Look Out for Gradually Falling Margins at Portfolio Pick Cisco Systems
06/16/2014 5:30 pm EST
When it comes to his long-term portfolio, MoneyShow's Jim Jubak is limited to how many buys and sells he can make per year, but given that its margins keep getting chipped at, he's confident this tech company is going to make the cut as a sell this year.
I'm now working on my annual update to the Jubak Picks 50 Long-Term Portfolio. By the rules of this portfolio, I get to buy and sell just once year and I'm limited to no more than five buys and five sells annually.
When it comes to sells, every year I go through this list of potential long-term portfolio holdings looking to see what, if anything, has changed that has eroded the long-term competitive advantage of these stocks.
This year it looks like Cisco Systems (CSCO) isn't going to make the annual cut. The stock was a member of the original Jubak Picks 50 portfolio posted in December 2008. The gain since that pick was 62.86% as of June 16.
The problem is that something called “Software Defined Networking” is chipping away at Cisco's incredibly juicy margins. As the dominant company in the networking sector, Cisco has long captured the bulk of the profits in the networking industry. In cell phones, Samsung and Apple (AAPL) collect more than 100% of sector profits. That same kind of reward for being Number One has gone to Cisco in networking. And that has translated into gross and operating margins that dwarf those at competitors. Cisco's gross margin in the fiscal 2013 year, for example, was 62.1% across the company. In some segments, gross margins were even higher. Switching pulled in gross margins of 65% to 70%, for instances.
The rise of Software Defined Networking (SDN) threatens those margins. Software defined networking separates networking software from networking hardware. The promise of software defined networking is that, by reprogramming the software of a network, a customer can create a different networking solution using the same hardware. That's a big challenge to a company such as Cisco that has cemented its dominance of the sector by bundling hardware and software into single network packages. Software Defined Networking doesn't, by any means, mark the end of Cisco. But it does mean that the company will face more competition at more points in the networking stack. And that greater competition will mean, I'd argue, a gradual erosion of Cisco's margins.
In something other than a long-term portfolio this wouldn't be a huge issue. In a portfolio like the Jubak Picks 50 that envisions 5- and 10-year holding periods (or longer) this kind of margin erosion over time is a big deal.
Software Defined Networking isn't a radical idea. In fact, I'd argue that the change in the networking space has been slow in coming. The shift from hardware determined systems to flexible systems that use software to change system configurations, or to deploy application specific solutions, is a fact of life among information technology sectors such as servers and storage. From the experience of watching what has happened to margins in the server and storage segments with the introduction of software defined technologies, I think it's reasonable to think that networking margins are headed 15 to 30 percentage points lower over time.
This doesn't have anything to do with inefficiencies at Cisco or a lackadaisical approach to product development. I think Cisco CEO John Chambers has, in fact, done a great job in taking costs out of the company in response to the global financial crisis and the Great Recession. And Cisco has been very aggressive in continuing to acquire small networking companies in order to add new technologies to its products.
It's just that Software Defined Networking will change the whole cost structure—gradually—of the networking sector. Credit Suisse has looked at the cost and total cost of ownership for a Cisco datacenter switch and a SDN switch and found that the SDN solution is about 70% cheaper on an annual basis. If Cisco is going to compete in a Software Defined Networking world, it's going to have to cut hardware margins and/or move to a Software Defined Networking approach itself over time. In either case, gross and operating margins will be lower for Cisco. The relatively modest growth in networking revenue for the industry—forecast at slightly less than 5% a year—won't be enough to make up for the decline in margins that Cisco faces.
The decline is likely to be gradual, but I think the long-term trend no longer makes Cisco a great long-term portfolio holding. I will be dropping the stock from the Jubak Picks 50—officially—in the next couple of weeks when I do my complete update of this portfolio.
Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I managed, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund shut its doors at the end of May and my personal portfolio is now in cash. I anticipate putting those funds to work in the market over the next few months and when I do I'll disclose my positions here.