Technology companies typically spend a lot of money on capital expenditures, which should come as no surprise. After all, in the technology world, innovation is critical. Companies have to spend aggressively to ensure they don't get left behind in a rapidly evolving landscape.
One technology company spending aggressively is Cisco Systems (CSCO -1.49%), which has tried to engineer a turnaround for the past few years. The company hasn't been very successful, however, as its underlying financial performance continues to disappoint.
Cisco spent $1.2 billion on capital expenditures in fiscal 2014, which was a 10% increase from the prior year. Cisco's fiscal year ends in late July. Unfortunately, the company's revenue and profits are still going down. Cisco's management has long promised its investments would pay off, but investors are still left waiting. At this point, investors should more closely scrutinize its spending priorities.
Cisco swings and misses in a huge market
An emerging opportunity has come about in recent times, and unfortunately, Cisco has largely missed it. That opportunity is in an area called software-defined networking, which has applications in the data centers and cloud computing businesses. Data centers and the cloud are high-growth areas of the technology sector, and Cisco has made no secret that it wants to pursue these areas and diversify away from its traditional routers business.
The software-defined networking market is a significant opportunity, and has demonstrated measurable growth in a short time. Technology industry research firm IDC published a report estimating that the SDN market should eclipse $2 billion by 2016. This is up from just $168 million in 2013, which would be astronomical growth. Capturing just a small slice of this pie would significantly add to Cisco's bottom line.
Unfortunately, Cisco has not been able to do this so far. What's worse is that smaller competitors have proven to be more nimble than Cisco, which is looking more like a lumbering giant with each passing quarter. For example, smaller rival VMware (VMW -1.54%) bought a company called Nicira two years ago for $1.2 billion. This acquisition was designed to boost VMWare's position in software-defined networking, and the results are materializing. VMware posted 15% revenue growth through its second quarter ended June 30, year over year. By comparison, Cisco just ended its fiscal year, and its revenue actually declined 3% versus fiscal 2013.
Throughout this, Cisco Chief Executive Officer John Chambers has downplayed the threat posed by competitors, and essentially dismissed the company's competition. On the most recent quarterly conference call with analysts, he said, "Our innovation this period has secured us the leadership position in cloud and hybrid cloud, made us the recognized leader with our customers and SDN, and has driven new opportunities with customers embracing the Internet of everything."
Whether this is true is highly debatable. Judging by Cisco's underlying results last year, it certainly doesn't seem to be accurate. This calls Cisco's significant capital expenditures into question.
Product innovations coming up short
On the conference call, Chambers touted new products in routers and switching, such as the NCS 6000 and the Catalyst 3850, but Cisco still posted revenue declines in both routers and switching last quarter.
One positive note is that the company is seeing strength in data centers with the Nexus 9000. Cisco is seeing strong demand from a variety of end users, including cloud providers, financial services, and technology providers. In all, Cisco's data center customers tripled last quarter. Unfortunately, its strong performance in these areas isn't enough to lift the entire company, since Cisco is still heavily reliant on routers and switches. Cisco has invested a great deal in new businesses, but the fact that these emerging technologies still represent a small portion of the overall company is a real disappointment.
Investors understandably losing patience
Cisco keeps putting up weak results, and its stock price is bearing the brunt of the backlash. Despite spending more money on product innovation, Cisco continues to lose ground. Earnings and revenue are still going in the wrong direction, and this is having a real effect on investors. Cisco shares are down slightly over the past year, while it continues to spend more money on strategic initiatives that are falling flat. Because of this, investors are right to be critical of Cisco's capital spending decisions.