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Summary

  • Investors are relieved as the company beat expectations and is more upbeat for the final quarter.
  • Despite this, revenues are still shrinking as competition attacks the business from all sides.
  • Despite a rock solid financial position and fair valuation, the business model remains under pressure which is my major doubt.

Investors in Cisco Systems (NASDAQ:CSCO) are relieved after the company beat on low third quarter expectations while issuing a relatively solid outlook for the fourth quarter.

Despite the improved performance and outlook, I remain concerned about the long-term outlook for the business with sales being under pressure and competition continuing to be a dominant factor.

Third Quarter Results

Cisco reported third quarter revenues of $11.55 billion which is down by 5.5% compared to last year.

Reported GAAP earnings fell by 12.0% to $2.18 billion. Thanks to share repurchases in the fall earnings per share was limited to 8.7% with earnings falling by 4 cents to $0.42 per share.

Closely watched non-GAAP earnings came in at $0.51 per share, unchanged from last year.

Operational Review

The fall in revenues is due to falling product sales which were down by 7.7% to $8.82 billion. Service sales rose modestly, increasing by 2.6% compared to last year, coming in at $2.72 billion. What's encouraging is that important US orders rose by 7%, offset by a similar decline in emerging market orders.

Gross margins compressed by 80 basis points to 60.8% of total revenues. As Cisco could not offset the fall in sales entirely in its operating cost structure, operating margins fell by 1.3% to 38.7% of sales.

A one-time $76 million ¨other income¨ provided a modest boost to earnings. This benefit was partially undone by a slightly higher effective tax rate compared to last year.

Fourth Quarter Outlook

For the current fourth quarter, Cisco anticipates revenues to come in between $12 and $12.3 billion, representing a 1-3% drop in revenues year-on-year. The guidance comfortably beat the analyst consensus outlook at $11.8 billion.

Non-GAAP earnings are seen between $0.51 and $0.53 per share.

Valuation

Cisco ended the third quarter with an incredible $50.5 billion in cash, equivalents and investments. Total debt amounts to $20.9 billion which results in a net cash position of $29.6 billion.

For the first nine months of its fiscal year revenues came in at $34.78 billion on which the firm reported earnings of $5.61 billion. Full year revenues are seen around $47 billion as earnings could approach $7 billion.

Trading at $24.50 per share, Cisco is valued at $126 billion which values operating assets of the firm at around $97 billion. This values operating assets of the firm at a little over 2 times annual revenues and 13-14 time annual earnings.

The quarterly dividend of $0.19 per share provides investors with a 3.1% dividend yield.

Investors Are Being Looked After In Terms Of Cash Returns ...

Besides receiving a 3.1% dividend yield, investors furthermore received implicit cash through share repurchases which totaled $2 billion over the past quarter, at a rate of 6.3% per annum. Even after the recent share repurchases, the company still has $10 billion being authorized.

..While They Become Impatient With Chambers

Despite this, investors are becoming inpatient with CEO Chambers who has led the company for nearly two decades now. It seems that he wants to put the company into better shape before turning the company over to a new leader as Cisco is more confident for the final quarter of its fiscal year. Note that Mr. Chambers is 64-years-old at the moment.

Investors have been very disappointed with Chambers after the company cut its multi-year forecast at the end of last year. Cisco has resorted to restructuring and layoffs to keep earnings up. At the time, Cisco lowered its multi-year sales growth target to 3-6%, down from a previous guidance of 5-7%.

The company is seeing structural weakness in its business as mobile businesses and different network architecture allows companies to use more cloud-applications, thereby avoiding Cisco's products.

So-called software defined networking is used by more and more companies, which thereby reduces reliance on Cisco. Furthermore competition is heating up from all other sides with emerging Huawei Technologies attacking the core business while specialized companies like FireEye (FEYE) focus on the security of networks.

Takeaway For Investors

Chambers is confident that the company can fend off and crush the biggest threat which it believes is software-defined networking, a development led by VMware (NYSE:VMW). With software-defined networking, companies can replace expensive Cisco routers and switches by cheaper commodity hardware.

The technology is embraced by all majors including Hewlett-Packard (NYSE:HPQ), Oracle (NYSE:ORCL) and even Facebook (NASDAQ:FB). In a response Chambers bought Insieme for $863 million, while 50 some customers are testing its SDN software at the moment.

I remain in doubt. Cisco's rock-solid balance sheet and shareholder payouts are to be applauded. On the other side the valuation at 13-14 times earnings excluding cash is not too demanding. That being said the company might at best be able to report flat revenue growth, or very little revenue growth next year.

With smaller competitors still attacking the company from all sides, and showing meaningful revenue growth, I'm still not certain of the competitive position in the medium to long term. I remain cautious and staying on the sidelines for now.

Source: Cisco Systems: Despite A Beat, I Remain Uncertain About The Long Term