Cisco Is A Buy Following Post-Earnings Drop

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About: Cisco Systems, Inc. (CSCO)
by: Gary Gambino
Summary

Cisco Systems disappointed the street in its last earnings release with a below-consensus growth forecast and large drop in China sales.

The reaction appears overdone, given the low percentage of Cisco’s sales in China and steady performance in other businesses.

At 14.6 times FY 2020 earnings estimates and a 2.9% dividend yield, Cisco is attractively priced. The stock looks ready to resume its climb after revisiting post-earnings lows.

4Q Results Okay but Outlook Disappoints the Street

Cisco Systems (CSCO) reported 4Q 2019 earnings on August 14. (Cisco’s fiscal year runs from August to July.) Non-GAAP EPS of $0.83 beat estimates by a penny. The company showed mid-single digit to low teens percentage sales growth across most product lines. In Cisco’s geographic segments gross margins improved in all regions and sales grew in two out of three regions, with only APJC (Asia-Pacific, Japan, and China) showing a decline.

Cisco Revenue Highlights Cisco Revenue and Gross Margin Source (Above 2 slides) - Cisco Q4 FY2019 Earnings Slides

The problem came with the outlook. New product orders in 4Q 2019 were flat year-on-year. Looking at the changes geographically, APJC declines offset growth elsewhere. By customer type, Service Provider continued to be a drag on overall sales.

Cisco Q4 2019 Product Orders Source - Cisco Q4 FY2019 Earnings Slides

The company, which provides guidance only one quarter at a time, projected fiscal 1Q 2020 revenues flat to up 2%. EPS projection was $0.80 to $0.82, which is slightly down sequentially and 5% above the prior year. The stock, which had already lost about 10% in the month prior to the earnings report, lost another 12% following the release. It has since traded in a sideways channel.

Cisco price chart

Based on analysts’ consensus estimate of $3.34 for FY 2020 EPS, Cisco went from a forward P/E ratio of 17.4 at its 52-week high to 13.8 at its post-earnings low. It has since recovered to 14.6. With an annual dividend of $1.40, yield went from 2.4% to 3.0%, all within one month. This decline from in-line with the market average forward P/E to nearly a 20% discount seems to be an overreaction when you dig deeper into the results.

Outlook Not as Bad as the Stock Price Implies

Markets overall have been hypersensitive to each twist and turn in the US-China trade relationship. The market may have been spooked by CEO Chuck Robbins’ revelation that China appears to be actively avoiding Cisco as a tactic within the trade war:

I mean tell the overall Chinese market as I said earlier is certainly not a major play for us, but it has just dropped precipitously in light of the trade discussions. So, it has a short-term impact and if you were -- where we are selling for years we've sold infrastructure to the large carriers in China, which has just -- it's been slowly declining and we saw it even decline more rapidly last quarter.

And then, what we've seen is in the state-owned enterprises anymore, we're just being we're being uninvited to bid. We're not being allowed to even participate anymore. So those are the enterprises that's where the large impact was this past quarter, so it was just a much faster decline of what we candidly expected.

Source: Cisco 4Q2019 Earnings Call Transcript

For Cisco though, it is just not that big of a deal. As you can see on the slide above, the APJC segment makes up less than 15% of overall sales and China itself comprises less than 3%.

Even the long-suffering Service Provider customer segment performance in 4Q appears to be more China-related and not anything specific to Cisco’s execution. Additionally, a couple of large contracts in India helped the prior year quarter.

The Americas was generally the same from an order perspective from the prior quarter, so no real shift positive or negative. Europe was actually positive in the SP space. In Asia, we saw continued weakening in our China service provider business and we had two massive build outs in India a year ago that just didn't replicate this year with the two major players there. That's the net of the service provider situation it's not more complicated than that.

If you look at our overall business, our orders outside of service provider grew mid-single digits.

Source: Cisco 4Q2019 Earnings Call Transcript

While the China issue is real, I see it as one with quick upside if the trade war is resolved but limited downside if it continues due to Cisco’s low existing share of sales in China.

On the Enterprise side, Cisco is delivering on its strategy to become more subscription-based rather than doing one-off product sales. The Catalyst 9000 line of switches is also seeing good uptake by customers and the company still sees itself in the early stages of an upgrade cycle.

So, in the last 120, 180 days, I mean we completed the full refresh of our portfolio across switching, routing and wireless in the enterprise. And we're now in a position where all of those have mandatory subscriptions. So we've made that transition from a product development perspective and now those are all out in the marketplace with our customers.

On the catalyst 9000, Q4 was the -- we added more customers in Q4 for the catalyst 9000 than in any quarter prior. So, that continues to move forward favorably. In the campus what I would suggest to you is that we're -- I'd say maybe we're in the second inning at this point of this transition that we see from our customers. As you know they're all rearchitecting their entire enterprise infrastructure to accommodate these traffic flows that are presented from the massive number of cloud applications that they're running. And so it requires a completely different architecture which is what this portfolio is built for.

Source: Cisco 4Q2019 Earnings Call Transcript

Risks

While the Service Provider segment outside of Asia was around flat in 4Q 2019, Cisco remains pessimistic about it picking up considerably anytime soon. Telecom providers upgrading their networks to 5G will not be a near-term boost for Cisco as long as the providers are focused on the consumer side:

I think that if you look at the early 5G build outs, most of the telco customers, we have particularly in Americas, they're focused on the consumer 5G trials today they're not -- I mean that is the primary focus. And then getting their 5G consumer networks built out. But they also don't -- I would say don't anticipate that being a huge profit driver off of the 5G transition that's going to come when they build more robust broader 5G infrastructure where they'll deliver enterprise services and that's going to come after they do the consumer side.

Source: Cisco 4Q2019 Earnings Call Transcript

Additionally, do not look for share buybacks to support the stock price as much going forward. With the 2018 tax reform allowing companies to repatriate foreign cash, Cisco returned $31 billion via buybacks. With this buyback complete, the company is going back to its goal of returning at least 50% of free cash flow as dividends and buybacks. With free cash flow of around $14.9 billion and dividends around $6 billion, buybacks could drop to around $2 billion per year versus the $20.7 billion they did in FY19.

Valuation

Compared to its peers in the Communications Equipment industry, Cisco has one of the lowest P/E ratios. Despite the low sales growth forecast for 1Q 2020, Cisco has a better growth forecast than all except Ciena (CIEN) although the two are similar on a PEG basis. Cisco is the most efficient operator with higher margins and far better return on assets and return on equity. Dividend yield is near the high end of peers with a payout ratio below 50% implying that future dividend growth is likely, especially with the reduction in buybacks as compared to recent years.

Cisco Valuation Comparison

While I am not a technical analyst, the chart above shows the stock testing and not breaking support at its post-earnings low. It also seems ready to break above the channel it has been trading in for the three weeks following the earnings report. More importantly, the fundamentals are good based on the current valuation.

Conclusion

Cisco was beaten up by the market for its 4Q 2019 results. While China was a serious drag, further downside is limited and there is upside potential if the trade war cools off. The Service Provider segment also negatively impacted results but was at least flat outside of Asia. Cisco’s longer term strategy to shift from a product-focused model to a more subscription-based network services model featuring both software and hardware is working and is still in the early stages. This will continue to drive sales growth with Enterprise customers, which are becoming an increasingly larger part of Cisco’s business.

The overreaction to Cisco’s earnings report has created an opportunity to get one of the best companies in its industry at a discount to its peers and the overall market average.

Disclosure: I am/we are 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.