In general, the network space is in a cyclical bounce and Cisco has enough products that see an improved demand, so that the company returns to a modest growth.
The company should be able to continue to exceed short-term estimates based on lower memory prices, which are now experienced.
Although I do not see an end in sight for the losses of market share in switching and routing, where Arista and other competitors continue to gain participation, the company's software and security solutions, although relatively small at this point, are mitigating some of the Impact of market share decreases.
Are there enough positive elements to guarantee a positive evaluation?
Earlier this week, a contributor to this site recalled the technology bubble of 1999-2000. For better or for worse, I was there trying to make sense of madness. Personally I think there are more differences than similarities with those years in the market today. (Bitcoin is likely to be a bubble, but bitcoin is nothing more than a class of assets that simply is not a dominant element in financial markets - there are no signs that technology purchases are driven by sales to start-ups that they have no real means to pay for what they are buying or that they do not have real customers to use the products / services that are sold, and in technology, at least, the passage to consumption agreements of several years, has meant that space is much more stable than the case a couple of decades ago). But remembering that interlude reminded Cisco (CSCO) as one of the main beneficiaries and main victims of the bubble.
I do not think anyone is arguing that Cisco is in a bubble these days. The value of its shares, even after appreciating by 25% this year at $ 38 per share, is still only half of the maximum it reached in March 2000 before everything collapsed like a rope of sand. Yes, Cisco sold a lot of products back then to companies that would never pay for it and that did not have customers who needed what they were buying, I think the relatively strong performance of stock prices after the quarterly publication of the financial resources of the company. the performance suggests that many investors are hungry for classic GARP investments. Now it is perceived that Cisco is adjusting that invoice and that a new classification has been made.
Net sales for Cisco, all those years ago were approximately $ 19 billion. The company achieved pro forma earnings at that time of $ 0.53. The company's earnings would fall to $ .39 / share only a couple of years later. These days, Cisco is forecast to get $ 48 billion of revenue and EPS of $ 2.50. Do you care about those statistics to anyone who is not a business historian? They could, if you think the current market is in a bubble. Whatever the case, Cisco, which at that time was on the cusp of what turned out to be a near-death experience in terms of operational performance, has become a name of dividend / value par excellence. The question is, in the context of its recent strong performance of stock prices, if there are enough positive aspects in the business prospects of the company to guarantee a positive view of the shares.
Although I have the shares for clients in what I call income / stability accounts, the prospects for this company are not particularly transparent, at least for me. Cisco is losing market share in what used to be its main business of selling switches and routers, as I have detailed in previous reports, mainly for Arista (ANET), at an alarming rate, and as far as I can determine, lawsuits or do not. , that will not change in the near future. Arista is simply offering users better technology at a lower total cost of ownership and how that does not end immediately.
On the other hand, Cisco has achieved a certain level of success in its efforts to diversify its portfolio outside the network space. Cisco has become a leading provider of security space, primarily through acquisitions and has clung to the position. The company's initiatives in application networking services are enjoying remarkable success. At least the words in the commercial are correct in terms of the company's focus on simplicity, automation and security. The company, like many others in the IT world, is in the midst of moving its revenue sources to what it describes as recurring offers that have now reached 32% of the total, approximately 300 basis points year after year. The company has had reasonable success in integrating analysis driven by machine learning on its platforms. The AppDynamics merger, which was completed earlier this year, is an important element of Cisco's strategy and the company also bought a company called Perspica to strengthen that business segment. More recently, Cisco announced its acquisition of BroadSoft (NASDAQ: BSFT), which will further enhance the company's platform for cloud applications. Cisco is developing capabilities in its new areas of focus using a strategy similar to the way it developed its network portfolio: acquisition of leading suppliers followed by integration and a certain redirection of resources.
As has been mentioned by many since the tax reform has been a significant probability, Cisco will be a great beneficiary. I am not absolutely sure of the final form of the reform and the tax rate for the repatriation of benefits, but regardless of the details, the new law will have positive impacts for all the large multinationals, of which Cisco is an excellent example. The company has indicated that it will increase its dividends in a manner consistent with the growth of reported earnings, but that the ability to repatriate funds at a lower tax rate will have a material impact on the timing of share buybacks. At this point, the company has just over $ 65 billion in gross cash located abroad.
At this point, looking at Cisco is like looking at a caterpillar that is becoming a butterfly. He continues to derive most of his income from the sale of products, but the end of that paradigm is appearing. It is not entirely clear at what point Cisco will become a company whose sources of revenue are derived mainly from software and services and will be based on recurring revenue consumption agreements. But it seems that is happening and, as it does, Cisco should be able to achieve better header numbers than many observers feared. That said, it will be some time before the company produces headline numbers that show persistent revenue growth. The company, in order to better align its reports with the changing contours of its solutions offerings, has now reformulated its reporting categories to include Infrastructure Platforms, Applications, Security and other Products and Services.
There are few ideal investments in the world. I do not suggest to readers that Cisco is one of those. But I do believe that the company has embarked on a reasonable transition that is beginning to produce visible results, at least sub headlines. Given its current valuation, both absolute and relative, I believe that stocks deserve to be recognized by investors more focused on income and stability than real growth.
A review of the last quarter
A month has passed since Cisco discussed the results of its initial fiscal quarter. Presumably, at this moment, the price of the company's shares reflects the investors 'analysis and the precepts of the results, as well as the investors' discount of the almost approved tax reform legislation. Cisco shares have revalued 12% as a result of the earnings report, compared to a 2.5% decrease for the IGV, one of the strongest relative returns that Cisco shares have seen in many years. I think that, given the good performance, it is important that investors take the time to see the details of a results publication that hides some of the achievements in the corners of the subtitles.
The headline numbers say that Cisco's revenue declined again, this time by two percent. Some observers like to compare Cisco's numbers with those of IBM (IBM), which also went through a multi-year period of revenue contraction. I fundamentally disagree with most of the points of the analysis in the linked report, not with the mathematics, no doubt, but with the lack of understanding or comment regarding the product strategy and the management philosophy between the two providers. There are similarities and there are also differences.
I will not highlight the differences here, but simply observe that Cisco is basically moving much of the revenue from what it calls infrastructure platforms to categories that it calls applications and security. These categories tend to derive most of their income from accounting sources. Infrastructure platforms still derive the majority of their income from the sale of discrete boxes. It would be reasonable to imagine that the transition of Infrastructure platforms (still 57% of revenues) will hinder the growth reported in the future. Cisco has forecast a minimum revenue growth for the second quarter. Management has suggested that currently the change to subscription revenue sources is a 2% contra wind in terms of reported revenue growth numbers. Over time, as Cisco develops growing revenues from what it calls its intuitive network, that percentage will grow, although presumably the percentage of organic revenue growth will also grow.
Currently, all Cisco switches are available in terms of subscription and many of their products can also come with attached software. This is no different from many other hardware providers that respond to user preferences, and really also respond to the low cost of capital. Cisco now describes the complementary software as the difference between its Essential offer and its Advantage offer.
Some of the deferred revenue metrics suggest that reserves increase at significant rates. The 42% growth in deferred security revenue is impressive, and the deferred growth in revenues from subscription and computable products that reached 37% to $ 5,200 million in the last quarter, suggests that reserves growth is reaching levels that suggest that The company is achieving a fair level of sales success that is not apparent in the reported income numbers. The company was able to achieve an increase in sequentially deferred revenue, a significant achievement given normal seasonal patterns. Although not always launched, Cisco apparently had a sharp increase in unbilled deferred revenue, at least in its application space. It would be useful for Cisco to disclose enough information so that interested parties can calculate proxy reservations, including unbilled deferred revenue, but that has not happened yet.
The company indicated that its product orders increased 1% last quarter, but without context it is a difficult number to consider in isolation. The company does not present the data to calculate the reserves, nor is it still in a position where the ARR calculation is terribly useful. I guess the overall value of order entry, including software and services, increased by more than 1%, but that is not a metric that has been specifically discussed.
The company achieved better than expected growth in cash flow from operations (CFFO) and free cash flow. The improvement in the CFFO of the company and the free cash flow was mainly due to the elements of the balance sheet, including receivables and other liabilities. Obviously, the balance sheet items are not a long-term source of CFFO, but I expect that the higher reserve growth and the concomitant growth in the balance of deferred revenues will increase the CFFO metric in the coming quarters.
Cisco exceeded estimates for EPS in the last quarter, mainly because gross margins were slightly better than expected. In general, under GAAP, gross margins were reduced from 63.9% to 61.2%. Of that amount, close to half was due to memory costs, which continued to rise in the quarter that ended in October. The company's guidance required that gross margins decrease by another 0.5%, entirely driven by memory costs. At this point, with memory costs seemingly reaching their peak and beginning to reverse, this is probably an advantage zone in terms of expectations for the coming quarters.
Cisco sells an incredible number of SKUs. It is difficult to try to see gross margins and assess the problems of price pressures and the total cost of ownership for the company on a general basis. But I suspect that gross margins are under some pressure due to companies like Arista and perhaps Ubiquiti (UBNT), which can only compete in some specific areas, but which offer the apparent price / performance ratio in most cases for users. It would be difficult to suggest that the competition with Arista has not had or will not continue to have an impact on gross margins in the future. Over time, of course, as the software becomes a more important component of revenue for Cisco, it should begin to have a positive impact on gross margins, but that is several years in the future, I imagine.
As has been the case for years, Cisco has restricted operating expense growth to offset pressures on gross margins. In the last quarter, the company reduced its operating expenses by a notable 7% year-over-year, and this allowed the company to report GAAP operating margins within 50 basis points of previous year's levels despite the decrease in the gross margins. As the company had positive trends in other income and a lower tax rate, it was able to report a positive comparison for EPS GAAP.
The non-GAAP EPS, which was slightly above the previous consensus, was limited due to a lower level of restructuring charges and a slightly higher tax rate in non-GAAP adjustments.
The company was able to modestly increase its EPS forward estimate for the current quarter. As mentioned above, it seems reasonable that, given the overall positive trends in IT demand, along with decreases in the cost of memory, Cisco should be able to overcome the current consensus of $ .59 in terms of earnings per share. and that will help analysts to raise the current First Call consensus beyond the current estimate of $ 2.46.
Some thoughts on Cisco's competitive positioning
Cisco offers many products in many markets. It is simply not feasible to highlight them all in this type of article. Companies that lose market share, in technology or in almost any other field of activity, often do not work well as an investment. While market share data may be difficult to achieve in the network space, what is there that is credible, continues to suggest that Cisco has not been able to maintain its historical market share. The latest market statistics, which were previously linked, and cover the second calendar quarter of 2017, show that both the router and router markets have returned to healthy growth, increasing 8% and 7% respectively in terms of total revenues year after year.
Cisco continues to lose market share within its core network franchise, although its losses in shared points are slowing, at least in the change. In the last quarter, Cisco had a 54.7% share in the switchboard market, a reduction of 40 basis points sequentially and a decrease from the 56.8% of the previous year. Cisco's share in the router market fell to 41.2% of the market in the second quarter, down from 43.9% in the first quarter and below the 44.8% in the previous year. Much of Cisco's loss has come to Huawei, but Cisco lost market share to Hewlett Packard (HPE), Arista and even Juniper (JNPR). The success of Huawei comes mainly from geos like APJ and even MEA, regions that show a growth close to 17%, and where Cisco has a much less rooted position.
According to Gartner, in its most recent study linked here, regardless of anything else, Cisco charges a little more -80% on average-than the market average for the change based on a metric per port. How that price differential plays into the company's gross margins is a significant risk, although so far it has not greatly impacted the Cisco model. I imagine that, over time, Cisco will have to reduce part of the price premium that it has been able to charge, to further contain the falls in market share.
Cisco recently launched its Catalyst 9000 switch that has elements of intuitive intelligence and other specific features / benefits that set it apart from the competition. That said, however, the table linked here is notable for its exclusion of Arista as a competitor. The Catalyst 9000 is achieving strong traction according to management in its latest call and its availability may be a sufficient factor in some decisions to provide Cisco with slightly faster growth for several quarters.
I'm not going to try to evaluate the issue of software-defined architecture and how that will affect Cisco in the future. The fact is that Cisco came late to the party and is a somewhat reluctant guest, but is now trying to develop competitive offers that can protect the space from potential disrupters. So far, that has proven to be a daunting task. It is likely that SD-WAN disrupts traditional routing architectures and that is one of the main problems Cisco faces in the foreseeable future.
Cisco is considered a leader, along with Hewlett Packard Enterprise (HPE) for wireless and wired LANs. But the fact that the Gartner study linked here does not include Ubiquiti, which has a 7% market share from other sources, could question the credibility of this research. Gartner does take note of the strong competitive position of UBNT in this other linked survey.
Cisco is not seen as a leader in Gartner's latest revision of the network security solutions listed here. Gartner suggests that sales execution for Cisco is robust and that customers like integration with other elements of Cisco's security portfolio. Gartner is not a source of devices in terms of evaluation of technology providers, but it is undoubtedly the best known and most cited. In reviewing the revisions, my guess is that Cisco has the general capabilities that will allow it to continue to produce strong security results, both in the form of headlines and in particular as the company moves more customers to subscription-based offers that include the addition of software. ons. The change to subscriptions will eliminate one of the main Gartner precautions shown in your survey.
As I said at the beginning of this article, Cisco is not a perfect company, but it could be a decent investment. While there are some obvious problems that Cisco has yet to overcome in terms of its product / competitive positioning and how it is competing in the SDN space, and while, anecdotally, Cisco has a relatively inefficient process for the internal development of new products, in In general, the company has presented an alignment in networks that should allow the company to achieve results that capture at least a reasonable percentage of the potential growth in the creation of networks. For many years, Cisco has solved the problems of product inadequacy through acquisition, and I imagine that it will continue to be the strategy in the future.
Valuation and investment thesis
Before getting involved with details, there is no such stream as some kind of agreed consensus regarding Cisco's growth rate. The current First Call consensus has revenues that increase at a rate of 1% -2% over the next 18 months. That estimate is probably a bit low, simply because it does not include acquisitions, and Cisco will acquire Broadsoft, which will add 1% to growth reported from the quarter ending next April. I am also inclined to believe that the strongest global economic macros in the world are a tide that will elevate both Cisco and many other companies. Can Cisco reach a couple of quarters of 5% growth and what could that do for stocks? I think that kind of result is very possible and I am inclined to imagine that it will lead to a certain level of requalification of the shares with a corresponding increase in the target prices that I do not seem to be totally in tune with the average recommendation of First Call.
Currently, Cisco has a market capitalization of around $ 190 billion. With a net cash position of approximately $ 36 billion, the value of the company's company is $ 154 billion. I think future sales will be just over $ 49 billion, which leads to an EV / S calculation of approximately 3.1X. That's not a territory of fairly deep value unless Cisco can achieve that aforementioned top line growth of 5% for a couple of quarters.
Cisco's current EPS consensus estimate is approximately $ 2.50 over the next 12 months. So, that's a 15X P / E. Again, at this point, it is neither an outlier nor a notable one, although it seems likely that investors will seek to re-qualify the shares if the growth of the top line can reach mid-single digits.
As mentioned, Cisco reported an unusually strong cash flow last quarter, but the sources of the strength will not continue in the future. Last year, the company achieved an operating cash flow of $ 13.9 billion, compared to the previous year's period. The CFFO was approximately 114% of the earnings not reported under the GAAP. That ratio could possibly increase a bit if the deferred balances of the company's revenues continue to rise at the rates observed in the first quarter. I think CFFO is more likely to reach a little over $ 14 billion for this current fiscal year and that free cash flow is probably around $ 13 billion. That translates into a pretty high free cash flow yield of 8.3%, undoubtedly one of the most reasonable parameters in the IT world, and one that allows the company to pay dividends at an accelerated rate and aggressively repurchase shares. It is probably worth noting that stock-based compensation represents only 11% of that total, relatively low as those things go.
Cisco is currently paying a dividend of $ 1.16. The dividend represents a future return of 3.04% and it seems almost certain that it will increase in the new year. The company seems to have available financial resources to increase the payment of dividends and continue the rapid pace of repurchase of shares. The repurchase of shares of $ 1,600 million last quarter represented approximately 1% of outstanding shares, and that level, if it continues, will have a notable impact on outstanding shares over the course of a year.
Cisco, since an investment is not for everyone. It is not now, and it is not likely to return to rapid growth at any time in the foreseeable future. Networks are no longer a fast-growing space and are unlikely to change in the foreseeable future. As mentioned above, the market is growing around 7% -8% per year, and that is considerably faster than in the recent past. SD-WAN is achieving a much faster growth rate, but from a much smaller base and it is not enough, according to the forecast linked here, to provide more than a couple of hundred base points of growth for Cisco.
I think it will be difficult for Cisco to greatly improve its gross margins, until it solves the competitive problem it has with Arista and other disruptive competitors in different market segments. Management says its gross margins are in a range that depends more on memory prices than anything else, but it's a subject that I have not yet explored in depth. I think Cisco can improve margins a little, if growth starts to improve beyond the minimum levels by continuing to restrict the OPEX.
I would be surprised if Cisco shares could appreciate another 25% in the next calendar year. The rate of appreciation was a pleasant surprise for me this year. But for investors looking for dividends paying shares in the IT space, I think investing in this company is a good option. I hope that the dividend will continue to grow, I hope that stock repurchases will continue to reduce capitalization and I think there is a reasonable possibility that the company will achieve a growth in the upper single-digit line with modest margin gains. All that should be enough to provide the tailwind necessary to see a certain level of appreciation that is satisfactory for GARP investors.
Disclosure: I am / we are long CSCO.
I wrote this article myself and expressed my own opinions. I am not receiving compensation for it (which is not from Seeking Alpha). I have no business relationship with any company whose actions are mentioned in this article.
