Cisco's Dramatic Q2 Shortfall Triggering Deserved Sell-Off

| About: Cisco Systems, (CSCO)

Shares of Cisco Systems (NASDAQ:CSCO) saw a big retreat on Wednesday after the close after the company warned for a terrible second quarter earnings report.

The shortfall in revenues is very aggressive and makes me hesitant to invest in Cisco at the moment. I remain on the sidelines.

First Quarter Results

Cisco generated first quarter revenues of $12.08 billion, up 1.8% on the year before. Consensus estimates stood at $12.34 billion, as the company guided for growth of 3 to 5%.

GAAP earnings came in at $2.00 billion, down 4.6% on the year before. Given modest dilution, earnings per share fell by two cents to $0.37 per share.

Non-GAAP earnings totaled $2.9 billion, or $0.53 per share. Consensus estimates for non-GAAP earnings stood at $0.51 per share.

CEO and Chairman John Chambers commented on the first quarter results, "This quarter we delivered record non-GAAP profitability and continued our steady stream of innovation and market leadership. While our revenue growth was below our expectation, our financials are strong, our strategy is strong and our innovation engine is executing extremely well."

Looking Into The Results

The little bit of revenue growth was mostly spurred by service revenues which were up by 4.2% to $2.69 billion, with the remainder of growth being driven by product sales.

Cisco did a good job at expanding gross margins, increasing them by some 34 basis points to 61.29% of total sales. The problem are operating expenses which rose by 235 basis points to 40.98%.

While additional research & development efforts should be applauded, it was notably the charges of $237 million related to the workforce reduction which impacted GAAP earnings.


The major disappointment was the outlook. Cisco sees its revenues fall by some 8 to 10% compared to last year's revenues of $12.1 billion. Note that analysts were looking for growth of 4% compared to a year earlier.

As such, Cisco sees revenues of $10.9 billion to $11.1 billion, as non-GAAP earnings are seen between $0.45 and $0.47 per share. This compares to consensus estimates of $0.52 per share.


Cisco ended its first quarter with $48.2 billion in cash and equivalents. Total debt stands at $16.2 billion, for a net cash position of around $32 billion.

For the fiscal year of 2013, Cisco generated annual revenues of $48.6 billion, up 5.5% on the year before. Earnings rose by 24.1% to just miss the $10 billion mark.

Factoring in losses of 10% in after-hours trading, with shares exchanging hands at $21.50 per share, the market values Cisco at $116 billion. This values operating assets of the firm at $84 billion, the equivalent of 1.7 times annual revenues and 8-9 times last year's earnings.

Cisco pays a quarterly dividend of $0.17 per share, for an annual dividend yield of 3.2%.

Some Historical Perspective

Long-term holders in Cisco have seen poor returns. Over the past decade, shares have gone nowhere. Shares have moved in a $15-$35 trading range, currently trading around $21-$22 per share. Note that shares peaked at $80 at the start of 2000, during the internet bubble.

Between 2010 and 2013, Cisco has increased its annual revenues by a cumulative 21% to $48.6 billion. Earnings rose by some 29% to just below the $10 billion mark. The company repurchased some 7% of its shares over the past four years.

Investment Thesis

Cisco's investors are very disappointed with the company after Chamber's turnaround plan is not moving along as planned. Over the past two or three years, Chambers has cut the payroll by some 12,000 workers, while acquiring nearly 60 companies to rejuvenate innovation and thereby revenue growth.

The slowdown in revenue trends, as witnessed in October and continuing in November, is quite pervasive. As such, Cisco does not see revenue growth until August 2014.

Cisco is seeing competition for the low-end of its networking equipment from the likes of Huawei, Juniper Networks (NYSE:JNPR) and Alcatel-Lucent, among others. Other emerging companies like Palo Alto Networks (NYSE:PANW) are emerging as well. Chambers even sees competition from low-cost Asian manufacturers which sell basic routers. He stresses that customers will still need more complicated systems combining hardware with software amidst increased complexity of networks.

On top of that, Cisco blamed the guided sales shortfall to hesitance among clients given the political repercussions after the US has been spying on foreign governments. Cisco furthermore notes that companies are still facing economic uncertainty, after the company is pulling away from less profitable set-top box sales.

Despite the dramatic outlook for the second quarter, Cisco still sees 5 to 7% revenue growth over the long term, as the company sticks to its current strategy. Cisco will continue to focus on the enterprise market, while cutting jobs. To somewhat please shareholders, Cisco announced a new $15 billion share repurchase program. Over the past quarter, Cisco repurchased $2.0 billion worth of its own shares.

Back in September, Cisco announced the $415 million acquisition of WHIPTAIL. At the time I last took a look at Cisco's prospects. This deal came after the $2.7 billion deal to acquire Sourcefire in July, to boost its cyber security solutions.

At the time I concluded that Cisco was creating value by cutting expenses and staff, while making opportunistic and strategic acquisitions. The dramatic shortfall in revenues for the second quarter makes me very hesitant though.

While the valuation, when excluding the cash position, is very appealing, the major businesses are clearly in turmoil. While Cisco is employing its massive cash balances to please shareholders, I am not convinced. At the moment, Cisco is returning some $8 billion per year through share repurchases and another $3.5 billion in dividends, eating into the cash balances. Combined, these cash flows result in combined cash flows to investors of around 10% per annum.

I remain on the sidelines, as things will get worse before they get better.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.