3 Red Flags for Cisco Systems' Future

Cisco Systems (CSCO -2.16%), the world's largest networking-hardware company, has been a resilient investment, even as inflation, rising interest rates, and other macroeconomic headwinds battered the tech sector. The company's stock price rose 5% over the past 12 months and stayed flat over the past six months.

While those returns may seem anemic, they're certainly preferable to the double-digit declines in other high-growth tech stocks.

Image source: Getty Images.

Cisco held up well because it's holding plenty of cash, pays an attractive forward yield of 2.8%, generates stable profits, and trades at a low multiple. Those strengths made it a good defensive stock for a volatile market.

Last month, I called Cisco a big and boring stock that should keep investors safe with its wide moat, consistent dividends, and big buybacks. But today, I'll review three red flags that also shouldn't be ignored.

1. Cisco has supply-chain challenges

Cisco's adjusted gross margin declined 140 basis points year over year to 65% in the first half of fiscal 2022, which started last August. It expects that figure to slip to 63.5%-64.5% in the third quarter.

It mainly attributes that margin compression to higher component costs and supply-chain challenges for its hardware business. During the company's latest conference call in mid-February, Cisco CFO Scott Herren predicted those headwinds would "continue into the second half" of fiscal 2022.

However, Russia's invasion of Ukraine, which started in late February and is already applying pressure on the semiconductor supply chain, could exacerbate and prolong those supply-chain challenges well into fiscal 2023.

2. Cisco has some competitive threats

Cisco's global share of the ethernet switching market fell from 57% in 2016 to 45.3% in 2021, according to IDC. Its share of the combined service provider and enterprise router market also declined from 42.2% to 34.6%.

During those five years, the Chinese tech-giant Huawei expanded its market share in both switches and routers -- even as it faced blacklists and sanctions related to the trade war between the U.S. and China. Arista Networks and Hewlett-Packard Enterprise also expanded their single-digit shares of the switching market.

Furthermore, Cisco faces competition from "white box" switches and routers, which are assembled with cheaper off-the-shelf parts. That money-saving approach appeals to large telecom companies and data center operators.

All that competitive pressure could curb the long-term growth of Cisco's hardware business and force it to aggressively expand its software businesses.

3. There's sluggish growth in Cisco's collaboration business

Last September, Cisco reorganized its products into five new business segments: secure and agile networks, hybrid work, end-to-end security, internet for the future, and optimized application experiences. The hybrid work unit, which will be rebranded as the "collaboration" business starting in the current quarter, has been its weakest link this year:

Data source: Cisco Systems. YOY = Year over year.

Cisco's collaboration business provides on-site conference call, meeting, and contact-center products. It also develops the video-conferencing platform Webex. This segment struggled as offices closed down during the pandemic, and many businesses subsequently pivoted toward newer cloud-based video-conferencing services like Zoom Video Communications.

Cisco upgraded Webex to keep up with Zoom -- which was ironically founded by a former Webex executive -- but couldn't match Zoom's early-mover advantage, streamlined interface, and brand recognition.

But Zoom isn't Cisco's only competitor. Microsoft Teams has been disrupting the collaboration market by bundling communication tools, video-conferencing services, and productivity software together. Five9's cloud-based contact-center platform could also eventually eliminate the need for Cisco's unified contact-center products.

Should investors be wary of these red flags?

Cisco's supply-chain challenges, competitive headwinds, and the weakness of its collaboration segment could all impact its near-term growth. However, the tech giant still seems confident in its ability to grow both its revenue and adjusted earnings per share at a compound annual growth rate (CAGR) of 5%-7% between fiscal 2021 and fiscal 2025. That rock-solid outlook indicates it will likely overcome the current headwinds and remain a compelling investment for long-term investors.