Cisco: A Buy Despite A Terrible Quarter

| About: Cisco Systems, (CSCO)

After rallying a solid 22% year to date, shares of Cisco (NASDAQ:CSCO) were pummeled after hours on the release of a weak fiscal first quarter and even worse guidance. On the news, shares fell by 10% after hours to $21.50. In this article, I will go over the quarterly data, second quarter guidance, what that means for the rest of 2014, and whether or not you should take advantage of the drop to buy shares of this tech bellwether.

In the quarter that just ended (release available here), Cisco earned $0.53 on $12.09 billion compared to $0.48 on $11.88 billion one year ago. However, analysts were hoping for faster sales growth to $12.34 billion while EPS was a positive surprise compared to expectations for $0.51. Considering the government shutdown, these were decent numbers from Cisco. Importantly, Cisco is maintaining significant pricing discipline with gross margins remaining robust at 63%. CSCO also continues to generate significant cash with operating cash flows of $2.65 billion compared to $2.47 billion a year ago. Cisco now has $48 billion in cash and investments on its balance sheet against $13 billion in debt. As such, its board increased its share repurchase authorization to $15 billion. Including the remnants of the existing plan, Cisco can repurchased $16.1 billion shares or 13.5% of shares outstanding at their current price.

Now, there is no end date to this program, so we cannot be certain of the pace of repurchases. In the past quarter, CSCO spent $2.0 billion to retire shares, and with the size of this authorization, I would expect a mild acceleration in the coming four quarters, likely in the $2.1-$2.5 billion range for up to $10 billion in the year, which should help Cisco maintain its EPS while it faces down challenges. The company also spends about $900 million on its dividend every quarter and after the drop yields a solid 3.16%. Cisco has been aggressively increasing its dividend since initiating it in 2011. With a 30% payout ratio, I would expect 10-15% annual dividend growth rate over the next 5 years.

Let's turn now to Cisco's truly awful guidance. Analysts had been looking for 4% sales growth in the current quarter. CEO John Chambers said on the conference call (available here) that sales will actually drop by 8-10%. Cisco is in the process of shifting its business as enterprise IT needs change with hardware sales declining thanks to the advent of the cloud. Cisco is trying to shift into services, but given its massive size, the transition is neither easy nor speedy. There have been several bumps along the road with this quarter a relatively large one. It is also unlikely to be their last such bump.

The biggest weak spot in the quarter actually came from emerging markets with sales orders dropping by 12% year over year from 13% growth two quarters ago. This reversal is stunning. There have been suggestions in tech circles that NSA spying revelations are causing trouble for U.S. tech companies overseas but these numbers imply weakness beyond the NSA. Routers continue to lag while data center revenue was impressive (44% growth), though they account for only 5% of revenue. Set top box orders fell 20%, and as they account for 20% of revenue, played a leading role in the awful guidance. With significant competition in this area, I expect set top boxes to be one of Cisco's weaker legacy businesses.

China sales declined by 10%, though they worsened in the back half of the quarter, down 18%. Similarly, India and Mexico were down 18% while Brazil fell 25% and Russia dropped 30%. Chambers said the company expected to return to growth in these countries in a "few quarters." With worsening sales trends, this guidance seems quite optimistic, but if he could turn around emerging markets by the end of 2014, the stock will be rewarded. While everyone expected weakness at legacy hardware businesses, the drop-off in emerging markets was jaw-dropping and bring into question the modernization of the company.

The one positive about guidance was that management was optimistic about gross margins, expecting 62% in this quarter. Cisco is not prepared to undercut on price to boost sales temporarily and impair future profitability. By maintaining extremely high gross margins, Cisco should be able to insulate its net income somewhat from declining sales. In this upcoming quarter, management is looking for $0.45-$0.47 in EPS on that 8-10% drop in revenue. Last year, the company reported non-GAAP EPS excluding items of $0.50, so we will see an annual drop of 6-10%. For the year, Cisco expects $1.95-$2.05. In fiscal 2013, the company earned $2.02, so there will likely be a mild year over year decline. Now, analysts had been expecting $2.10 this year, so I would expect a lot of downgrades in the next 48 hours.

Cisco's transition from a mainly product to mainly service company continues to be challenging with businesses like set top boxes struggling. The big takeaway from this quarter was that emerging markets are absolutely terrible with double digit declines. There appear to be structural shifts in these countries that have hurt other tech firms like IBM, and I believe expecting growth to return in the next 12 months is an optimistic take. Cisco will continue to see sales volatility in the coming quarters as the majority of its business no longer has any organic growth. It will take time before Cisco's new businesses are big enough to outweigh the old ones.

So should investors buy Cisco's shares on hopes of a turnaround? Given horrible sales trends, I tend to think Cisco's $2.00 EPS midpoint is probably optimistic and would look for $1.90. After the earnings drop, this gives Cisco an 11.3x multiple, which seems mildly attractive despite the challenges, especially coupled with the growing 3.1% dividend. However, investors should back out some of its net $35 billion in cash. Much of this cash is overseas and would be subject to repatriation so I will only count 75% of it in. That still leaves Cisco with $4.88 in cash per share for an ex-cash earnings multiple of 8.75x.

I believe this multiple provides investors with a pretty strong margin of safety. Even if you doubted the turnaround, Cisco would need to see significant erosion to justify its current valuation, especially as the company is returning so much cash to shareholders in dividends and buybacks. Personally, I would like to see the company use some of its existing cash pile to purchase a growing service-oriented company in the $10-$15 billion range like a Netapp (NASDAQ:NTAP) or even F5 Networks (NASDAQ:FFIV) to hasten the transition and cut the relative size of its legacy business. Second to an acquisition, this bigger share buyback should be beneficial for shareholders as it is repurchasing stock below intrinsic value. Frankly, I believe CSCO has the cash to do both this buyback and an acquisition, though a major deal would surprise me.

Poised for dozens of downgrades, I do not see CSCO shares rallying anytime soon, and you could probably wait a few weeks to initiate a position at a similar price, though I cannot imagine shares dropping much below $20. At 8.75x earnings, the stock is more than fully pricing in an inability of management to ever grow the business again. Even then, cash flows would have to deteriorate by more than 8% per annum forever before projected returns fall below the long-run market average of 8%. If by 2015 the company can become more service oriented and start to grow again, the stock could soar. After this drop, you can buy shares of Cisco at a good price in the worst case scenario with essentially a free call option if management can execute. Below $22, I would be a buyer of Cisco. I am right now looking over my portfolio to find a position I can sell to make room for Cisco, and I suggest you do the same.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CSCO over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.