Cisco Systems (NASDAQ:CSCO) must transition its portfolio to remain competitive in the context of accelerated consumption of cloud computing services, which has been induced by the coronavirus. Its fiscal fourth-quarter results released this week revealed that legacy network businesses remain a significant drag to its performance. Because of these important challenges, the stock trades at modest valuation multiples. Thus, should investors take this opportunity and bet the tech giant will succeed in adapting its portfolio? 

Challenging results

Cisco posted better-than-expected fiscal fourth-quarter results, but the year-over-year 9% drop in revenue to $12.2 billion remains weak. More importantly, the top-line decline confirmed an important contrast between the company's cloud businesses and its legacy activities.

As usual, management didn't provide the individual performance of each product, but CEO Charles Robbins mentioned some strong spots during the Aug. 12 earnings call. For instance, he said the collaboration tool Webex and the monitoring solution AppDynamics generated strong revenue growth. Also, cloud security boosted the company's security segment, which grew 10% to $814 million.

In contrast, the core infrastructure platforms segment, which includes legacy networking hardware such as routers and switches, dropped 16% to $6.6 billion. The on-premises unified communication platform penalized the company's results, too.

In the short term, Cisco's global performance isn't likely to improve, as management expects revenue to drop by 9% to 11% year over year during the fiscal first quarter, ending on Oct. 31.

Granted, the coronavirus pandemic partly contributed to the decline in the company's legacy networking businesses as some customers postponed investments in data centers and local networks (campus) to develop remote-working capabilities for their employees. But some difficulties seem more profound as Cisco's portfolio isn't fully capturing the opportunities cloud computing represent for tech vendors.

As a result, management announced a new phase in the company's transformation.

A hand touching an illuminated cloud with a padlock icon

Image source: Getty Images.

Shift to as-a-service products

During the earnings call, Robbins announced, "We will accelerate the transition of the majority of our portfolio to be delivered as a service."

That represents a significant shift for the company. Management didn't communicate the percentage of revenue currently delivered as a service, but it is safe to assume it corresponds to a portion of the 51% of total trailing-12-month (TTM) revenue software and services represent (the rest being hardware).

And even if CFO Kelly Kramer said the company will already propose many as-a-service offerings by the end of 2020, this transformation will span over several years, as it should also involve its vast networking hardware portfolio.

Thus, you should take into account the execution risks associated with such a decision.

The company will rebalance its research and development spending, which amounted to $6.3 billion during the last 12 months, to drive this transformation. But it remains to be seen whether Cisco will succeed in these efforts against high-growth, cloud-native specialized competitors such as the video communications specialist Zoom Video Communications, the monitoring outfit Datadog, and the cybersecurity player CrowdStrike.

Also, with $14.8 billion of cash, cash equivalent, and investments in excess of total debt at the end of the last quarter, Cisco could proceed with transformative acquisitions to accelerate its transition. But it could overpay for such transactions as many tech stocks have jumped to lofty valuations over the last several quarters.

Verdict

Because of these uncertainties, Cisco stock looks reasonably valued with TTM enterprise value-to-sales and price-to-earnings (P/E) ratios of 3.6 and 17.0, respectively.

However, besides its risky -- but necessary -- shift to as-a-service solutions, the company remains exposed to the long-term tailwinds the new technologies 5G, Wi-Fi 6, and 400G represent.

In addition, during the last quarter, the company sustained its non-GAAP (adjusted) gross margin to 65%, compared with 65.5% one year ago, which suggests it held its pricing power. Also, thanks to its large scale, its operating margin remained high at 33%, up from 32.6% in the prior-year quarter. And management announced the company will be saving $1 billion annually, which will support these high margins during its transformation.

Yet given the company's modest valuation, the market doesn't take into account any upside potential. Thus, investors looking for exposure to cloud computing at a reasonable price should consider buying Cisco stock.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.