Why We're Downgrading Cisco's Moat Rating

 Cisco Systems (CSCO) provided an update on its longer-term strategy and financial road map yesterday at its financial analyst conference. Management's updated three- to five-year revenue growth forecast of 3%-6% annualized is moderately above our current five-year projection of 2% annualized organic growth, while the rest of management's financial targets are about in line with our current model. 

We remain comfortable with our current five-year explicit financial forecasts, and we are maintaining our fair value estimate. We continue to expect Cisco's operating margin to remain relatively stable and the firm's free cash flow to grow moderately during the next five years, as the company offsets pressures in its core router and switch businesses with ongoing investment in network security, systems management software, mobile infrastructure, services, and converged computing systems.

However, we are no longer confident that Cisco's competitive advantage period will extend 20 years, and we are downgrading its economic moat rating to narrow from wide. At a high level, the ongoing commoditization of data networking equipment and increasing customer concentration have caused us to revisit our economic moat rating. Cisco's router and switch product categories still account for nearly 50% of Cisco's revenue, and these businesses are still central to the firm's competitive position.

Specifically, three key long-term considerations have caused us to change our view of the sustainability of Cisco's competitive advantage period. 

First, we think that switches and routers have become increasingly commoditized over the past several years, and these two categories still account for nearly 50% of Cisco's total revenue, and likely a larger portion of operating profits. While we continue to expect Cisco to maintain its leadership position in these categories for the foreseeable future, we do think the company will be forced to cede a growing portion of these markets over time to protect its operating margin targets. Specifically, we think  Hewlett-Packard (HPQ),  Juniper Networks (JNPR), and white-box switch vendors will pose an increasing challenge in the data center switch segment, and we expect Huawei and Alcatel-Lucent  will continue to price aggressively as they look to gain share in the service provider router market. 

Second, we think that large cloud service providers will account for a growing portion of total hardware demand over the next few decades, and these customers will have increasing negotiation leverage over traditional suppliers like Cisco. The firm has invested heavily over the past few years in new products and architectures in order to maintain its lead in data center networks, and Cisco has thus far been successful in defending its market share in the data center. Still, we think the company will find it increasingly difficult to generate an acceptable return on these investments, as cloud service providers will increasingly be less likely to pay premium prices for feature or service differentiation, in our view. 

Third, we expect an increasing proportion of Cisco's revenue to come from areas such as converged x86-based computing systems, network security, wireless infrastructure, and systems management software. Cisco's competitive position in these industries is not nearly as strong as in the router and switch industries, and we think leading competitors can build narrow moats in these industries, but not wide.

Importantly, we continue to view Cisco as one of the strongest competitors among enterprise and service provider infrastructure suppliers. We also note that our revised moat rating aligns with our narrow moat rating for other entrenched enterprise and carrier infrastructure suppliers, including  EMC ,  NetApp (NTAP),  Check Point Software Technologies (CHKP),  F5 Networks (FFIV), Juniper, and Hewlett-Packard. In short, we continue to believe Cisco has durable competitive advantages tied to the stickiness of its products, its broad customer and channel relationships and intangible assets tied to its services organization and deep expertise in networking, security and data center technologies.

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