Published by Nicholas McCullum on May 19th, 2017
Cisco Systems (CSCO) recently reported financial results for the third quarter of fiscal 2017.
The company’s bottom-line performance was robust. GAAP earnings-per-share increased to $0.50, a ~9% increase from the $0.46 recorded in the same period a year ago.
Adjusted financial results were almost as positive, with this quarter’s adjusted earnings-per-share of $0.60 representing a 5% increase from the $0.57 figure in the same period a year ago.
Despite this solid performance, Cisco’s stock was hammered following the announcement. The stock declined by nearly 8% on the day following the earnings release.
Looking more closely, Cisco’s stock price decline was driven by poor revenue growth and lackluster revenue guidance.
However, it appears that the markets are unfairly punishing this technology stock. Cisco is a mature business and has endured since its founding in 1984; 8% daily moves for a company of this size are almost unheard of.
Further, Cisco is very profitable and quite shareholder friendly. The company initiated its dividend in 2011 – preventing it from becoming a Dividend Achiever or a Dividend Aristocrat any time soon – but it has grown its payout immensely in that time.
So, by many measures, Cisco is a high-quality business. And, as we know…
“The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.” – Warren Buffett
Fortunately for investors, Cisco is far from being ‘on the operating table’.
This article will outline the buying opportunity presented by Cisco’s recent stock price decline.
Business Overview & Current Events
Cisco is a diversified technology giant. The company was founded in 1984 and has grown to a market cap of $154 billion and quarterly revenues of $12 billion.
Cisco operates in 9 unique segments, which can be seen in the following diagram.
Source: Cisco Third Quarter Earnings Presentation, slide 6
Cisco is a highly globalized company. Approximately 40% of the company’s revenues are generated outside the United States.
This benefits Cisco because of the potential to penetrate new markets and increase its operational diversification.
However, when the U.S. dollar is strong against a basket of other global currencies (like it has been recently), Cisco’s international revenues become less valuable when swapped back to USD for reporting purposes. This can present a meaningful headwind to Cisco, depending on prevailing exchange rates.
The purpose of this article is to discuss the factors behind Cisco’s recent stock price decline.
As mentioned in the introduction, the main factor behind this price movement after Cisco’s earnings release was the announcements surrounding revenue.
Cisco’s revenues declined 1% from the same period a year ago. However, a 1% decline in quarterly revenue is relatively inconsequential considering that the company’s GAAP and adjusted earnings-per-share increased by 9% and 5%, respectively.
What really hurt Cisco’s stock price is its revenue guidance for the next quarter.
Cisco’s management team is expecting next quarter’s revenues to decline by 4%-6% from the same period a year ago.
This is very unusual for Cisco – the company has seen healthy revenue growth during most of its history as a publicly-traded company.
Cisco’s long-term annual revenue trend can be seen below.
So what are investors to make of Cisco’s reduced quarterly revenue guidance?
Well, it is very important to avoid looking at this revenue guidance in isolation. While revenue is important, there are other financial metrics (net income and free cash flow, for example) that provide other important information about a company’s financial health.
For example, the past decade has seen Cisco meaningfully increase its profitability (as measured by adjusted earnings-per-share).
The past quarter was no different. As mentioned, Cisco saw GAAP and adjusted earnings-per-share increase meaningfully from the same period a year ago.
Other profitability metrics experienced the same upwards trend. Operating cash flow grew 10% to $3.4 billion, and adjusted operating margin increased by 2.3% to 32.3%.
Looking ahead, next quarter’s poor revenue expectations are not expected to affect the company’s bottom line.
Cisco’s management is forecasting adjusted earnings-per-share of $0.60-$0.62 in the fourth quarter. For context, this quarter’s number was $0.60.
Altogether, the Cisco business appears to be performing well. The headline decrease in company-wide revenues is being offset by increasing margins and share repurchases – thus, earnings-per-share are continuing to grow.
Cisco system’s future financial performance will be driven by a healthy combination of organic growth and inorganic acquisitions.
Organically, Cisco continues to generate cost savings, which improves its earnings-per-share even though company-wide revenues are in a slight decline.
Despite company-wide revenue pressures, there are particular areas of Cisco’s business that show a great deal of promise.
One example is Cisco’s budding cyber security business.
As we have seen recently with the WannaCry ransomware cyber attacks, the cyber-security industry is a very important part of today’s economy. This industry will only grow moving forwards.
Cisco is a beneficary of this trend. The company’s cybersecurity segment grew rapidly in the most recent quarter, adding 6,000 customers and bringing their total customer base to 73,000. Cisco continues to invest heavily in cyber security, and this segment will certainly be a tailwind to the company’s future returns.
From the acquisition side, Cisco has shown the ability to be a very bold player in the M&A markets.
The most recent quarter saw Cisco close on the acquisition of AppDynamics. This transaction was valued at approximately $3.7 billion and will bolster Cisco’s presence in the ever-important Internet of Things industry.
Cisco also recently announced the acquisition of MindMeld, an artificial intelligence startup based in San Fransisco. MindMeld’s specialty is the creation of intelligent and human-like conversational interfaces for a wide range of applications.
Cisco’s management believes that MindMeld’s technology can be integrated in a number of ways across the broader Cisco business. CEO Charles Robbins touted the benefits of this transaction on Cisco’s third quarter earnings call, saying:
“Our intended acquisition of MindMeld will help us simplify and enhance the collaboration experience even further through the power of artificial intelligence and machine learning. As chat and voice quickly become the interfaces of choice, MindMeld’s AI technology will enable Cisco to deliver unique experiences throughout its portfolio. This acquisition will power new conversational interfaces for Cisco’s collaboration products, revolutionizing how users will interact with our technology while increasing ease-of-use and enabling new capabilities. For example, users will be able to interact with Cisco Spark via Natural Language Commands, providing an experience that is highly customized to the user and their work.”
The company looks to continue acquiring smaller, up-and-coming technology service companies. In addition to his previously-quoted comments on Cisco’s conference call, Mr. Robbins stated:
“We were also pleased to announce our intent to acquire some new additions to our software and analytics portfolio. Software-defined WAN is a critical market transition and addresses the evolving customer demands and branch routing as a foundational block of executing in cloud networking.”
Growth in Cisco’s existing businesses, as well as the addition of complimentary acquisitions, will drive the company’s growth for the foreseeable future.
The company also has a potential catalyst at the government level. Cisco would seriously benefit from repatriation tax reform as proposed by the new presidential administration.
Right now, multinational corporations like Cisco that generate overseas income must pay the U.S. corporate tax rate of 35% to transfer – or ‘repatriate’ – this capital to domestic accounts. Companies receive a tax credit for any corporate income tax that was already paid to international tax authorities.
The reason why Cisco would benefit from such a policy change is its substantial hoard of overseas cash.
At the end of the third quarter, Cisco reported cash, cash equivalents and investments of $68.0 billion. Amazingly, only $2.9 billion of this capital is held in domestic accounts.
Some quick math tells us that Cisco currently holds $65.1 billion of capital in overseas accounts. To repatriate this capital, the company would have to pay at most $22.8 billion of tax (35% of $65.1 billion).
Under the 10% tax repatriation holiday proposed in President Trump’s economic plan, this $22.8 billion tax liability would be reduced to $6.5 billion (10% 0f $65.1 billion), resulting in savings of $16.3 billion for Cisco.
More importantly, it would trigger Cisco to actually repatriate its overseas cash. The company could spend this new capital on shareholder-friendly activities such as additional share repurchases, a special one-time dividend, or an increase to the existing quarterly dividend payment.
Alternatively, Cisco could use its overseas capital to fund acquisitions or increase internal investment.
Whatever the proceeds are used for, Cisco will benefit immensely from repatriation tax reform and investors should watch closely for any sign of progress on this front from the current administration.
Competitive Advantage & Recession Performance
Cisco has a very strong scale-based competitive advantage over its smaller competitors.
As a very large globalized technology provider, Cisco’s fixed cost are spread over a wider revenue base, which improves the company’s profitability metrics.
This can be seen by looking at Cisco’s financial statements: the company reported GAAP and non-GAAP gross margin of 63.0% and 64.4% in the most recent quarter. Further, Cisco reported GAAP and non-GAAP operating margin of 26.5% and 32.3% in the same period.
Cisco is quite recession-resistant. During the global financial crisis of 2007-2009, the company only saw one year of decreased earnings. The company set a new record for per-share profits in the next fiscal year.
Cisco’s earnings-per-share history during the last recession can be seen below.
- 2006 adjusted earnings-per-share: $0.89
- 2007 adjusted earnings-per-share: $1.17 (31.4% increase)
- 2008 adjusted earnings-per-share: $1.31 (12.0% increase)
- 2009 adjusted earnings-per-share: $1.05 (19.8% decrease)
- 2010 adjusted earnings-per-share: $1.33 (26.7% increase)
Since Cisco’s ~20% decline in adjusted earnings-per-share in 2009, the company has seen that metric increase every year without exception. Thus, I would expect Cisco to perform reasonably well during the next recession.
Valuation & Expected Total Returns
Future total returns for Cisco’s shareholders will be composed of valuation changes, dividend payments, and growth in the company’s earnings-per-share.
One of the most appealing characteristics of Cisco’s stock right now is the company’s valuation.
Cisco’s management is guiding for adjusted earnings-per-share of $0.60-$0.62 in the fourth quarter of this year (the only quarter they have yet to report).
Taking the midpoint of this range – $0.61 – and combining it with Cisco’s year-to-date adjusted earnings-per-share of $1.78 gives a full-year expectation of $2.39 in adjusted earnings-per-share.
As I write this, Cisco’s stock is trading at $31.25, which is a remarkably low valuation of 13.1x 2017’s expected earnings (using the adjusted earnings-per-share estimations outlined in the previous paragraph).
The following chart compares this valuation to Cisco’s long-term historical average.
Source: Value Line
Although Cisco’s current valuation is a bit higher than recent years, it is still well below the stock’s long-term average. It is also below the valuation of other similar technology stocks.
With that in mind, I believe that the stock’s recent decline provides investors with a solid opportunity to initiate or add to a position in Cisco.
Cisco’s post-earnings decline has also pushed up the company’s dividend yield. Cisco currently pays a quarterly dividend of $0.29 per share, which yields 3.7% on the company’s current stock price of $31.25.
Cisco’s current dividend yield is nearly twice that of the average yield in the S&P 500 index and will be an important part of shareholder returns moving forward.
The remainder of Cisco’s future shareholder returns will be driven by the company’s earnings growth. Cisco has compounded earnings at a rate of 10.2% per year over the past decade.
However, Cisco is a much larger business than it was 10 years ago. Accordingly, its growth will likely slow. I believe a reasonable expectation is 6%-8% earnings growth per year (on average) over full economic cycles.
Moving forward, the company’s shareholders will continue to be rewarded by Cisco’s shareholder-friendly capital allocation policies. Cisco returned approximately $2 billion of capital to its shareholders in the most recent quarter, divided into $0.5 billion of share repurchases and $1.5 billion of dividend payments.
More details about Cisco’s shareholder-friendly capital allocation can be seen below.
Source: Cisco Third Quarter Earnings Presentation, slide 11
Without a doubt, a continued reduction in Cisco’s share count will be a tailwind for the company’s earnings-per-share.
To conclude, Cisco’s total returns will be composed of:
- 3.7% dividend yield
- 6%-8% earnings-per-share growth (boosted by share repurchases)
For expected total returns of 9.7%-11.7% before the impact of any valuation changes.
Cisco looks to be a solid investment right now. I’m not the only one who thinks so – Cisco is the third largest holding in Joel Greenblatt’s investment portfolio.
Cisco’s attractiveness as an investment comes from its high dividend yield, strong competitive advantages, and low valuation (particularly considering it is a technology stock). The company has a serious potential catalyst in the form of repatriation tax reform, and will continue to benefit from the growing importance of cybersecurity technology.
For these reasons, Cisco’s post-earnings stock price decline represents a buying opportunity, not a reason to be fearful of this security.
For investors looking to learn more about the investment prospects of Cisco, the following Sure Dividend articles may be of interest: