The headline numbers from Cisco Systems' (NASDAQ:CSCO) fiscal second-quarter report were far from impressive. Revenue slumped by 2% year over year, driven by weakness in the core switching and routing segments. Non-GAAP EPS was flat, aided by share buybacks.
There were some bright spots. The security business expanded by 14%, continuing its impressive streak of growth. And the collaboration business returned to growth after a disappointing first quarter. But data center, another growth business, suffered a decline in revenue, and weakness in the core businesses overwhelmed any pockets of strength.
Cisco has been shifting toward a recurring-revenue business model, embracing subscription software and services as it aims to lower its dependence on hardware sales. This shift is hurting the company's results, knocking at least 2 percentage points off revenue growth, according to CFO Kelly Kramer.
The good news for Cisco investors is that progress is clearly being made. Deferred revenue, particularly deferred revenue related to subscriptions, is soaring. With a weak top line, that's the number that Cisco wants investors to focus on. However, investors shouldn't ignore the price tag associated with the acquisitions that are helping to drive that growth.
$17.1 billion and counting
Deferred revenue is booked as a liability on the balance sheet when a company receives payment for a product or service which it has yet to deliver. In the case of a subscription, this deferred revenue is transformed into real revenue over the length of the contract. Subscription businesses that take payment upfront for software or services that will be delivered over time often use deferred revenue growth as a proxy for future revenue growth. It's far from a perfect measure, but it gives investors a rough way to judge a subscription company's performance.
Cisco's total deferred revenue reached $17.1 billion at the end of the second quarter, up 13% year over year. Deferred revenue related to services grew 9% year over year to $10.5 billion, while product deferred revenue jumped 19% to $6.6 billion. The rapid growth of the product deferred revenue was mostly due to a surge in software and subscriptions.
Deferred revenue from software and subscriptions was up 51% year over year at the end of the second quarter, reaching $4 billion. This explosive growth has yet to drive meaningful revenue growth for the company overall, but the numbers are starting to get big. Roughly two-thirds of this growth can be attributed to the security, collaboration, and wireless businesses, with the rest coming from Cisco's larger segments.
Even growing by 51%, $4 billion of subscription deferred revenue doesn't yet mean much for a company that does nearly $50 billion in revenue each year. Cisco remains highly dependent on hardware sales, and that's unlikely to change anytime soon. But if the company can continue growing its subscription businesses at a rapid pace, revenue should eventually start consistently growing once again.
Driving growth with acquisitions
One pillar of Cisco's growth strategy is acquisitions. The company has made plenty of software acquisitions in recent years, adding to its security, collaboration, and Internet of Things portfolio. But the deal announced in January to acquire AppDynamics represents an escalation. Cisco agreed to pay $3.7 billion for the application monitoring company, a staggering 16 times sales.
The deal makes strategic sense, and it will help Cisco further fill out its software business. But the price tag suggest that Cisco is putting growth ahead of discipline. Cisco has tens of billions of dollars of excess cash earning next to nothing, but dramatically overpaying for start-ups is a good way to waste it.
More software acquisitions are likely, especially if Cisco is able to repatriate some of its foreign cash at favorable rates in the near future. Additional deals will help turbocharge the company's shift to software and subscriptions, but investors should be concerned about the company's newfound willingness to pay excessive premiums.
The rapid growth of Cisco's deferred revenue is an encouraging sign that the company's shift to subscriptions and software is making progress and will eventually pay off. But acquisitions are driving a portion of that growth, and Cisco is paying a high price for AppDynamics to keep the ball rolling.
As a Cisco investor, I have mixed feelings about all of this. The push toward subscriptions and software is the right move, but the price tag for AppDynamics, which Cisco plucked right before its planned IPO, is troubling. I'm hoping that the company will be a little less eager to close deals in the future.