What Cisco Must Do to Preserve Its Moat

Pat Dorsey: Hi, I'm Pat Dorsey, director of equity research at Morningstar.

Tech bellwether Cisco this week posted its second disappointing earnings outlook for the past two quarters, sending the stock down about 15%. The market is worried about competition in Cisco's core routing and switching markets, but we think it's actually not the bigger concern for Cisco's competitive advantage, or economic moat as we like to say at Morningstar.

With me to talk about Cisco's economic moat, and some of the things they might be able to do to fill it in or widen it, is the associate director for our technology group, Grady Burkett.

Thanks for joining me, Grady.

Grady Burkett: Thanks for having me.

Dorsey: So, we've talked for a while in our Analyst Reports about our worries with Cisco's push into the consumer market, and now we're seeing perhaps some of those chickens come home to roost. You want to give viewers some background on that?

Burkett: Over the past five or six years, Cisco has been moving into the consumer market. They bought Scientific Atlanta in 2005, and that brought them into the set-top box industry. They picked up Linksys in 2004 and that was home routers. More recently, they acquired Pure Digital, which makes flip cameras, which are just those small video cameras that you are starting to see in the consumer [market], and these are really commoditized areas for Cisco.

Dorsey: And not an area where it has much experience, right? I mean, selling into the consumer market, the distribution channel, the audience is quite different than selling a mission critical router to Procter & Gamble?

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Burkett: That's exactly right. And what we've seen is a few mistakes along these lines, so in the flip video, Cisco is really trying to position that as an architecture, a high-end kind of product, and really it's something that's just going to be integrated into smartphones, and it already has been, and so really that looked like a strategic mistake in Cisco's part. They spent almost $600 million to buy that company, really not a good use of shareholder capital.

Most recently, they've launched a product called umi, which is home video conferencing, and again that's a very expensive product for the consumer to buy and something where you've got free options on your PC to do the same thing.

Dorsey: So what do you think was Cisco's motivation for these moves into the consumer market, because it seems reasonably obvious that this is not their core competency, and all these ads we see on TV about "the human network," I'm not really sure what that adds to Cisco's competitive advantage in routing and switching.

Burkett: The growth is slowing in Cisco's core markets, so switches are maturing and really you can't expect much more than about mid-single-digit growth for Cisco in switches.

Routers are maybe growing a little faster, but these are the markets where Cisco has a very strong competitive advantage, they are very high margins, and these are Cisco's core competencies.

Cisco has been targeting and signaling 12% to 17% growth rates to its investors over the last three or four years as a long-term goal, and so we just think Cisco has been doing whatever it feels like it needs to do to try to hit those targets.

Dorsey: Instead of accepting this mid-life crisis that all large companies go through and realizing that delivering shareholder returns does not necessarily mean allocating capital to growing quickly.

Burkett: That's exactly right. Cisco's current revenue run rate is about $43 billion a year. That's a very large run rate for a company to try to grow 12% to 17% a year. We would much rather see Cisco exit these noncore businesses, and we're starting to see signals that Cisco maybe is starting to get the message...

Dorsey: ...from investors. We saw an exit recently in the consumer group just in the past day or so, not Hooper, the head of the consumer group, but a key executive there.

So, let's posit a couple of scenarios over the next year or so, and specifically let's think about maybe how that might play into how we view Cisco's economic moat, which we rate as "wide" right now. One is, they continue to plunge forward into the consumer business, and the other is, they get the message and they either sell or spin most of the consumer businesses.

Burkett: So Cisco generated about $9.2 billion in free cash flow last year, and it's on very high returns on capital, and so, we think that to the extent that Cisco would cut some of these consumer businesses, we think they could exit the set-top business. We think they could really exit the low-end router business through Linksys business, and we think they could cut some of these really commoditized consumer products and lower their cost structure a little bit, save on the OpEx line, and drive higher free cash flows for investors.

So, if Cisco were to do that, we think they would be able to defend their core markets more effectively against some of the growing competition from really well-capitalized firms like HP and Huawei in China, and then return some of that capital to shareholders in the form of dividends and maybe accelerating the share buyback.

Dorsey: Where as if they continue to A) distract management attention and B) just allocate capital to low- or frankly no-return businesses like the flip phone, that would be a negative for the moat?

Burkett: We'll be watching Cisco very closely over the next four to six quarters to see how they are reacting to their clear inability to compete in the consumer market and the fact that it really is not accretive at all. It's dilutive to shareholder value, and so if we see Cisco make the right moves, we think that it could extend its moat life, if you will.

Right now, we have it as a wide moat that is narrowing, and if they make these smart decisions, and if they are willing to return capital to shareholders instead of pursuing growth, we think that extends the moat.

If they continue to pursue these opportunities, you're going to continue to see distractions, competitors are going to take the opportunity to try to continue to move in the core markets, and we're concerned that with Cisco, you could start to see some deterioration in returns on capital for the company.

Dorsey: Just to wrap up with the stock for a moment, so the company is doing about $9.5 billion in free cash flow right now; it's about a 10% free cash flow yield, the stock is around $20. So, in your view, does it seem like the market is assuming that they continue down the consumer path and is giving Cisco no credit for the possibility that they'll exit those businesses?

Burkett: Right. Cisco has clearly been disappointing the market and investors for a few quarters now, and the market absolutely has given them very little credit for their ability to control these capital allocation decisions, maybe lever off the growth and focus on their core businesses and returning capital to shareholders. So, in our view at a 10% free cash flow yield, we think Cisco is very attractive.

Dorsey: Basically priced for continued stupid moves by management when you would hope that the clue train arrives at Cisco headquarters.

Burkett: That's a good assessment.

Dorsey: All right. Thanks for joining me, Grady.

Burkett: Thanks, Pat.

Dorsey: I'm Pat Dorsey and thanks for watching.