Cisco Analysts Are About To Be Wrong Again

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About: Cisco Systems, Inc. (CSCO)
by: Damon Verial
Summary

Cisco reported earnings, producing an up gap in the charts; my analysis shows that this is most likely a breakaway gap.

The analysts have been almost consistently wrong on Cisco, and statistical analyses have been much more reliable for predicting this stock's price action.

The post-earnings gap presents an opportunity for an annual ROI of 18% with only six days of exposure.

With the current earnings and sentiment trends, Cisco should head upward.

I am always amazed by how often analysts get Cisco (CSCO) wrong. It is almost as if they are giving us contrarians free buy/sell signals. As I’m sure you know, CSCO is way up today, as the company reported earnings, “easing analyst concerns.”

The Analysts Are Often Wrong

Indeed, CSCO was the target of upgrade/downgrade flip-flopping recently. One quarter ago, both Morgan Stanley and Nomura downgraded the stock, just before it rose 35%. These companies also gave CSCO upgrades in 2017 and 2018, respectively, right before periods of consolidation and underperformance:

(Source: StockCharts)

Analyst opinions are not always useless, but the track record for using analyst opinions and price targets on CSCO has been abysmal in price prediction. This is funny, as CSCO has many reliable patterns. Statistical properties inherent in the stock make it rather predictable in the short and medium term.

Take the recent gap, for instance. We are most likely looking at a breakaway gap. The visual characteristics of the gap share more in common with those of an area gap (average relative volume, post-gap price is within the previous trading region, white-white candlestick pattern), but the statistics point to a breakaway gap:

Breakaway Gap?

(Source: StockCharts)

I know this is more likely to be a breakaway gap than an area gap because I backtested it. CSCOs gaps of this type tend to lead to sustained upward momentum lasting one to three weeks. The results of trading this gap by buying and holding for six days (the optimal holding period for maximizing ROI/time) appears below and gives traders an annual ROI of 18% when they trade this type of gap whenever it appears:

(Source: Damon Verial; data from Yahoo Finance)

The possibility of the gap closing exists, but is not supported due to the nature of the gap. Specifically, this gap appears after earnings, and is thus based on novel information being priced into the stock. Earnings were clearly good, but sometimes earnings gaps fill because of a mismatch between the raw financial data on earnings and management sentiment shift.

Cisco Sentiment: Net Positive

I ran a financial lexical analysis on CSCO’s earnings to arrive at a sentiment score, comparing the score to the company’s previous earnings reports. The result supports the idea of a breakaway gap: sentiment and earnings results were aligned in the positive direction. Sentiment is average for the company and with respect to the market, but we do see a slight drop in optimism: 14% lower quarter over quarter.

Still, sentiment was net positive. This analysis supports the breakaway gap thesis, namely that CSCO will continue upward after this gap. However, we do not expect excess returns of the likes of the previous quarter.

Let’s take a look at some of the forward-looking statements that were flagged by the lexical analysis:

“Going forward, we will integrate this platform with our broad data center portfolio, including HyperFlex, ACI, SD-WAN, and Stealthwatch cloud to deliver the best multi-cloud experience for our enterprise customers.”

- This is in regard to Cisco’s joint project with Google (GOOG, GOOGL). Anthos, a multi-cloud application, is set to become a large part of Cisco’s business, as it focuses on offering application-building cloud services to enterprises. Projects that are built on partnerships within a competitive industry tend to result in excess returns for the stocks of the companies, perhaps because of synergy or the alleviation of costs typically attributed to fighting for market share.

“The new innovations we launched include people insights, facial recognition, and WebEx calling, all which helped to increase our customers' productivity, making work simple and seamless.”

- Cisco attended Enterprise Connect this quarter, revealing new features for its WebEx conferencing platform. For the most part, these are machine learning applications that are mostly unavailable on other platforms. These features give WebEx some better positioning in its unique selling proposition and should help the platform gain and maintain its market share.

“When we look at the impact of acquisitions on our Q3 results year-over-year, there was a 40 basis point positive impact on revenue.”

- For mature companies, growth is difficult to achieve. Acquisitions are often necessary to increase margins but not always successful. Cisco has shown that its acquisitions have been productive - though marginally so - for its balance sheet.

“There will be - there we still have some manufacturing happening in China, but we've greatly, greatly reduced our exposure working with our supply chain and our suppliers.”

- One of the major concerns of analysts (and investors alike) is the China-US tariff war. Communication equipment companies manufacture and source in China to a large degree, and this places extra risk into stocks in this sector. Cisco is well aware of this, not only altering guidance but also actively reducing its exposure to where its supply chain is almost entirely removed from China.

“Note that we have normalized our fourth quarter guidance to exclude the SPVSS business for Q4 of fiscal 2018 which we divested on October 28, 2018.”

- Another change in guidance of which investors should be aware is the divestment of Cisco’s Service Provider Software Solutions business, which has been acquired by Permira. This officially removes video from Cisco’s portfolio of tech industries.

Overall, sentiment was net positive, bolstered by new developments and innovations in the company’s software portfolio. Cisco saw decent growth in many of its categories: 10% in enterprise and the public sector; 5% in the commercial sector. In addition, total product orders rose 4%. As 65% of the company’s software sales are recurring revenue via subscriptions, these numbers have more weight going forward into successive quarters.

Rising EPS Predicts a Rising Stock

The result is a continuation of CSCO’s slowly rising EPS trend. As a rolling average, EPS is on the upswing. This comes after a few problematic quarters:

(Source: Damon Verial; data from ADVFN)

EPS is almost as important as sentiment here, as it has predictive validity for the stock price. Statistically, we see increases in EPS leading the stock higher and decreases leading it lower. With the current trend, CSCO is set to continue moving upward:

(Source: Damon Verial; data from ADVFN)

Conclusion and Trade Idea

The gap, sentiment, and EPS trend all support a bullish thesis on CSCO. If you want to play the gap into the upward momentum from earnings, consider the following strategy:

  1. Buy Jun21 $55 put
  2. Sell Jun21 $49 put
  3. Buy Jun21 $57 put
  4. Sell Jun21 $63 put
  5. (optional) Buy May24 $55 call

If you are holding stock outright, you can skip the optional long call. The strategy is essentially taking the other side of a condor trade which the buyer believes will profit due to CSCO remaining stagnant; we disagree, as the gap implies a breakout (high probability) or a closure (low probability), both implying movement. We can do this with call options, but my review of the two strategies showed that the put-based strategy is more profitable. You can increase profitability by legging into the play, but this requires more short-term speculation than needed.

Close the strategy at the end of June, rolling the long call over weekly as long as CSCO is not overextended.

Happy trading!

Disclosure: I/we 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.