I Bought Cisco On Its Earnings

Feb.13.14 | About: Cisco Systems, (CSCO)

Executive summary:

  • Cisco reported earnings that slightly beat extremely low expectations.
  • Legacy businesses, like switches and routers, continue to struggle but are approaching a bottom.
  • Growth businesses, like security and cloud, are showing solid sales and orders growth.
  • Cisco is cash-rich and is finally returning large amounts of cash to shareholders.
  • Shares should trade at least 10x earnings ex-cash or $25-26, suggesting at least 15% upside.

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Cisco (NASDAQ:CSCO) shares drifted 4% lower after the company reported earnings that mildly beat estimates (press release available here). Of course, Wall Street dramatically lowered expectations after Cisco's previous quarter, with many firms taking down their revenue estimate by $1 billion. While Cisco beat these low expectations, its results were far lower than the figures that were anticipated three months ago. Moreover, the company expects another annual decline in revenue in the next quarter, and investors continue to wonder when Cisco will be able to grow revenue again. Until that time, shares are likely to remain in the low $20s.

In the second quarter, Cisco earned $0.47, which beat analyst expectations by a penny, while revenue of $11.16 billion beat by around $100 million. However, sales were down 7.4% from the quarter a year ago, while EPS was down 7.8%. Essentially, Cisco is struggling to adapt to the new wave of technology that is focused on the cloud and has rendered much of its hardware-focused businesses less valuable. The company has also struggled to maintain market share, with fierce competition from the likes of Alcatel-Lucent (ALU) and Juniper Networks (NYSE:JNPR).

Cisco can basically be broken into two units: the weak legacy unit and new growth units. As expected, legacy units like set-top boxes continue to struggle, while there are signs of life in growth units. Gross margins of product sales were expectedly weak in the quarter, falling to 48.7% from 59.1% last year. However, Cisco is seeing improvement in services, with gross margins increasing to 67.8% from 66.3% a year ago. The company has also cut $270 million in operating expenses, mainly from SG&A, to maintain profitability. Importantly, the company is not shortchanging R&D. Many struggling tech firms cut R&D to bolster current results, but that action only compounds problems going forward. R&D as a percentage of revenue increased in the quarter to 12.7% from 12% last year.

On the negative side, Cisco's switch and router businesses continue to struggle. Switch revenue was down 12% year-over-year, while router sales were down 11%. Cisco's set-top boxes, which it is wisely de-emphasizing, fell 22%. With significant competition, terrible margins, and some consumers cutting the cord, set-top box sales are going to continue to be terrible. The unit is in secular decline and is the perfect example of a lousy legacy business for Cisco. Videoconferencing revenue was down 7%, which was a bit weaker than I was looking for. Fortunately, new order trends were not as bad as sales trends. Overall, new orders were down 4% year-over-year, which is better than the 7% decline in sales. Switch orders were down 6% and router orders were down 5%. The business is not at a bottom, but the declines are starting to soften. We should hit a bottom in switch and routing at the end of this year. Unsurprisingly, Cisco's set-top unit's orders were as bad as its sales, coming in at -20%. Set-top boxes will be nothing but a drag for the foreseeable future, while switches and routers are seeing their worst days.

Wireless was down 4%, though there appear to be timing issues. Its Meraki platform grew over 100%, but over a third of the revenue was deferred. As a consequence, revenue should improve in future quarters. Security continues to be the leading bright spot, with revenue up 17%. Orders are up 30% thanks to strength in network security and the Sourcefire acquisition, while a shift to recurring revenue will improve visibility. Security business is robust and accelerating. Conversely at first glance, data center revenue looked disappointing, as it was only up 10% compared to 44% last quarter. However, there were timing issues, with orders up over 30%. These orders will drive stronger revenue growth in coming quarters. Overall, cloud bookings were up double-digits. When you combine the sales and orders data, Cisco's new businesses performed pretty well and will offset weakness in the company's legacy business.

The company also fared better internationally. Concerns over NSA spying crushed American tech companies like Cisco and IBM last quarter, but those pressures appeared to dissipate for Cisco. International orders were down 3% in the quarter, while the decline was down 12% in the previous quarter. BRICs continue to lag, as they were down 10%. Overall, orders in the Americas were down 5%, Asia down 5%, and Europe, Middle East, and Africa fared the best at down 2%. Enterprise was down 2%, while the public sector was up 1%. With spending constraints lessening thanks to better-budget deficits in the developed world, we should continue to see some public sector growth. Given all of these trends, Cisco expects Q3 revenue to be down 6%-8% compared to street consensus of down 7%. Given some of the order trends, I would look for a decline closer to the 6% level than 8% level.

Last, management is increasingly focused on returning its excessive cash hoard to shareholders. Last quarter, the company authorized a $15 billion buyback plan (which was equal to about 12% of its market capitalization) in an effort to boost EPS by cutting the share count. Management took advantage of the depressed share price to buy back $4 billion in stock at an average of $21.73, and is on pace to complete the authorization in the next nine months. This pace was double last quarter's buyback. The buyback is finally cutting into the share count after employee options had been offsetting previous buybacks. The share count has declined 30 million year-over-year to 5.327 billion. Given the current price, a share buyback is a good use of capital, and I hope the company maintains this brisk pace.

The company's quarterly dividend also totaled $900 million last quarter. On that front, management hiked its payout 11.8% to $0.19, giving shares a yield of 3.25%. Last year, Cisco raised the payout from $0.14 to $0.17 for an increase of 21.4%. In other words, there was a significant deceleration in the dividend growth rate. Frankly, I was hoping for an increase to $0.20, though management may want to allocate more resources to buying back stock than raising the dividend given the current share price. With a payout ratio of less than 40%, Cisco can afford to keep raising the dividend once a year, and a 3.3% yield helps to make shares even more attractive.

At the end of the quarter, Cisco had $47.1 billion in cash, with $17.1 billion in debt for a net cash position of roughly $30 billion. That breaks down to about $5.63 per share. At the same time, the company should earn $1.95-$2.05 this year. At current prices, shares are trading at an ex-cash multiple of 8.2x, which provides a significant margin of safety. Given the headwinds that make revenue growth uncertain, Cisco should trade at a discount to market, but 8.2x earnings discounts entirely Cisco's growth units.

Shares should trade at least 10x earnings on an ex-cash basis for a fair value of about $25-26, which suggests 16% potential price appreciation. Even then, it is hard to argue a 10x multiple is a stretched valuation. After this quarter, it is clear that Cisco faces challenges, but its business is not in collapse. Order trends are favorable and suggest legacy businesses (excluding set-top boxes) are approaching a bottom, while growth units continue to perform well. Moreover, the biggest NSA problems are in the rear-view mirror. Given this, shares are extremely cheap. In fact, I used the decline after-hours to initiate a long position in Cisco. I don't expect shares to rally in the immediate term, but for long-term investors, the current valuation more than prices in Cisco's challenges. Shares should be bought here.

Disclosure: I am long CSCO. 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.