component Cisco to be undervalued. Here's a deeper dive into how exactly the company makes its money.

Jun 18, 2014 at 1:00PM
Take The Long View

The Dow Jones Industrial Average (DJINDICES:^DJI) was down 11 points in early afternoon trading on Tuesday. After flirting with 17,000 just a few weeks ago, the Dow has retreated into a wait-and-see position, declining nearly 200 points over the last eight days. 

Dow component Cisco (NASDAQ:CSCO) moved 0.45% higher in morning trading. Earlier this week I identified Cisco as a potentially undervalued stock and then compared it to some competitors in the networking business.

Today we'll go a step further and break down Cisco's business into its income-generating components. 

The fundamental business model
At its core, Cisco designs, builds, and sells networking technology. This hardware is the backbone that makes the Internet work. It's the modems, switches, routers, and data centers hidden behind the user interfaces of your computer, smartphone, and tablet.

Cisco Logo

Cisco also provides consulting and data management services to assist customers with managing their networks. It makes sense that Cisco would provide these services; who would have better knowledge of a product than the actual manufacturer? 

Cisco operates across the globe, as you might suspect from its massive $125 billion market cap. However, the majority of Cisco's business remains in the Americas, despite the high growth potential in other regions.

As the Internet evolves, so does Cisco. Two decades ago, Internet users dialed into their Internet service providers via phone lines. Today, users can choose between cable lines, fiber-optic connections, or high-speed phone connections. Cisco can provide the hardware needed to facilitate all of these connections, just like it was the leader back when the Internet was still running at 56.6k.

Break it down
The following two charts, sourced from recent company filings to the SEC, clearly lay out Cisco's product categories and geographic breakdown, for the nine months ended on March 31 -- the end point of the company's fiscal third quarter.

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As this revenue chart demonstrates, Cisco's core business remains in routers, switches, and services to support its networking products. Cisco has also recently made a strategic push to advance its position as a cloud service provider, meaning we should expect to see both the wireless and data center product categories grow over the next few years. 

This transition, and Cisco's shift to new routing technologies in general, are having a short-term negative impact on the company's market share. It's router revenues have been down in recent quarters, and competitors Juniper Networks (NYSE:JNPR) and Alcatel-Lucent have made gains in market share.

Taking a long-term view, I don't see this short-term pain persisting. Cisco's next-generation technology will bring major improvements to high bandwidth activities such as streaming video online. Consumers will demand these improvements, forcing Cisco's business customers to upgrade. This moment in time is simply a weak point as the larger trend transitions.

G

The ability to grow in the APJC (Asia-Pacific, Japan, and China) region and in EMEA (Europe, the Middle East, and Africa) is less certain. The Americas region is clearly Cisco's largest, but recently the EMEA region has been a strong driver of growth.

However, after the recent revelations about U.S. government spying online, both domestically and abroad, Cisco will likely face tough regulatory challenges in these foreign markets. In fact, it's possible that major markets such as China and Europe could turn to domestic companies for their networking hardware in order to prevent U.S. tampering with the Internet backbone in those countries. 

This challenge is, of course, not Cisco's alone, but will be a concern for many U.S. technology manufacturers. 

What all this tells us
Building upon our valuation work from earlier this week, this dive into Cisco's revenue mix helps to understand what drives the company today and what will drive it tomorrow.

Cisco is the dominant switch and router provider today around the world, and particularly so in the U.S. That market position is not in any danger in the near future, even if Juniper or Alcatel-Lucent steal some basis points here and there in the short term. The company seems to have done a very good job finding new revenue streams to complement and supplement that core business.

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Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends 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.

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