Supply chain issues have taken center stage for communications equipment manufacturers like Cisco (NASDAQ:CSCO) or Juniper (NYSE:JNPR) which need components from China to make fully-assembled switches or firewalls.
As the chart below shows, Cisco’s stock has lost more than 15% of its value within a few days after it missed revenue expectations for its third quarter of 2022, with Juniper also penalized by around 5% due to its exposure to China.
The aim of this thesis is to assess the degree of impact and the actions they have undertaken to mitigate risks in the electronics components supply chain. I start with Cisco.
First, making a switch or firewall requires thousands of components, anything from semiconductor chips to copper for the circuitry or aluminum for the casing. Furthermore, there are different types of chips including passive ones like resistors or capacitors to the more active ones like high-performance programmable FPGAs.
To further complicate matters, in some cases components first have to be shipped to China from another country to be then assembled with others on circuit boards before being shipped out to countries like Singapore. However, this is not the case for Cisco where it is primarily about sourcing components from China for its power supplies to be then assembled in about 11,000 printed circuit boards. This entailed $300 million of potential sales losses or 2.3% of Q3's sales.
Additionally, the company saw a $200 million loss from Russia which makes for less than 1% of its revenues, but what seems to have really spooked investors is the weaker guidance for the fourth quarter which ends in July. Still, as shown in the table below, the company managed to deliver a slight growth of $32 million compared to Q3-2021 as shown in the table below.
Now, I check Juniper's supply chain.
As for Juniper, it had not seen any impact for its first quarter 2022 results which ended in March 2022 as seen in the left-hand table below. This is most likely due to the fact that the China lockdowns which started only on March 27 did not have any material effect on Q1, but things may be different in Q2 when the company bears the brunt of the supply chain bottlenecks crippling Chinese ports.
This explains the adverse market reactions seen towards the stock on May 18 as wary investors preferred to sell their shares instead of waiting for financial results in July. In this respect, the company is likely to be impacted as it is still dependent on China for components, despite having considerably reduced its manufacturing footprint in that country since 2020. This effectively means that, in the same way as Cisco, it should face component shortages from China.
Moreover, the company has not been immune to supply issues, namely in the fourth quarter of 2021 when its Cloud-Ready Data Center segment had seen a decline in revenues compared to the previous year. This is highlighted by the red circle in the right-hand table above.
Now, the production of electronics components in China and outsourcing manufacturing to that country enabled a reduction in equipment costs. Going forward, the trend to trust geopolitically friendly countries in East Asia and elsewhere, or in-shoring to the U.S. is likely to increase costs in a complex supply chain.
According to a report by the Global Semiconductor Alliance, the electronics industry has an elaborate supply chain with components traveling across 70 international borders before the customer receives the end product. This opens several bottlenecks causing events, such as Covid impacting a port, and a power outage at a semiconductor foundry in addition to the usual logistics challenges associated with container ships traveling over long distances.
Now, in response to these concerns, component manufacturers like Intel (NASDAQ:INTC) have allocated capital to expand their production in the U.S. but this normally takes 18-24 months or more to materialize. Also, this will entail higher costs as domestic manufacturing tend to be more expensive.
Higher component costs should adversely impact the gross margins of networking equipment suppliers, but there are other dynamics into play here.
First, with a higher dose of software used allowing for the same piece of electronic to be used by more users, and second, by converting networking devices into Platform-as-a-Service whereby more sustained subscription revenues are obtained, both Cisco and Juniper have managed to increase gross margins from 2020 as shown in the charts below.
However, with more economies of scale due to its capacity to order massive volumes of components, Cisco is seeing less per-unit costs. This enables the company to spread its relatively higher revenues on lower costs resulting in better gross margins as evidenced by the blue chart above sloping higher from August 2021.
Also, this should increase as the company is proceeding with some strategic changes in the way it designs networking gear.
Thus, as per Cisco’s executives during the last earnings call, its engineering team has been redesigning about 100 products that are uniquely used by Cisco for the last 6 to 9 months as part of the supply chain risk mitigation, allowing for a wider diversity of components. This is in addition, to constantly evaluating and redesigning its global supply chains to add more resiliency during the last 15-20 years.
As for Juniper, I have noted the will to improve resilience, but these relate mostly to getting manufacturing out of China to Taiwan, Malaysia, Mexico, and the U.S. ever since the first wave of the pandemic hit in Q1-2020. As part of risk mitigation, it also has implemented multi-sourcing, pre-ordering, and logistics-focused strategies. However, this does not go to the same extent as Cisco, namely in redesigning the products themselves.
Thus, in the long term, Cisco should benefit from more profitability, and I value it accordingly.
First, a few words of caution for those who want to buy the dip.
Even if the Chinese authorities were to suddenly remove all Covid-related restrictions and allow the flow of transportation logistics to resume, investors should expect the high degree of congestion at the ports to continue for some time as a result of tough competition for both ports and airport capacity. Thus, Cisco's fiscal fourth-quarter should equally suffer, not only from a revenue shortfall, in line with the lower guidance, but also in terms of gross margins as expedited costs and competition for ports and airport capacity eats away some profits.
The same should be the case with Juniper and Arista Networks (ANET), whose current quarters last from April to June and should see significant effects from China’s lockdown unless these companies have been able to diversify sourcing. Consequently, there is a risk of the shares of these three communications equipment manufacturers dropping when financial results are announced.
Looking at one-month price performance, despite its vertiginous drop, Cisco has suffered relatively less as shown in the table below. This may be due to its ability to pay higher dividend yields while being profitable and having a low debt-to-equity ratio. Juniper also, despite its revenue growth being less than one-fourth of Arista's but paying dividends has not been unduly punished by investors. This shows that with the prevailing value strategy, growth is not necessarily being prioritized.
Looking at the demand side, with backlogs of over $17 billion and $2.1 billion for Cisco and Juniper respectively, which is at least 30% more than their revenues for the last quarter, these two companies have some cushion against any temporary demand slowdown triggered by a potential economic contraction. For this purpose, some analysts have pointed out that Cisco seems to have received fewer orders than normal, especially for its enterprise business which groups its large customers.
However, customers may not necessarily be in the mood to order in a supply-constrained environment. Also, with Cisco's backlog having peaked with an additional $30.2 billion of remaining performance obligations, the exceptionally high inventories can be converted into sales. Pursuing along the same lines, it is unlikely for corporations, big and small, to just halt key digital transformation projects which enable infrastructure modernization, customer differentiation, or support for the hybrid workforce. Also, with the removal of Huawei from the 5G equation and the opening of the radio access network with Open RAN, Cisco and Juniper should play a more prominent role in mobile networking.
Therefore, demand is there, but Cisco's attractiveness comes primarily from its ability to improve gross margins while facing supply issues. As a result of these margins filtering to the bottom line, the company managed to beat Q3's earnings by 0.93%. Thus, it deserves a higher non-GAAP price-to-earnings multiple. Carrying out an adjustment based on Juniper's 14.72x, I obtain a target of $49 (42.9 x 14.72/12.79), based on its share price of $42.9.
However, I am not bullish as there are pains to come in the short term. As for Juniper, it is better to wait for its financial results, which explains my hold rating.
Finally, with constant adjustments to its sourcing strategy, which goes as far as redesigning products, Cisco should be the main beneficiary of the new pandemic-dictated and geopolitically-oriented world economic order, where in response to higher components prices, its larger economies of scale should permit better margins.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
Additional disclosure: This is an investment thesis and is intended for informational purposes. Investors are kindly requested to do additional research before investing. This article was edited with the help of Bhoshan Woodun.