Cisco: Lots Of Moving Parts Make For A Nuanced Call

Summary Cisco reported the results of its 1st quarter of fiscal 2018 about a month ago. Both the results and the guidance were considered to be a significant positive inflection for the shares of this long be-calmed equity. Overall, the networking space is in a cyclical rebound and Cisco has just enough products that are seeing improved demand, for the company to return to modest growth. The company should be able to continue to beat estimates in the short-term based on lower memory prices, now being experienced. While I see no end in sight for market share losses in core switching and routing, where Arista and other competitors continue to gain share, the company's solutions in both software and security, while relatively small at this point, are mitigating some of the impact of market share declines. Are there enough positive elements to warrant a positive evaluation? Earlier this week, a contributor on this site reminisced about the tech bubble of 1999-2000. For better or worse, I was there in the thick of trying to make sense out of the insanity. I personally think there are more differences than similarities to those years in the market today. (Bitcoin is indeed likely a bubble but bitcoin is but a single asset class that is simply not a pervasive element in financial markets. There is no sign that tech purchases are being lead by sales to start-up ventures who have no real means to pay for what they are buying or who do not have real customers to use the products/services being sold. And in tech, at least, the move to multi-year consumption arrangements, has made the entire space far more stable than was the case a couple of decades past.) But reminiscing about that interlude brought Cisco (CSCO) to mind as one of the chief beneficiaries and chief sufferers from the bubble. I do not imagine anyone would argue that Cisco is on a bubble these days. Its share value, even after appreciating by 25% this year to $38/share, is still just half of the peak it reached in March 2000 before it all came apart like a rope of sand. Yes, Cisco sold plenty of product back then to companies who would never pay for it and who themselves did not have customers who needed what they were buying, I think the relatively strong share price performance in the wake of the quarterly release of the company’s financial performance suggests that there is a hunger on the part of many investors for classic GARP investments. Cisco is now perceived as fitting that bill and some re-rating has gone on. Net sales for Cisco, all those years ago were about $19 billion. The company achieved pro-forma earnings at that time of $.53. The company’s earnings would fall to $.39/share just a couple of years later These days Cisco is forecast to achieve $48 billion of revenues and EPS of $2.50. Do those statistics matter to anyone but a business historian? They might, if you think the current market is on a bubble. Whatever else the case may be, Cisco, which back at that time was on the cusp of what turned out to be a near death experience in terms of its operational performance, has become a quintessential dividend/value name. The question is, in the context of its recent strong share price performance, whether there are enough positives in the company’s business outlook to warrant a positive view on the shares. Although I own the shares for clients in what I call income/stability accounts, the outlook for this company is not particularly transparent, at least to me. Cisco is losing market share in what used to be its core businesses of selling switches and routers as I have detailed in past reports, primarily to Arista (ANET) at close to an alarming rate-and so far as I can determine, lawsuits or not, that isn’t going to change in the near future. Arista simply is offering users better technology at a lower total cost of ownership and how that ends is not immediately apparent. Advertisement  On the other hand, Cisco has achieved a certain level of success in its efforts to diversify its portfolio outside of the networking space. Cisco became a leading vendor in the security space, primarily through acquisition and it has held on to the role. The company’s initiatives in application networking services are enjoying noticeable success. At least the words in the commercial are right in terms of the company focusing on simplicity, automation and security The company, like so many others in the IT world, is in the midst of moving its revenue sources to what it describes as recurring offers which have now reached 32% of the total, up about 300 basis points year on year. The company has been reasonably successful in integrating machine learning driven analytics into its platforms. The AppDynamics merger, completed earlier this year is an important element of the Cisco strategy and the company bought a company called Perspica as well, to bolster that business segment. More recently, Cisco announced its acquisition of BroadSoft (NASDAQ:BSFT), which will further enhance the company’s platform of cloud applications. Cisco is building capabilities in its new focus areas using a similar strategy to the way it built its networking portfolio-acquisition of leading vendors followed by integration and some redirection of resources. As has been mentioned by many since the time that tax reform has been a significant probability, Cisco will be a major beneficiary. I am not absolutely certain as to the final shape of the reform and the tax rate for profit repatriation, but regardless of the specifics, the new law will have positive impacts for all large multi-nationals of which Cisco is a prime example. The company has indicated that it is going to be increasing its dividend 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 cadence of share buy-backs. At this point, the company has something in excess of $65 billion in gross cash located overseas. At this point, looking at Cisco is somewhat akin to looking at a caterpillar that is morphing into a butterfly. It still derives most of its revenue from selling products, but the end of that paradigm is coming into view. It isn’t quite clear at what point Cisco will become a company whose revenue streams are mainly derived from software and services and will be based on recurring revenue consumption arrangements. But it does seem as though that is happening, and as it does, Cisco should be able to achieve better headline numbers than have been feared by many observers. 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 reporting with the changing contours of its solution offerings has now recast its reporting categories to include Infrastructure Platforms, Applications, Security and other Products and Services. There are few ideal investments to be found in the world. I do not suggest to readers that Cisco is one of those. But I do think the company is embarked on a reasonable transition that is starting to produce visible results-at least on a sub-headline basis. Given its current valuation, both absolute and relative I think the shares are worth owning for investors more focused on income and stability than actual growth. A review of the last quarter It has been a month now, since Cisco discussed the results of its initial fiscal quarter. Presumably, by this time, the company’s share price, reflects investor analysis and preceptions of the results as well as investor discounting of the nearly passed tax reform legislartion. Cisco shares have appreciated by 12% in the wake of the earnings report, compared to a 2.5% decline for the IGV, one of the stronger relative performances Cisco shares have seen in many years. I think, given the strong performance, that it is important for investors to take the time to look at the specifics of an earnings release that hides some of the attainments in sub-headline corners. The headline numbers say that Cisco’s revenues declined-again-this time by a couple of percent. Some observers like to compare Cisco’s numbers to those of IBM (IBM) which has also gone through a multi-year period of revenue contraction. I fundamentally disagree with most of the points of the analysis in the linked report-not the math, to be sure, but the lack of understanding or commentary regarding product strategy and management philosophy between the two vendors. There are similarities and there are also differences. I will not highlight the differences here, but simply observe that Cisco is essentially moving much of the revenue from what it calls infrastructure platforms to categories it calls Applications and Security. Those categories tend to derive the bulk of their revenues from ratable sources. Infrastructure platforms still derive most of their revenue from selling discrete boxes. It would be reasonable to imagine that the transition from Infrastructure platforms (still 57% of revenues) will hobble reported growth into the future. Cisco has forecast minimal revenue growth for the second quarter. Management has suggested that currently the switch to subscription revenue sources is a 2% headwind in terms of reported revenue growth numbers. Over time, as Cisco develops increasing revenue grom what it calls its intuitive network, that percentage will grow, although presumably percentage organic revenue growth will also be growing. Currently all of Cisco’s switches are available on subscription terms and many of its products can come with attached software as well. This is not different from many other hardware vendors who are responding to user preferences-and really responding to the low cost of capital as well. Cisco now describes the add-on software as the difference between its Essential offering and its Advantage offering. Some of the deferred revenue metrics suggests that bookings are increasing at significant rates The growth of 42% in security deferred revenues is impressive,and the deferred product revenue growth for subscription and ratable software which reached 37% to $5.2 billion last quarter, suggests that bookings growth is reaching levels that suggest the company is achieving a fair level of sales success that is not apparent in the reported revenue numbers. The company was able to achieve an increase in deferred revenues sequentially, a significant achievement given normal seasonal patterns. While not always released, Cisco apparently had a strong increase in unbilled deferred revenue, at least its applications space. It would be helpful for Cisco to release enough information so that stakeholders could calculate proxy bookings, including unbilled deferred revenue, but that has yet to happen. The company indicated that its product orders rose by 1% last quarter but without context that is a difficult number to consider in isolation. The company doesn’t present the data to calculate bookings, nor is it yet in a position where the ARR calculation would be terribly useful. I assume that the overall value of order entry including software and services rose by a rate greater than 1%, but that is not a metric that has been specifically discussed. The company achieved better than anticipated growth in both cash flow from operations (CFFO) and free cash flow. The improvement in the company’s CFFO and free cash flow was primarily a results of balance sheet items including financing receivables and other liabilities. Obviously, balance sheet items are not a long-term source of CFFO but I expect that the stronger growth of bookings and the concomitant growth in the balance of deferred revenues, will enhance the CFFO metric in future quarters. Cisco beat estimates for EPS last quarter, primarily because gross margins were a bit better than expected. Overall, on a GAAP basis, gross margins fell from 63.9% to 61.2%. Of that amount, about half came memory costs which were still rising in the quarter that ended in October. The company guidance called for gross margins to decline by another 0.5%, entirely driven by memory costs. At this point, with memory costs apparently having peaked and beginning to reverse, this is likely an area of upside in terms of expectations for the coming quarters. Cisco sells an amazing number of SKU’s. It is difficult to try to look at gross margins and evaluate the issues of pricing pressures and total cost of ownership for the company on some kind of overall basis. But I suspect that gross margins are under some pressure because of companies such as Arista and perhaps Ubiquiti (UBNT), who may only compete in some specific areas, but who offer what appear to be more attractive price/performance in most cases for users. It would be difficult to suggest that competition with Arista hasn’t or will not continue to have some impact on gross margins going forward. Over time, of course, as software becomes a more significant component of revenues for Cisco, it should start to positively impact gross margins-but that is several years in the future, I imagine. As has been the case for years, Cisco has constrained the growth of operating expense to make up for pressures on gross margins. This past quarter, the company reduced its operating expenses by a rather noticeable 7% year on year, and this allowed the company to report GAAP operating margins within 50 basis points of year earlier levels despite the decline in gross margins. As the company had positive trends in terms of other income and a lower tax rate, it was able to report a positive comparison for GAAP EPS. Non-GAAP EPS, which was marginally ahead of the prior consensus, was constrained because of a lower level of restructuring charges and a slightly higher tax rate on non-GAAP adjustments. The company was able to modestly increase its forward EPS estimate for the current quarter. As mentioned earlier, it seems reasonable that given overall positive demand trends for IT, coupled with declines in the cost of memory, that Cisco should be able to beat the current consensus estimate 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 about Cisco’s competitive positioning Cisco offers lots of products in lots of markets. It is simply not feasible to highlight all of them in this kind of article. Companies that lose market share, in tech or in almost any other field of endeavor, often do not work out well as an investment. While market share data can be elusive in the networking space, what there is of it that is credible, continue to suggest that Cisco has not been able to sustain its historical market share. The latest market statistics, which were linked above, and cover the 2nd calendar quarter of 2017, show that both the switch and the router market have returned to healthy growth, rising 8% and 7% respectively in terms of total revenues year on year. Cisco is still losing market share within its core networking franchise, although its losses in share points are decelerating, at least in switching. Last quarter, Cisco had a 54.7% share of the switch market, down 40 basis points sequentially and down from 56.8% the prior year. Cisco’s share of the router market dropped to 41.2% of the market in Q2, down from 43.9% market share in Q1 and down from 44.8% share in the prior year. Much of @Cisco ’s loss has come at the hands of @Huawei, but Cisco lost market share @Hewlett Packard ( #HPE), @Arista and even @Juniper ( #JNPR ). Huawei’s success is mainly coming in geos such as APJ and even MEA, regions that are showing growth of close to 17%, and where Cisco has a far less entrenched position. According to Gartner, in its most recent study linked here, regardless of anything else, Cisco charges quite a bit more-80% on average-than the market average for switching based on a per port metric. How that price differential plays into the company’s gross margins is a significant risk, although so far not one that has hugely impacted Cisco's model. I imagine that over time, Cisco will have to abate some of the price premium it has been able to charge, to staunch further market share declines. Cisco recently released its Catalyst 9000 switch which has elements of intuitive intelligence and other specific features/benefits that distinguish it from the competiton. 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 on its latest call and its availability may be enough of a factor in some decision making to provide Cisco with slightly faster growth for several quarters. I am not going to attempt to evaluate the issue of software defined architecture and how that will impact Cisco going forward. The fact is that Cisco was late to the party and a somewhat reluctant guest, but is now attempting to develop competitive offerings that can protect the space from the host of potential disruptors. So far that has proven to be a daunting task. SD-WAN is likely to disrupt traditional routing architectures and that is one of the major issues that Cisco faces in the foreseeable future. Cisco is considered to be 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 is credited with a market share of 7% from several other sources might put the credibility of this research at question. Gartner does take note of UBNT's strong competitive position in this other linked survey. Cisco is not quite viewed as a leader in the latest Gartner review of network security solutions linked here. Gartner suggests that sales execution for Cisco is strong and customers like the integration with other elements of the Cisco security portfolio. Gartner is not a dispositive source in terms of evaluating technology vendors, but it is certainly the best known and most quoted. In reviewing the reviews, my guess is that Cisco has the overall capabilities that will allow it to continue to produce strong results in security, both on a headline basis but particularly as the company moves more of its customers to subscription based offerings including software add-ons. The move to subscriptions will remove one of the principle Gartner cautions shown in its survey. As I said at the outset of this article, Cisco is not a perfect company but it might still be a decent investment. While there are some glaring issues 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, overall the company has fielded a lineup in networking that should allow the company to achieve results that capture at least a reasonable percentage of the potential growth in networking. For many years, Cisco has cured issues of product inadequacy through acquisition, and I imagine that will continue to be the strategy going forward. Valuation and investment thesis Before getting involved with specifics, there is no current such thing as some kind of agreed consensus regarding Cisco’s growth rate. The current First Call consensus has revenues rising at a 1%-2% rate over the next 18 months. That estimate is probably a bit low simply in that it does not include acquisitions, and Cisco will be acquiring Broadsoft, which will add 1% to reported growth starting in the quarter that ends next April. I am also inclined to believe that stronger global economic macros across the world are a tide that will lift Cisco as well as many other companies. Can Cisco achieve a couple of quarters of 5% growth-and what might that do for the shares. I think it is quite possible for that kind of an outcome and I am inclined to imagine that it will lead to some level of re-rating of the shares with a corresponding increase in price targets that seem to me not totally in-synch with the average First Call recommendation. Currently, Cisco has a market capitalization of around $190 billion. With a net cash position of about $36 billion, the company’s enterprise value is $154 billion. I think forward sales will be a bit above $49 billion which leads to an EV/S calculation of about 3.1X. That isn’t quite deep value territory unless Cisco can achieve that aforesaid top line growth of 5% for a couple of quarters. Cisco’s current consensus EPS estimate is about $2.50 over the next 12 months. So, that is a P/E of 15X. Again, at this point, that is neither an outlier or a remarkable value although it seems likely that investors would look to re-rate the shares if top line growth can reach mid single digits. As mentioned, Cisco reported unusually strong cash flow last quarter, but the sources of the strength are not likely to continue going forward. Last year, the company achieved cash flow from operations of $13.9 billion, up from the prior year period. The CFFO was about 114% of non-GAAP reported earnings. That relationship could possibly rise a bit if the company’s deferred revenue balances continue to increase at rates seen in Q1. I think CFFO is most likely to reach to a bit greater than $14 billion for this current fiscal year and free cash flow is likely to be around $13 billion. That translates to a rather high free cash flow yield of 8.3%, certainly one of the more reasonable of such metrics in the IT world, and one that allows the companyh to pay dividends at an accelerating pace and to buy back shares aggressively. It is probably worth noting that stock based comp 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 forward yield of 3.04% and seems almost certain to be raised in the new year. The company would appear to have financial resources available to raise the dividend payout and to continue the brisk pace of share repurchase. Share repurchase of $1.6 billion last quarter represented about 1% of the outstanding shares, and that level, if continued will have a noticeable impact on outstanding shares over the course of a year. Cisco, as an investment is not for everyone. It is not now, and is not likely to return to rapid growth any time in the foreseeable future. Networking is no longer a rapidly growing space and that is not likely to change in the foreseeable future. As mentioned earlier, the market is growing around 7%-8% a year, and that is quite a bit faster than in the recent past. SD-WAN is achieving a much faster growth rate, but from a much smaller base and is not enough, based on the forecast linked here, to provide more than a couple of hundred basis points of growth for Cisco. I think that it is going to be difficult for Cisco to improve its gross margins much, until it solves the competitive problem it has with Arista and other disruptive competitors in different market segments. Management says that its gross margins are in a range that is more dependent on memory pricing than anything else, but it is a subject I have yet to see explored in depth. I think that Cisco can improve margins a bit, if growth starts to improve beyond minimal levels by continuing to constrain 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 to me this year. But for investors looking for dividend paying shares in the IT space, I think investing in this company is a good choice. I expect the dividend to continue to grow, I expect share buybacks to continue to shrink the capitalization and I think there is a reasonable chance for the company to achieve mid-single digit top line growth with modest margin gains. All that ought to be enough to provide the tailwind necessary to see some level of appreciation that is satisfactory to GARP investors.

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