Image Source: Ecole polytechnique
Networking giant is executing effectively in its ongoing shift to an emphasis on software subscription revenue, and deft execution appears to be helping insulate it from macroeconomic and geopolitical headwinds. Shares are trading in the lower half of our fair value range and offer solid income generation potential.
By Kris Rosemann
Simulated newsletter portfolio idea Cisco (CSCO) continues to execute on its transformation to a greater focus on software subscription revenue, and management noted another quarter of demand that was not impacted materially by ongoing macroeconomic and geopolitical uncertainty. The company conveyed a sense of confidence in its ability to continue delivering a growing stream of free cash flow via its announcement of a 6% increase in the quarterly dividend and the authorization of $15 billion in share buybacks. The strong fiscal 2019 second quarter report, released February 13, helped drive shares higher, but the stock continues to trade below our fair value estimate of $54 per share.
Cisco’s revenue in the quarter advanced 7% on a year-over-year basis, reflecting growth across all geographies and businesses. ‘Infrastructure’ revenue grew 6% from the year-ago period due to double-digit growth in switching and wireless more than offsetting weakness in data center servers and routing, the latter of which was impacted by softness from its service provider customers. ‘Applications’ and ‘Security’ revenue both advanced at solid double-digit rates as well, and the company is experiencing rising demand for its security solutions. Global Internet traffic is expected to three times current levels over the next five years, which should continue to drive demand higher for its next-generation high-speed networks and integrated security solutions.
The company faced ongoing gross margin headwinds in the form of DRAM and component costs in its fiscal second quarter, but management expects a shift in the back half of its fiscal year in terms of the DRAM headwind turning to a tailwind. The ongoing shift to software subscriptions is expected to continue providing a benefit to gross margin over time, and software subscriptions as a percentage of software revenue jumped to 65% in the period from 54% in the second quarter of fiscal 2018. Non-GAAP operating margin in the quarter was flat from the year-ago period, as a decline in operating expenses as a percentage of revenue was offset by lower gross margin performance, and non-GAAP earnings per share advanced 16% on a year-over-year basis to $0.73 thanks in part to a lower share count.
Cisco’s free cash flow generation remains strong, and it delivered a 5% year-over-year increase in the measure in the first half of fiscal 2019, which came in at $7.1 billion) despite a ~25% jump in capital spending. Cash dividends paid of ~$3 billion in the first six months of the fiscal year were less than half of free cash flow generated, but the company repurchased nearly $10.1 billion of its shares in the period. Robust levels of buybacks helped drive the company’s cash, cash equivalents, and investments down to $40.4 billion at the end of the fiscal second quarter from $46.6 billion at the beginning of the fiscal year, but it still holds a net cash position of nearly $14.8 billion at the end of the quarter, which is down from $21 billion at the beginning of the fiscal year. With the recent addition of $15 billion to share repurchase authorization, the company’s share repurchase program now has $24 billion authorized for future buybacks.
Management expects revenue growth to remain solid in its fiscal 2019 third quarter, with guidance coming in at 4%-6% year-over-year growth, and gross margin is expected to expand to the 64%-65% range compared to 63.9% in the comparable period of fiscal 2018. Non-GAAP operating margin guidance comes in at 31%-32% for the quarter, capturing the prior-year period’s mark of 31.5%, and non-GAAP earnings per share is expected to be in a range of $0.76-$0.78, up from $0.66 in the third quarter of fiscal 2018. Fiscal third quarter guidance has been adjusted to exclude the October 2018 divestiture of its SPVSS business.
Cisco’s portfolio is the strongest it has been in some time, and the attractiveness of its ongoing shift to a focus on software subscriptions is becoming increasingly evident. We love the confidence of management in its ability to continue delivering robust levels of free cash flow generation, as evidenced by its dividend raise and buyback authorization, but we’re watching its shrinking net cash position closely. The company’s Dividend Cushion ratio is a strong 3 at last check, and shares carry a dividend yield of nearly 2.9% as of this writing, which makes for a compelling combination of current yield and future dividend growth potential. We continue to highlight Cisco as an idea in both simulated newsletter portfolios.
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Kris Rosemann does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.