Not Worried About Cisco

Image Source: Fiscal fourth-quarter 2019 press release

We think the market is overreacting when it comes to Cisco’s outlook. Our fair value estimate remains in the mid-$50s, and Cisco’s Dividend Cushion ratio is still very healthy at ~2.8x.

By Brian Nelson, CFA

On August 14, Cisco (CSCO) reported solid fiscal fourth-quarter results (ends July 2019) that showed revenue growth of 6% on a year-over-year basis, while non-GAAP earnings per share leapt 19%. The performance was roughly in-line with the growth rates for full-year fiscal 2019, which came in at 7% and 20%, respectively. The pace of expansion was solid, its transition to a business model with software subscriptions continues nicely (now at 70% of its software revenue, up 12 points on a year-over-year basis), and CEO Chuck Robbins was upbeat on the quarterly performance:

Our Q4 results marked a strong end to a great year. We are executing well in a dynamic environment, delivering tremendous innovation across our portfolio and extending our market leadership. We are committed to providing our customers ongoing value through differentiated solutions, and we are well positioned to take advantage of the long-term growth opportunities ahead.

For the first quarter of fiscal 2020, Cisco is guiding for 0%-2% top-line growth on a year-over-year basis ($13.1-$13.36 billion), a non-GAAP gross margin in the range of 64%-65%, a non-GAAP operating margin in the range of 32%-33%, and non-GAAP earnings per share in the range of $0.80-$0.82. The guidance came in below consensus numbers, which were at $13.41 billion on the top line and $0.83 per share. Shares sold off on Cisco’s outlook for the fiscal first quarter 2020, but we think the executive team is just being conservative entering a new fiscal year and given US-China trade concerns. We’re not reading much into it. CEO Chuck Robbins on the conference call:

Let me just comment on the China situation. I mean you’re right, it’s down below 3% (of revenue), it’s a small part of our business, but obviously when it falls very dramatically, it can still have some impact because it is greater than zero. But, long term, it’s not a concern that I worry about much at this point. And so, that’s really the extent of what we saw there. I mean the China reduction contributed to a point of the issue in all of enterprise for us. So, it was that significant, and we definitely saw significant impact on our business in China as it relates to what’s going on with the trade war right now.

We think the market is being a little short-sighted, too, downplaying the positive commentary with respect to pricing on the conference call. Gross-margin performance is a closely watched metric, and Cisco might experience upside on the bottom line in the current quarter given healthy trends in pricing. CFO Kelly Kramer had this to say on the conference call:

…on your margin question. So, yes, pricing, the environment stays good, actually we had a very good quarter on pricing. It was less than a point that you’ll see when we give you the Q. So, that’s been very good. And again, you can see, we are benefiting in our gross margins and OMs from the tailwind from DRAM as we expected and you’re seeing that in not only the results but also as we’ve been guiding on the margin…So, on the margin, yes, I mean I’d say the margins are going great. We feel good about it. I kept the range in that 64% to 65% to take into account the cutting end of list four of the tariffs.

For the completed fiscal 2019, Cisco hauled in $15.8 billion in cash flow from operations, an increase of 16% on a year-over-year basis from the $13.7 billion mark in fiscal 2018. Free cash flow was $14.9 billion in fiscal 2019, better than the $12.8 billion mark in fiscal 2018. Cisco ended the fiscal year with $33.4 billion in cash, cash equivalents and investments, and it holds short- and long-term debt of $24.7 billion. The company remains a very healthy free-cash-flow generator with a strong net cash position on the books. Cash dividends paid during fiscal 2019 were $6 billion, so Cisco’s dividend is also very, very healthy.

Concluding Thoughts

We think the market is overreacting when it comes to Cisco’s outlook. We still like shares a lot, and we have no qualms with its capital allocation strategy of returning a minimum of 50% of free cash flow annually through share repurchases and dividends. The company’s valuation is supported by strong expected free cash flows and a solid net cash position. Though some caution is warranted given the ongoing trade war between the US and China, we were very encouraged by commentary regarding its gross margin and pricing. Our fair value estimate remains in the mid-$50s, and Cisco’s Dividend Cushion is still very healthy at ~2.8x.