Cisco: Short-Term Uncertainty Is Advantageous To Long-Term Investors

Dec. 14, 2021 8:15 AM ETCisco Systems, Inc. (CSCO)5 Comments
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Summary

  • Cisco has an uncertain short-term outlook but excellent long-term prospects, and the stock is a Hold.
  • The company has a rapidly growing backlog due to increased product orders and supply constraints.
  • It is somewhat uncertain if and when these orders will become revenue.
  • This uncertainty led to conservative FY 2022 revenue guidance, a misguided market drop, and a muted analyst reception.
  • Long-term investors can hold and wait for the supply disruptions to dissipate, management to guide higher, and analysts to upgrade the stock.

Antique Glass Clocks In The Desert

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Background

At first glance, Cisco (NASDAQ:CSCO) seems to be moderately recovering from 2020. Revenue is increasing at mid-to-high single digit rates and should exceed pre-COVID levels next year.

Cisco Revenue

Source: Seeking Alpha

Last quarter, however, management announced that both revenue and costs were being affected by supply constraints. As a result, gross margin decreased and was below expectations.

Cisco Profit Margin

Source: Seeking Alpha

In addition, management guided disappointing 5-7% FY 2022 revenue growth. On the announcement, the stock dropped as much as 9% before recovering.

Cisco price return

Source: Seeking Alpha

On the earnings call, management did not give a timeline for resolution of supply issues. This uncertainty seemed to rattle the analysts, which is corroborated by their declining ratings.Cisco stock analyst ratings

Source: Seeking Alpha

Aligning with management's forward guidance, the current (<= 1 year) portion of unearned revenue grew 6.6% year-over-year during FY 2022 Q1. However, the growth of the non-current (> 1 year) unearned revenue has consistently outpaced both revenue and current unearned revenue.

Cisco unearned revenue

Source: Seeking Alpha

This is one sign of the building backlog. Perhaps even more importantly, management announced that year-over-year orders increased 33%. This indicates that demand is rapidly expanding.

Thesis

Cisco routers, switches, and software are crucial internet infrastructure components, and the company has been the long-term leader in this space. On this basis alone, it is poised to benefit from such trends as 5G, cloud computing, cyber security, remote work, infrastructure spending on rural internet access, monitoring of energy and industrial infrastructure via the internet-of-things, and smart electric grids that distribute power across state and country borders. It is clear that the pandemic accelerated many of these.

It appears that Cisco may now be benefitting from the infrastructure upgrades. Cisco's order growth rate is the largest in ten years as management pointed out in both the most recent earnings call and FY 2021 Annual Report. At the segment level, service provider and web scale order growth were 66% and 200%. This indicates that the Silicone One portfolio of products is gaining traction.

However, orders do not necessarily convert to revenue. As stated in the Risk Factors section of the 10K, the recent growth in orders might be from duplicate orders, and orders in general are subject to cancellation. In addition, orders were probably low in 2020, and some of the growth reflects the low base. Finally, it is possible that the order growth might be an ephemeral reaction to supply constraints as customers attempt to guarantee fulfillment.

Gross margins are also falling. Management claims this is due to added logistics costs caused by the pandemic. However, it is not clear if and when Cisco will be able to raise prices to offset the added costs. In the short-term, management will likely continue to issue guarded guidance, and analysts will stay neutral.

The thesis of this article is that this short-term uncertainty is advantageous to the long-term investor. Cisco is a highly profitable, established company with a new product portfolio in a rapidly expanding market. The stock is also reasonably valued. The company is well-positioned to use its size and cash to its advantage in an inflationary environment. If the additional expense on logistics and inventory now translates into long-term, profitable sales later, then the money is well spent.

Key Inputs

The three inputs to the valuation are: revenue growth, gross margin, and multiple expansion. These parameters are estimated for five different scenarios: Minimum (0th percentile), Worst Case (10th percentile), Most Likely, Best Case (90th percentile), and Maximum (100th percentile). Historical data, current data, management estimates, and best guesses underlie the following assumptions:

Revenue Growth: Base case matches top of 5-7% FY 2022 guidance

  • Minimum: Supply constraints or COVID cause 0% growth, or -7% below base
  • Worst Case: Matches bottom of 5-7% FY 2022 guidance, or -2% below base
  • Most Likely: Matches base case
  • Best Case: Matches 9% growth of non-current unearned revenue, or 2% above base
  • Maximum: Accelerated product delivery results in 10% growth, or 3% above base

Gross Margin TTM: Base case matches current gross margin of 64%

  • Minimum: Supply constraints cause margin to fall 3%
  • Worst Case: Follows trend to fall 1%
  • Most Likely: Matches base case
  • Best Case and Maximum: Supply constraints ease and margin expands by 1%

2022 Price-to-Earnings TTM: Base case matches current value of 20

  • Minimum: 14, or 30% contraction
  • Worst Case: 16, or 20% contraction
  • Most Likely: 20 or stable
  • Best Case: 24, or 20% expansion
  • Maximum: 28, or 40% expansion

The base case annual total return is assumed to be the earnings yield, or 5%. The above assumptions are then applied relative to the base case. This results in estimates of total return for each of the five scenarios.

Source: Poppertech

Forecast

To create the forecast, the above scenarios are input into software that creates the graph below and associated statistics. The black values underneath the graph indicate the total return values as shown in the previous table of scenarios. The white percentage values overlaid on the graph correspond to the proportion of the total area under the curve within each colored region. This is the forecast probability of the total return falling within the associated range. For example, the light green region represents a 39% chance that total return is between 5% and 29% over the next year.

Cisco return forecast

Source: Poppertech

Based on the above forecast, the software performs a Monte Carlo analysis to calculate expected return and risk. The resulting statistics are shown below.

Cisco expected return and risk

Source: Poppertech

The expected return based on the above analysis is 4.5% and is ~1.5% higher than my expectations for the S&P 500. Forecast volatility of 17% approximately matches my expectations for the S&P 500. As might be expected from the short, left tail and the long, right tail in the graph, the forecast is positively skewed. The negative excess kurtosis derives from the shortness of the tails, or a lower probability of extreme events than a normal distribution with the same mean and standard deviation.

This article was written by

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PopperTech develops augmented intelligence software for investing

Disclosure: I/we have a beneficial long position in the shares of CSCO either through stock ownership, options, or other derivatives. 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.

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