Image Source: Cisco Systems Inc – Second Quarter Fiscal 2020 IR Earnings Presentation
By Callum Turcan
On February 12, Cisco Systems Inc (CSCO) reported second-quarter earnings for fiscal 2020 (period ended January 25, 2020) that beat consensus estimates on both the top- and bottom-line. However, shares of CSCO still fell initially on the news, possibly due to the company’s forward guidance for the third quarter falling short of expectations. Cisco is currently undergoing a major transition from a company that primarily sells hardware to one that also offers material subscription-based services and software, in order to offset the structural declines facing the enterprise data application management space (which can be summed up as many/most enterprises around the world switching their IT infrastructure needs off-site to more flexible, powerful, and often relatively cheaper cloud computing offerings when considering the dynamic effects of the change).
Shares of CSCO are included in both our Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio as we appreciate the strength of its free cash flows, its pristine balance sheet (nice net cash balance), and see the firm’s strategic shift as one with promise (albeit, this is still a work in process). Here’s a summary of that change (from Cisco’s fiscal 2019 Annual Report):
We are transforming our offerings to meet the evolving needs of our customers. As part of the transformation of our business, we continued to make strides during fiscal 2019 to develop and sell more software and subscription-based offerings. Historically, our various networking technology products have aligned with their respective product categories. However, increasingly, our offerings are crossing multiple product categories.
As our core networking evolves, we expect we will add more common software features across our core networking platforms. We are increasing the amount of software offerings that we provide and the proportion of subscription software offerings. We have various types of software arrangements including system software, on premise software, hybrid software and SaaS [software-as-a-service] offerings. In terms of monetization, our software offerings fall into the broad categories of subscription arrangements, including SaaS and term licenses, and perpetual licenses.
To reward shareholders, Cisco pushed through a sequential 3% increase in its per share payout the same day it published its most recent earnings report, bringing its quarterly dividend up to $0.36 per share (or $1.44 per share on an annualized basis). As of the end of normal trading hours on February 12, shares of CSCO yield ~2.9% on a forward-looking basis. Our fair value estimate continues to sit at $54 per share of CSCO, and we give the firm a 2.7x Dividend Cushion ratio which indicates quality dividend coverage on a forward-looking basis (if that ratio climbs just a tad higher, Cisco would earn an EXCELLENT Dividend Safety ratio). Now let’s go over its latest earnings report.
Income Statement Overview
Cisco reported $12.0 billion in GAAP revenues during the second quarter of its fiscal 2020, down ~4% year-over-year, with its ‘Product’ sales falling by ~6% and its ‘Service’ sales rising by 5% during this period. However, Cisco’s GAAP gross profit stayed broadly flat year-over-year at $7.8 billion due primarily to cost of its Product sales dropping by ~14% (allowing for meaningful segment gross margin expansion even as sales dropped, with management noting that Cisco’s non-GAAP Product segment gross margins were up ~310 basis points year-over-year), assisted by rising gross profit at its Service segment (gross margins at this segment were largely flat year-over-year).
Within its Product segment, Cisco’s ‘Security’ unit performed well by generating meaningful sales growth, offsetting some of the weakness of its ‘Infrastructure Platforms’ and ‘Applications’ units within this segment. Rising Service segment revenue indicates Cisco’s turnaround continues to take shape. Here’s what management had to say during Cisco’s latest quarterly conference call:
“Service revenue was up 5% driven by software and solution support. We continue to transform our business delivering more software offerings and driving more subscriptions. Software subscriptions were 72% of total software revenue, up 7 points year-over-year.”
Furthermore:
“Now to Security. We had another solid quarter with strength across our advanced threat and cloud-based solutions including Duo and Umbrella, which are important growth drivers of our business. We continue to see significant opportunity as we execute on our strategy to deliver an integrated security platform. As the market moves to a multi-cloud environment and the need for visibility grows, we’re benefiting from our strong position as our customers’ most trusted partner.
Our differentiated end-to-end approach across the network, cloud and endpoint is winning customers with 100% of the Fortune 100 now using one or more of Cisco security solutions. This quarter, we expanded our security portfolio from the cloud to the edge. We brought to market an integrated IoT architecture, providing enhanced visibility, insights and threat detection across our customers’ entire environment. This architecture includes our new software-based security solutions Cyber Vision; and our Edge Intelligence data collection tool to enable our customers to make better business decisions.”
As Cisco continues to focus on controlling both its cost of sales and operating expenses, the company’s GAAP operating margin rose by approximately 235 basis points year-over-year in the second quarter of fiscal 2020. By cutting G&A expenses, along with keeping ‘sales and marketing’ and R&D expenses broadly flat, Cisco was able to grow its GAAP operating income by 5% year-over-year last quarter.
Cisco’s weighted average diluted outstanding share count dropped from 4,505 million during the second quarter of fiscal 2019 to 4,260 million during the second quarter of fiscal 2020, a product of substantial share buybacks. Marginally higher GAAP net income combined with a reduced share count saw Cisco’s GAAP diluted EPS grow by 8% year-over-year to $0.68 in the second quarter of fiscal 2020. Management noted on an adjusted non-GAAP basis, Cisco’s diluted EPS rose by 5% year-over-year.
Guidance Commentary
Here’s what Cisco’s management team had to say about the firm’s guidance for the third quarter of fiscal 2020 (emphasis added):
“Let me reiterate our guidance for the third quarter of fiscal 2020… We expect revenue to decline in the range of minus 1.5% to minus 3.5% year-over-year. We anticipate the non-GAAP gross margin rate to be in the range of 64.5% to 65.5% [Cisco’s non-GAAP gross margin came in at 66.4% in the second quarter]. The non-GAAP operating margin rate is expected to be in the range of 32.5% to 33.5% [Cisco’s non-GAAP operating margin came in at 33.7% in the second quarter] and the non-GAAP tax provision rate is expected to be 20%. Non-GAAP earnings per share is expected to range from $0.79 to $0.81 [non-GAAP EPS came in at $0.77 in the second quarter]. Our guidance does not reflect any potential disruptions in our global supply chain that could result from the coronavirus. We will continue to monitor the situation closely.”
Clearly there’s more work to be done as it relates to the structural shifts Cisco is angling for in its business model. As mentioned previously, within its Product segment the Security unit performed well last quarter, with sales up “9% with strong performance in identity and access, advanced threat” on a year-over-year basis. Due to rising cybersecurity threats worldwide, there’s room to keep building on that front going forward. Pivoting to its Service segment, as mentioned previously rising software and solutions sales represented a key reason behind that segment growing its revenue by 5% year-over-year last quarter, and the outlook for this segment continues to look bright relatively speaking.
Cash Flow and Balance Sheet Analysis
One of the reasons we like Cisco as a both a high quality dividend growth play and a firm that offers capital appreciation upside is its rock solid balance sheet. We are late in the business cycle, and global headwinds are building. The ongoing novel coronavirus epidemic (now officially abbreviated as ‘COVID-19’) in China is just one of many examples. Companies with net cash balances are always better positioned to deal with slowing global economies, potential black swan events, and volatile capital markets than firms with net debt positions.
Cisco was sitting on $8.5 billion in cash and cash equivalents (Cisco historically has preferred to put cash into money market funds for the yield and incremental income) along with $18.6 billion in investments as of January 25, 2020. Please keep in mind the firm’s fiscal 2019 Annual Report notes that most of that line item was (at the time) represented by available-for-sale debt securities, specifically corporate debt securities (Cisco’s fiscal 2019 ended on July 27, 2019, so this could have changed since then but that’s unlikely in our view). When looking at Cisco’s $1.5 billion in short-term debt and $15.5 billion in long-term debt as of January 25, 2020, it’s clear the company continues to maintain a very healthy net cash balance.
Pivoting to Cisco’s cash flow profile, the firm generated $7.4 billion in net operating cash flow during the first half of fiscal 2020 and spent $0.4 billion on its capital expenditures. Free cash flows of $7.0 billion, roughly on par with the $7.1 billion in free cash flow generated in the same period last fiscal year, handedly covered dividend obligations of $3.0 billion during the first half of fiscal 2020, along with $1.6 billion in share repurchases under its buyback program. Please note Cisco’s net cash position, when including investments and short-term debt, improved from $8.5 billion at the end of fiscal 2019 to $11.1 billion at the end of the first half of fiscal 2020 due to its strong free cash flows.
Concluding Thoughts
Cisco has its work cut out for it as the firm continues to push deeper into the subscription-based services and software sales realm, but there are bright spots appearing (with Security sales helping mitigate structural declines in demand at its Product segment, and Service segment sales performing relatively well). Having a net cash balance and a very strong free cash flow profile makes this transition more viable and provides room to adjust course as needed, all while pocketing a nice yield in the process (a yield supported by Cisco’s decent per share dividend growth trajectory). Given that we are very late in the business cycle, having a more defensive name like Cisco, even one that’s undergoing a major shift in its business model, included in our newsletter portfolios is prudent in our view.
Communications Equipment Industry – CSCO JNPR KN NOK SMCI
Broad Line Semiconductor Industry – AMD AVGO FSLR INTC TXN
Integrated Circuits Industry – ADI MCHP MRVL NVDA SWKS TSM XLNX
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Callum Turcan does not own shares in any of the securities mentioned above. Cisco Systems Inc (CSCO) and Intel Corporation (INTC) are both included in both Valuentum’s simulated Best Ideas Newsletter and Dividend Growth Newsletter portfolios. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.