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This Is Why Cisco's Profits Are Holding Up

By Timothy Green - May 15, 2020 at 8:30AM

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Revenue took a hit from the pandemic, but the tech company was able to keep its bottom line afloat.

"Secondary collateral damage" is how Cisco Systems (CSCO -1.36%) CEO Chuck Robbins described the impact of the novel coronavirus pandemic on the networking hardware provider. With many of Cisco's customers facing the most uncertain economic environment in recent memory, the company is experiencing a pause in orders. In the fiscal third quarter, Cisco's total revenue slumped 8%, and revenue from the core infrastructure platforms segment tumbled 15%.

While sales are in decline, Cisco managed to grow its per-share earnings in the third quarter, at least on an adjusted basis. Adjusted EPS came in at $0.79, up 1% from the prior-year period, and adjusted gross margin expanded by 2 percentage points to 66.6%. There were a few factors driving those increases.

Cables plugged into computer equipment.

Image source: Getty Images.

1. Rock-bottom memory prices

Networking hardware like switches and routers contain memory chips, and the pricing on those memory chips impacts Cisco's margins. Memory chips are largely commodities, with pricing dictated by supply and demand. In 2019, memory chip prices collapsed due to oversupply. Major memory chip manufacturer Micron saw its selling prices for dynamic random-access memory (DRAM) tumble 30% last year, while selling prices for flash memory crashed 47%.

Memory chip prices have begun to rebound this year, particularly for DRAM, but that didn't hurt Cisco's profitability in its Q3. "I will say some of the dynamics we did benefit still this quarter because we had built up some inventory on memory at the lower prices. So we benefited greatly from that," CFO Kelly Kramer explained in the earnings call.

This benefit will disappear as Cisco works through its inventory of low-price memory chips, although weak demand for memory chips during the pandemic-driven recession could certainly put renewed downward pressure on prices.

2. A shift toward software

Cisco doesn't disclose exactly how much revenue it derives from software, but the company has been increasing its focus on software for years. The company's applications and security segments are both software-heavy, and some of its switching and routing products come bundled with software and services.

A positive mix shift was one thing that helped prop up Cisco's margins in the third quarter. With sales of hardware down, the shift toward high-margin software contributed to the strong profitability. Certain parts of Cisco's software business are doing particularly well during the pandemic. These include videoconferencing and AppDynamics, which Cisco acquired in 2017. AppDynamics revenue grew by a double-digit percentage in the third quarter, and the company's WebEx collaboration platform hosted over 500 million meeting participants in April alone.

Cisco's core business is still selling networking hardware, and that won't change anytime soon. But as the company continues to shift toward software, margins could benefit in the long run.

3. Share buybacks

Finally, Cisco buying back its own stock over the past year reduced its share count and pushed up per-share earnings. Cisco reported a 3.9% reduction in its share count since the third quarter of last year, enough to provide a small boost to EPS.

The tech giant spent $981 million buying back its own stock in the third quarter, and about $2.7 billion over the first nine months of the fiscal year. The company has another $10.8 billion authorized for share buybacks, although it wouldn't be surprising to see a slowdown in buyback activity, depending on the severity of the recession.

A tough road ahead

Cisco's results are going to be weak as long as economic uncertainty dictates the decisions of its customer. The bottom line will likely be hit as well, especially as the memory chip pricing tailwind dissipates. The company's guidance for the fourth quarter calls for an adjusted gross margin between 64% and 65%, and adjusted EPS between $0.72 and $0.74. Both are down from the third quarter, as well as from Q4 of last year.

Cisco's balance sheet is strong, with $28.6 billion in cash and investments offset by about $16 billion of debt. A recovery in demand may be many quarters away, but the company should have no trouble weathering this crisis.

Timothy Green owns shares of Cisco Systems. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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