Cisco Systems (CSCO) has announced the completion of its acquisition of NDS Group for $5 billion shortly after receiving the approval of antitrust regulators in Europe. The acquisition of the UK-based company gives Cisco the chance to use its large overseas cash holding without having to worry about taxes in the US. It also gets a services-based business that brings in steady recurring revenues from the strong presence in emerging markets. The biggest benefit to Cisco is that a proven video technology becomes available to be incorporated into its Videoscape platform. The resulting increase in video consumption is bound to boost the sale of routers and switches in the long-term.
Recently Cisco has streamlined its ambitious growth plans and decided to focus on areas which will add value to its core business of routers and switches. It is restructuring its organization accordingly to make it lean and more efficient. Video has been identified as one of these key areas, and the NDS acquisition is of strategic importance to its video plans. With rising demand for video services from both businesses and retail customers, Cisco is looking to provide the service platform for secure delivery of video content under the cloud computing umbrella. Moreover, the combination of NDS technology, in conjunction with the company’s own cloud-based Videoscape services, will ensure efficient delivery of pay TV content not only to television sets but also to PCs and mobile devices such as smartphones and tablets. Cisco’s own research reveals that the mobile video market has the potential to grow at a compound annual rate of 90% between 2011 and 2016, and will account for 70% of the total data traffic. Mobile data usage itself is expected to grow by 18 times in this timeframe.
Most of this growth is expected to come from the Asia-Pacific, Africa and Middle East regions. NDS has a strong presence in emerging markets like India and China, where it reaches over 35 million households. By focusing on video, which will be the primary driver of data usage, Cisco can expect increased sales of routers and switches which service providers need to install to cater to their consumers. It also enables Cisco to diversify from its main hardware sales business into becoming a fee-based service provider and growing steady, recession proof revenues. This also puts the company in the unique position of being an end to end hardware and software services provider.
This major strategic move is much needed, as disappointed investors have accused Cisco’s management of being asleep at the wheel because stock prices over the past few years have moved sideways instead of upwards. This criticism is somewhat unfair because, apart from the NDS acquisition, the company has launched other initiatives to boost shareholder value. In part, the crisis in Europe and the expected reduction in technology spending have forced these initiatives. On the cost front, the company is seeking to reduce costs and increased efficiency, and, because of its global domination in its core business, this should immediately translate into higher profits. Cisco has announced plans to cut 2% from its global workforce of over 65,000 employees, and this should result in significant long-term cost reduction. The company is currently highly dependent on its hardware business (it has, for instance, over half a million customers for its enterprise routing solutions) and is looking to shift part of its revenues to services-based businesses and cloud computing. As part of this new business model it has introduced Cloud Connecters software as an integral part of its cloud computing package.
The results of these initiatives are already showing. In the second quarter of 2012, total revenue reached $11.6 billion, up about 7% on a year on year basis, while net income of $2.2 billion marked a 20% increase on the same basis. Consensus estimates of analysts predict an EPS of $1.84 for this year and $1.92 for 2013. The company’s operating margin seems to have stabilized at 24% after having been as low as 13 % at one point in time. This is a strong performance considering the difficult global economic conditions and has put the company well ahead of rivals such as Juniper (JNPR) and Alcatel-Lucent (ALU). The performance of Cisco stock so far this year is satisfactory when compared to the performance of peers such as Qualcomm (QCOM), Ericsson (ERIC) and Broadcom (BRCM).
Cisco has been somewhat unfairly treated by the market. It is finally making the right moves both in terms of business expansion and in terms of maximizing the profitability of its huge global market share by minimizing costs. It is also well placed to cash in on the potentially phenomenal rate of growth in data usage and in particular video. I also believe that the operating margin will remain stable because virtually all of the $1 billion staff severance payments have already been realized. The company is financially strong and the cash mountain of $48 billion amounts to about a third of its total market capitalization. The company expects technology spending to be somewhat restricted by the present economic conditions, and this is certainly true in the short-term. But, in the longer term, as conditions improve, Cisco stands to gain the most because of its dominant market position.
I believe there is potential upside in the stock currently. I recommend buying Cisco if you are prepared to wait for the long-term returns. Meanwhile, if you have an existing investment, hold onto it as the downside is very limited and the upside potential is considerable.