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Newsletter portfolio holding Cisco continues to transition its business to a software and subscription-based model. Let’s take a look its progress as of its second quarter of fiscal 2017.
By Kris Rosemann
Networking giant and newsletter portfolio holding Cisco (CSCO) reported positive momentum in its business transformation in its fiscal second-quarter report February 15. The company continues to throw off gobs of free cash flow, and its board of directors approved a 12% increase in the quarterly payout to $0.29, good for a ~3.4% annualized yield as of this writing. We love shares for their dividend growth potential–Cisco’s Dividend Cushion ratio currently sits at 3–and we continue to see value in shares based on our fair value estimate of $42.
Cisco’s transition has not been without its share of skeptics, one potential reason why we think shares continue to trade near the lower bound of our fair value range, and management is expecting the transition efforts to continue negatively impacting its top line growth by 1%-2% moving forward (but this is down from 2% previously). Revenue in the most recently-ended quarter fell 2% from the year-ago period due to weakness in ‘NGN Routing,’ ‘Switching’ and ‘Data Center’ product revenues more than offsetting strength in ‘Security,’ ‘Collaboration’ and ‘Wireless’ product revenues and service revenue. Non-GAAP earnings per share in the quarter came in flat compared to the second quarter of fiscal 2016, thanks to share repurchases offsetting a 2% year-over-year decline in non-GAAP net income.
Despite weakness in reported top-line results, deferred revenue continues to grow as total deferred revenue advanced 13% from the year-ago period; product deferred revenue related to recurring software and subscription businesses jumped an impressive 51% in the quarter, and recurring revenue now accounts for 31% of total revenue. This measure has accelerated nicely since CEO Chuck Robbins implemented his transition strategy, and the company has high hopes for the long-term potential of its recent acquisition agreement with application intelligence software company AppDynamics for $3.7 billion due to both strategic opportunities and 75% of its revenue being of the recurring variety. From the fiscal second quarter conference call:
One, if you look six quarters ago when I came into the job, our overall revenue, our recurring revenue was 26% in the first four quarters. We spent time taking our teams and helping our teams understand the transition that we were going to make. So in the first four quarters, we gained 2 points. We took it up to 28%, and in the last two quarters we’ve added 3% so we’ve accelerated it. So it’s going to 31 in the last two quarters. And on the product side, that went from 6% to 7% in the first year and then in the last two quarters, it’s gone from 7% to 10%.
Cisco’s executive team appears confident it is on the right track in its business transition, with the minor exception of slight concerns over the pace of the transformation in its ‘Data Center’ business, which accounts for ~7% of total revenue, as the shift from “blade to rack” continues to weigh on performance. Looking ahead to the fiscal third quarter, Cisco is anticipating reported revenue to be flat to down 2% and non-GAAP earnings per share to be in a range of $0.57-$0.59 compared to $0.57 in the comparable period of fiscal 2016. However, the third quarter of fiscal 2016 contained an extra week, resulting in an extra $265 million in revenue being recognized in the period. After adjusting for the extra week, management’s guidance indicates that it is expecting to return to top-line growth in the period, albeit modestly.
All things considered, we’re pleased with Cisco’s performance of late. Though it dropped 2% in the first half of fiscal 2017 on a year-over-year basis, free cash flow generation remains robust at ~$6 billion through the first six months of the fiscal year, more than enough to cover its cash dividend obligations in the period two times over, and its balance sheet strength is nothing short of impressive. As of the end of its fiscal second quarter, the firm’s net cash balance was $36.9 billion, a balance we expect to continue being put to use in expanding unique capabilities as well as providing a cushion for the cash returned to shareholders. We’re going to continue holding shares in both newsletter portfolios as we feel they continue to offer meaningful and reliable income generation as well as a material opportunity for capital appreciation.