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Will 2016 Be Cisco Systems Inc's Best Year Yet?

By Leo Sun – Jan 17, 2016 at 5:11PM

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Will this networking giant rise after experiencing flat growth last year?

2015 was a dull year for Cisco (CSCO 0.50%) investors, who watched the stock end the year nearly flat with few bullish catalysts on the horizon. Last quarter, the networking giant's revenue rose 3.6% annually to $12.7 billion, beating estimates by $30 million. Unfortunately, its guidance for flat to 2% sales growth for the current quarter missed forecasts for 5.1% growth because of macro and currency impacts.

Looking ahead, can Cisco bounce back in 2016? Or will the new year ring in new challenges that could drag down its stock?

Image source: Cisco.

Estimates and valuations
Analysts, on average, expect Cisco's sales to fall 1.4% annually this quarter, another 0.6% next quarter, and end down 0.2% for fiscal 2016. But on the bright side, sales in fiscal 2017, which starts at the end of July, are expected to rise 3.7%.

On the bottom line, analysts expect Cisco to grow its annual earnings at an average rate of 9.4% over the next five years. That forecast gives Cisco a 5-year PEG ratio of 1.15. Since a PEG ratio under 1 is considered undervalued, I consider Cisco fairly valued based on its earnings growth potential. Cisco currently trades at 13 times trailing earnings, which is a considerable discount to the average P/E of 42 for the networking and communication devices industry. Based on these figures, it seems like Cisco shares have more upside than downside potential from current levels.

The main numbers to watch
Almost half of Cisco's revenue comes from sales of switches and routers. Last quarter, sales of switches rose 5% annually to $4 billion, but sales of routers fell 8% to $1.8 billion because of weak demand from carriers.

Cisco's higher switching revenue is encouraging, since many bears believe cheaper Chinese rivals like Huawei and ZTE will commoditize that core market. Cisco's 40% jump in total sales in China and India during the quarter helped put those fears to rest. However, Cisco's decline in router revenue is discouraging, since many carriers and enterprise customers are shifting toward cloud-based networking solutions, which require fewer routers.

Image source: Cisco.

Therefore, Cisco's long-term growth depends heavily on higher sales of software, services, and UCS (Unified Computing System) servers. UCS servers unify various stand-alone services onto a single platform, which can lower costs for enterprise customers. Last quarter, UCS sales rose 24% to $859 million. Collaboration revenue climbed 17% to $1.2 billion, wireless revenue rose 7% to $645 million, and security services grew 7% to $485 million. Demand for these services is rising -- deferred software and subscription product revenue rose 36% annually, deferred security revenue climbed 31%, and deferred collaboration revenue grew 18%.

Expect alliances and inorganic growth
Cisco's router and ethernet switch businesses are already the largest in the world, so there's little room for both businesses to grow. However, both remain vulnerable to its smaller rival, Juniper Networks (JNPR -0.96%).

Last November, research company Synergy Research Group reported that Juniper's share of the U.S. service provider routing market had reached 28% during the third quarter of 2015, up from 24% a year earlier. Cisco's share slipped from 53% to 49%, which contributed to its aforementioned decline in routing revenue. Juniper's share of the switch market has also been rising at a faster rate than Cisco's, according to research company IDC. Meanwhile, Cisco's UCS and networking growth could be threatened by the megamerger between Dell and EMC, as well as Huawei's aggressive pursuit of service provider partnerships across Europe.

To counter these threats, Cisco partnered with Ericsson (ERIC 2.35%), the largest telecom equipment provider in the world, last November. By offering their products together to customers, the partnership could generate revenues of $1 billion for both companies by 2018. Prior to that, Cisco partnered with Apple to build better networks for enterprise iOS devices, and it formed a $100 million joint venture with China's Inspur Group to expand into the country's cloud computing market. During last quarter's conference call, CEO Charles Robbins stated that these major partners "see Cisco as the market leader they want to work with to move faster and drive greater value to customers and the market."

Cisco has also been beefing up its software and services business through acquisitions, mainly focused on the cloud, security, video, and collaboration markets. Last year, it acquired or announced plans to acquire 11 companies, up from six companies in 2014.

Will it be Cisco's best year yet?
2016 probably won't be Cisco's "best" year yet, since the company experienced much faster sales growth in previous years. But it certainly won't be a bad year if Cisco keeps pivoting away from routers and switches, instead beefing up its software and services with smart partnerships and acquisitions. Cisco stock probably won't surge by the double digits this year, but it should remain relatively stable in these choppy markets while paying out a nice 3.4% dividend.

Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Apple. The Motley Fool recommends Cisco Systems. 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.

Stocks Mentioned

Cisco Systems Stock Quote
Cisco Systems
$49.97 (0.50%) $0.25
Telefonaktiebolaget LM Ericsson Stock Quote
Telefonaktiebolaget LM Ericsson
$6.52 (2.35%) $0.15
Juniper Networks Stock Quote
Juniper Networks
$32.92 (-0.96%) $0.32

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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