Back in November, shares of Cisco Systems (CSCO) took a beating after the company gave terrible guidance for fiscal Q2. This was the second straight earnings fall for Cisco, and shares ended up more than $6 off their 52-week high. Cisco's revenues are expected to decline a bit this year, and earnings per share are expected to decrease as well. While Cisco has become a high yielder in large cap tech, the increasing dividend only helps to offset part of the fall.
There have been many calling for Cisco's CEO John Chambers to step aside for years now. That process continued again in 2013, and the linked article was even before the November warning. There has been a fair amount of executive transition in large cap tech in recent years, with Microsoft (MSFT), Intel (INTC), and Apple (AAPL) all receiving new CEOs, whether due to retirement or unfortunately death. Chambers has been at the helm of Cisco for nearly 20 years now, through the good times and the bad.
This week, Cisco will report its fiscal second quarter results. Thanks to the warning, it is not likely to be a pretty report. Investors can only hope that the company was being conservative with its guidance and that business did not fall off as much as expected. However, if Cisco can't get things turned around, and guidance once again disappoints, you can imagine there will be outrage. For John Chambers, this might be his last hurrah. If Cisco cannot start to turn things around, there will be more calls for Chambers' head. Today, I'll look at where Cisco stands going into earnings, and why this report might be a positive no matter what Cisco reports.
The warning and current estimates:
This was Cisco's terrible warning, taken from the article linked in my opening paragraph:
Cisco completely surprised everyone by issuing awful guidance for fiscal Q2. The company said that year-over-year revenues for the quarter will decline by 8% to 10%, and earnings per share will be $0.45 to $0.47. That's well below analyst expectations for 4.1% revenue growth and $0.52, respectively. Also, Cisco stated that full-year earnings per share would be $1.95 to $2.05, well below the $2.10 analysts were looking for. Emerging market orders fell in Q1, and are not expected to pick up in Q2. China has also been challenging. The government slowdown was an issue for Cisco, and I would encourage all to read the conference call transcriptfor management's full comments on the issues facing this company.
Analysts have obviously responded by taking down estimates. For the Q2 period, current estimates call for an 8.9% drop in revenues to $11.03 billion. That's a fall of more than a billion dollars. In terms of earnings per share, analysts are right at the company's midpoint, $0.46 per share, down a nickel from the prior year period. As a reminder, Cisco's EPS estimates are non-GAAP.
For the fiscal year, estimates call for a 4.6% decline in revenues, a decline of more than $2.2 billion. Earnings per share are expected to come in at $1.98 after $2.02 in the year ago period. Cisco's fiscal year ends in July. Analysts are a penny below Cisco's guidance midpoint for the fiscal year.
Q2 will be very important for Cisco, but no matter what the results are, perhaps more important will be the company's guidance. Right now, analysts are looking for a 7.1% decline in fiscal Q3 revenues. Earnings per share are expected to decline by 3 cents to $0.48. A decline of 5% doesn't normally sound like a good thing, but if Cisco guides to that, I think investors will be happy. For Cisco estimates to stop falling, the company needs to beat for Q2 and issue decent guidance for Q3.
Comparisons - large cap tech:
There are two ways I look at Cisco. The first way is as a large cap technology company. Cisco is one of the largest tech companies on the planet in terms of market cap and revenues. In the following table, I've compared Cisco against some other large cap technology names, including Google (GOOG). These names all have similar market caps or revenue bases.
You can see why this quarterly report is so important for Cisco. The company is expected to have the worst year of these five large cap names. Intel is the only other name expected to show an earnings per share decline. Intel has posted two straight years of revenue declines and earnings per share drops. However, Cisco's revenue fall this year is expected to be double what Intel's revenues have declined total in the past two years. Cisco does have a decent dividend yield, but still only comes in third place in that category. Cisco's buyback also leaves a bit to be desired, as the company's diluted share count rose 1.8% in Q1 over the prior year period. Of the four names above buying back stock, Cisco's buyback is doing the least amount of good for investors.
When it comes to large cap tech, Cisco does not seem like a very strong candidate to own right now. When you convert Cisco's P/E to GAAP, Cisco trades at a slight premium to Apple. Why would you want to own a company with falling revenues and earnings for more than one growing revenues and earnings? Cisco needs to get its estimates closer to Intel's, and that process can start this week.
Comparisons - networking names:
A major concern of investors is that Cisco is losing out to the competition. There are certainly networking names like Juniper Networks (JNPR) and Riverbed Technology (RVBD) that are actually increasing revenues and earnings. Juniper is expected to grow revenues in the mid single digits this year and next, along with earnings to grow in the low double digits. When it comes to Riverbed, the company is expected to grow revenues in the high single digits this year and next.
Both Juniper and Riverbed do trade at a premium, about 17-19 times expected 2014 earnings. Neither company pays a dividend. Investors are willing to pay this premium for some amount of growth. I'm not arguing here that Cisco needs to show 6-8% revenue growth every single year, although it would help. That's why Cisco trades at just 11.45 times its expected fiscal year's earnings. Cisco needs some level of growth, and if competition is increasing, where do Cisco's revenues go in the future? Current estimates for the next fiscal year (ending July 2015) don't even have Cisco getting back to the levels seen in the fiscal year ending in July 2013.
Stuck in the middle:
When Cisco fell after earnings in November, it experienced a negative technical event known as the death cross. This happened when the 50-day moving average broke below the 200-day moving average. This hurt Cisco shares, which dipped further lower. You can see where Cisco stands now against its moving averages in the chart that I've put below.
(Source: Yahoo! Finance)
Right now, Cisco is sandwiched between the 50-day and 200-day moving averages. The 50-day has started to climb again as Cisco shares have rallied a bit in the past month or two. If Cisco rallies after earnings, we could see the golden cross, where the 50-day breaks above the 200-day. That will take a little time, however. If Cisco falls after earnings, both moving averages are expected to head lower. Given the recent rally, I think Cisco breaks below the 50-day on a bad report. That level probably won't provide too much support. In fact, if Cisco's report is bad enough, Cisco shares might remain under the 50-day and the moving average could represent a level of resistance.
Cisco warned for the current quarter, and investors are hoping this is not a sign of things to come. Cisco is expected to see a nearly 9% fall in revenues for the quarter, and almost 5% for the current fiscal year. Earnings per share are also forecast to decline. Investors are hoping that Cisco can get its growth story back on track, as the company doesn't offer the growth of other networking names or large cap technology companies.
What's the potential trade here? Well, in the past seven quarters, the average move after earnings is just over 8%. If you can get a straddle directly at the money for say 4% to 5%, I think that would be the recommended trade. Right now, a straddle at the closest strike ($22.50) costs nearly 7%. That is way too expensive, and doesn't allow for a lot of profits. But if options prices were to somehow come down, this would be the way I'd play it. Otherwise, I'd wait until after earnings to re-examine the name.
For Cisco, a bad report could ignite more calls for John Chambers' departure. You could easily see an activist investor, someone like an Icahn, come in and try to move this name (not saying Icahn personally will). In the fall of 2013, Microsoft shares popped after Steve Ballmer announced that he was retiring. Microsoft shares regained a bit of the losses sustained after its latest disappointment.
In the long-run, this week's earnings could be a positive for Cisco no matter what the outcome. Here are my reasons why:
- If the report is good, then the business is doing better than expected, and Cisco can return to growth sooner.
- If the report is bad, then calls for Chambers to go will increase. If Chambers does go, a Ballmer-like jump could occur.
Perhaps Cisco does need a new strategy. The company has increased the dividend nicely in recent years, but investors would like some growth to go along with the dividend/buyback. Cisco doesn't want to be a utility, but it is long past the high growth stage. A solid combination of some growth with a decent dividend and buyback would please investors. Right now, Cisco is not delivering on the growth front, something most investors find crucial. In the long run, I think this earnings report is great for shareholders for the reasons mentioned above. While shares could easily fall after a bad report, it would allow investors to come in at a higher dividend yield and lower price. The calls for Chambers to go would increase, and I think that would be positive too. Also, if Cisco gets down to like 10 times expected earnings, the valuation gets a bit more reasonable. I'm tagging this article as "Long Ideas" because of the potential of Cisco over the next couple of years, even if this week's report is not great and shares sell off afterwards. That might provide the opportunity investors are waiting for.
Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.