Image Source: Ashwin Kumar
Cisco’s fiscal third quarter results came in mostly as expected, but shares faced selling pressure following the release as the company’s operating margin was squeezed in the quarter. We still like Cisco a lot and are not concerned about the market’s tunnel vision. The company’s free cash flow performance and a huge net cash position are hard not to like. We’re not worried.
By Kris Rosemann
Networking giant and simulated newsletter portfolio holding Cisco (CSCO) showed solid progress in its ongoing transformation towards a software and subscriptions focused business model in its fiscal third quarter report, results released May 16, but shares faced selling pressure following the release as its operating contracted due in part to heavy investments related to recent acquisitions.
Revenue at Cisco grew 4% from the year-ago period, driven by strength in Product revenue, specifically in Applications and Security. Recurring revenue accounted for 32% of total revenue, up 2 percentage points from the comparable period of fiscal 2017, and deferred revenue advanced 9% on a year-over-year basis thanks to strong performance in subscription-based and software offers, which increased 29%.
Cisco’s gross margin continues to be impacted by higher memory pricing, a dynamic expected to persist in the near term, as non-GAAP gross margin contracted 50 basis points. GAAP operating income fell 1% from the year-ago period as operating expenses were elevated due to the aforementioned investments related to recent acquisitions that are in early development phases. GAAP operating margin fell to 25.1% from 26.5% in the third quarter of fiscal 2017. Non-GAAP earnings per share advanced 10% on a year-over-year basis to $0.66.
Cash flow from operations in Cisco’s fiscal third quarter fell 28% from the year-ago period due to a $1.3 billion payment of one-time foreign taxes, but excluding this impact, the measure advanced 11%. However, even after including this materially negative impact, free cash flow generation fell only 2% ($173 million in absolute terms) through nine months of fiscal 2018 on a year-over-year basis, and the more than $8.9 billion in free cash flow generated through three quarters is more than double cash dividends paid in the period of $4.4 billion. The company’s balance sheet remains strong with a net cash position of nearly $26.4 billion as of the end of its fiscal third quarter, and Cisco’s robust Dividend Cushion ratio of 2.4 is even more impressive when considering its dividend yield of ~3%.
We don’t expect to make any changes to our highlighting of Cisco in either simulated newsletter portfolio as its financial health and long-term outlook remain appealing, in our view. We like the steady progress the company is making in its transformation to a business model focused on software and subscriptions, which is far from over. For an enterprise of Cisco’s size, a rapid transformation is unrealistic, and there may be more bumps in the road related to the transformation and ongoing investments related to reshaping its portfolio.
We’ve been expecting Cisco to continue performing in-line with its projections of lower growth in the near term, and our current fair value estimate of $45 per share does not include meaningful operating margin expansion from levels seen in its most recent quarter. We’re sticking by this idea thanks to its robust free cash flow generation and strong balance sheet, the combination of which gives us confidence in its ability to navigate its transformation. Nevertheless, we’ll be watching its performance on the top line and operating line for potentially material and sustained weakness, neither of which we are seeing from its fiscal third quarter report.
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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.