Cisco (NASDAQ:CSCO) recently announced the acquisition of Meraki, a small networking firm that provides multiple cloud-based services to small and mid-sized companies. The acquisition gives Cisco a big opportunity to tap into the fast growing mid-market segment as well as use Meraki’s product line to create a compelling cloud-based platform for bigger customers down the road. While Meraki’s primary product continues to be WLAN gear, it has diversified its cloud-based portfolio to include switching, security and mobile device management services as well. With businesses increasingly looking to move to the cloud and networks becoming more software and cloud-focused, Cisco’s move will help it address changing trends and compete better with fast-growing rivals such as Aruba Networks.
Cisco’s enterprise muscle
Enterprise WLAN is a Cisco stronghold with the company boasting a market share upwards of 50% in a $4 billion market. However, most of Cisco’s revenues come from large enterprise customers – a market that is growing at a much slower pace than the midmarket where Aruba and Meraki play in. Meraki’s acquisition will therefore help Cisco grow outside its traditional customer base as well as give it a cloud-based platform for its other enterprise products. While enterprise WLAN itself may not yet be a big revenue contributor (less than $2 billion) for a company of Cisco’s size, having a cloud-based platform that can be scaled up to include other more revenue-generating enterprise businesses such as switching, routing and security is strategically more important to Cisco’s long-term plans.
Meraki’s acquisition is also a sign that the company is moving towards a more software and services-based business model. The fact that Cisco is actively focusing on the cloud is a good sign for the future and shows that its restructuring and turnaround efforts have realigned the company’s focus on key growth areas in its networking business. With data demand exploding and restructuring initiatives taking hold, we believe that Cisco is well-positioned to grow revenues at a healthy rate in the future.
As a result of the restructuring initiatives, the company has been able to keep its expenses low and make operations more efficient. This will help it meet its guidance of being able to grow earnings at a faster rate than revenues. The recent quarterly results have showed that Cisco’s operating margins which were fluctuating widely as a result of the restructuring are stabilizing at >20% levels. This increases confidence in management’s guidance of achieving long-term operating margins in the mid-20s and increasing profits at a faster pace than revenues. Cisco has realized almost all of the expected $1.1 billion in severance charges related to the workforce reduction program it announced in July 2011, and the operating margins should remain fairly stable hereon.
Deeply undervalued at market price
However, the macro-economic uncertainty surrounding the European debt crisis could hit technology spending in the coming months, impacting Cisco’s earnings as well. Still, longer term, Cisco’s outlook looks strong not only due to an industry-wide change of fortunes once the uncertainty eases but also the company’s bigger market share within the industry. The company’s strong market position has helped it outperform rivals Juniper and Alcatel-Lucent in an uncertain economic environment so far, and will help it even further when the concerns subside.
With the company getting refocused on its core businesses and driving efficiency in its operations, we believe that it is being deeply undervalued at its current market price. We maintain our price estimate of $26.40 for Cisco, suggesting a 45% upside to the current market price as our model takes into account the aforementioned concerns together with the company’s long-term plan of achieving stable operating margins in the mid-20s.
Cisco also has tons of cash – almost 30% of its current market capitalization. It has also been generating huge positive cash flows in the order of billions from operations every quarter despite a challenging economic environment.
We believe the company will continue to execute well on its turnaround plans, banking on a leaner structure to grow its profits at a rate higher than revenues. The positive cash flow will ensure that the company is able to return cash to shareholders through regular dividends and share repurchases while keeping its gunpowder dry for new strategically-important acquisitions.