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Is Cisco Systems a Buy?

By Keith Noonan - Sep 7, 2019 at 11:35AM

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The networking stalwart may have attractive long-term upside after its post-earnings sell-off.

Shares of Cisco Systems (CSCO 1.40%) have nearly doubled over the last five years. It managed this with help from efforts to couple its hardware with a subscription component and expansion of its software and services. This has allowed Cisco to position itself for the next big trends in networking and internet communication.

More recently, the stock has pulled back a bit following its fourth-quarter earnings report and guidance published in August. The networking giant is now trading in the range of 14.5 times this year's expected earnings -- a level that looks cheap versus where it's been in recent years. 

CSCO PE Ratio (Forward) Chart

CSCO PE ratio (forward) data by YCharts.

While the stock has seen strong gains over the last half-decade, the movement has been supported by corresponding growth for earnings, free cash flow, and its dividend. Cisco's valuation doesn't look unreasonably stretched even in light of some near-term headwinds, and long-term investors seeking a solid dividend yield and market-beating growth potential could see strong returns from the stock at current prices. 

What to make of Cisco's guidance for a near-term slowdown

Cisco's fourth-quarter sales rose roughly 6% to reach $13.4 billion, and non-GAAP (adjusted) earnings per share (EPS) rose 19% year over year to come in at $0.83. That brought the company's full-year revenue to $51.7 billion (up roughly 7% annually) and its adjusted EPS for the period to $3.10 (up roughly 20%). Fourth-quarter results actually topped the average analyst estimates on both the top and bottom lines. But guidance for the first quarter underwhelmed investors and added to concerns that the broader technology sector is heading toward a slowdown.

The company expects sales to come in between flat to 2% growth year over year in the current quarter, and its midpoint guidance for adjusted EPS of $0.81 represents growth of roughly 8% versus the prior-year period. That's a substantial slowdown compared with the company's recent sales and earnings trajectories. And it comes even as it retired $4.5 billion in shares through buybacks last year and has spent billions bolstering its position in fields like cloud services, cybersecurity, analytics, and low-power wide area networks. 

In a market trying to weigh the stresses created by U.S.-China trade disputes and signs of weakening economies in other important markets like Germany and the U.K., Cisco's guidance reflected and reinforced concerns about potentially weakening macroeconomic conditions. Even amid broader trends of growth for data transmission and internet communication services, an economic slowdown can be expected to weaken demand for Cisco's products and services.

Management's statements about macro-level shifts in key markets contributing to softer demand in its service-provider category could be cause for concern when taken in conjunction with a 21% year-over-year sales decline in Q4 in that category. But the long-term picture looks less worrying.  

A network of points and lines covering the Earth.

Image source: Getty Images.

Getting ready for the next big networking push

Cisco's service-provider segment has taken a hit in recent quarters, and the company expects some weakness for that segment to continue in the near term. But management suggests that much of the slowdown is due to enterprises ramping up spending on radio equipment for the transition to 5G. It also said that it will see a sales resurgence in the category once these businesses have the foundation-level tech equipment in place to support their transition to the new networking technology.

Speaking during the company's third-quarter earnings call (a period that saw a 13% year-over-year decline for service-provider orders), CEO Chuck Robbins had this to say about macro spending trends and the company's outlook in 5G:

No. 1, the capex data that we saw last quarter and even the forecast don't look incredibly healthy for these guys. But where they are spending money primarily today as it relates to 5G is they're building out the macro radio portion of their networks first. And they're leveraging their existing core networks to run the early trials that they have on 5G, basically. And we believe that some time in the future when they have -- when the number of connections increases and the capacity gets to a point -- then they are obviously going to begin to build out in these new backbones dedicated to the 5G infrastructure, which is where we will generally come into play.

Cisco should eventually get a significant boost from 5G, but it's worth noting that the company's router and switch hardware face long-term pressure as an increasing number of online networking functions are able to be carried out through software. Companies including AT&T,, and Facebook have been adopting "white box" router and switch solutions that replicate many of the functions of Cisco's own hardware by offloading tasks to cloud servers -- and they are available to enterprises at substantially lower up-front cost than the networking giant's bundled device and service offerings. 

Cisco itself admits that current switching systems are outdated and that the movement is toward a more software-driven networking environment where connectivity hubs are virtualized rather than taking place across physical infrastructure. Still, the company maintains a dominant position in its core routing and switching hardware markets, and it appears to be making smart moves to reorient to meet shifting realities and customer needs in the networking space.

A strong balance sheet and smart use of capital

Cisco ended last year with $33.4 billion in cash and investments against debt of roughly $25 billion -- good for a net cash position of roughly $8 billion. That's down substantially from its average net cash position over the last five years, largely due to share buybacks. But it still has a healthy balance sheet to work with and room to pursue additional acquisitions to supplement its burgeoning services ecosystem. 

Its long-standing dominance in the router and switch markets allowed it to build up a massive balance sheet, and its recent acquisitions and moves to return value to shareholders through buybacks and dividends were aided by the opportunity to repatriate $67 billion in offshore cash at a lower rate courtesy of the 2017 tax reform bill. Concerns that money for share buybacks could have been put to better use in other areas don't appear particularly pressing in light of the big spending that has also gone toward acquisitions and preparing for the next generation of networking technologies. 

The company has found success in building up the recurring-revenue side of its business, transitioning customers and adding new clients to software-as-a-service plans that tend to be more dependable and profitable over the long haul. Along with buybacks, continued success along these lines should help Cisco grow its earnings and free cash flow per share. 

CSCO Free Cash Flow Per Share (TTM) Chart

CSCO free cash flow per share (TTM) data by YCharts. TTM = trailing 12 months.

The stock also comes with a substantial dividend, offering a roughly 3% yield. It has an eight-year history of consecutive annual dividend growth, and a reasonable payout ratio of 54% despite boosting its dividend by 84% over the last five years and more than 480% since it began paying a dividend in 2011. Management plans to keep its share of free cash flow returned to shareholders through buybacks and dividends at a minimum of 50%. So as long as things keep trending up on that front, investors can likely look forward to substantial dividend growth. 

Those concerned about a big pullback in the technology space amid a potential recession or some other cause for a broader sell-off for the stock market may not see much reason to jump into Cisco at current prices. On the other hand, the stock offers an attractive dividend and is backed by a healthy balance sheet and a relatively sturdy business, and there's a good chance that long-term investors will see strong returns.

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