Analysis: CSCO

Cisco Systems (CSCO) reported a top- and bottom-line beat with its fiscal-third-quarter report after the closing bell, but the stock is trading sharply lower after hours on management's weak outlook for the coming quarter. 

For the fiscal third quarter, revenues of $11.94 billion beat consensus of roughly $11.9 billion but declined year over year for the sixth straight quarter. EPS was also a beat, with $0.60 edging out consensus of roughly $0.58. These relatively strong results, however, were overshadowed by management's sluggish fiscal-fourth-quarter guide. EPS is expected to come in around $0.60 to $0.62, lower than consensus of $0.62 at the midpoint, and the company sees revenues declining 4%-6% in the quarter (to a range of $11.88 billion to $12.13 billion versus consensus of $12.53 billion). 

Before digging deeper into the results, we want to remind subscribers of Cisco's long-term transformation away from legacy switching and routing and into higher-growth and higher-margin software and security businesses. The key term here is "long-term transformation" -- although the company continues to experience growth in these newer, more exciting business areas, the fact remains that the overall business remains driven in the near term by declining legacy businesses. Management is aware of this dynamic, explaining why they initiated plans to transform the company over a three- to five-year period. However, there will be bumps along the road. 

This is why we have maintained our Two rating and why we trimmed our position back in February as a way to lock in year-to-date gains that we recognized could be unsustainable in the short term given the inherent difficulties involved with transitioning a business of Cisco's massive scale. Quoting from our members call hosted today, "We are conscious that Cisco reports tonight and we wish it had not run up into the quarter. Our investment with Cisco is long term, embracing the changes that CEO Chuck Robbins is engineering at the company." 

Perhaps adding to the after-hours pain is the underlying uncertainty that predicated today's selloff. This uncertainty regarding Washington raises doubts, as we explained, on whether the administration will be able to push forward its agenda. As such, CSCO shares see additional pressure as they had been partly supported by hopes for tax reform and cash repatriation (the company had $68 billion in cash at the end of the last quarter, only $2.9 billion of which is in the U.S.). So, on top of concerns regarding the legacy business and the outlook for the coming quarter, investors now must also battle with whether to model for tax reform and/or repatriation. After a day like today, where markets had their worst performance in recent memory, Cisco was already heading into its report with a tough setup. 

On a positive note, Cisco's deferred revenue balance continues to grow thanks to a continued mix shift toward services and software subscription sale, rising 13% year over year this quarter to $17.3 billion, matching the January quarter's growth rate. Deferred product revenue grew 26% (driven by subscription-based offerings) and deferred service revenue was up 7%. Product deferred revenue related to software and subscriptions grew 57%, or 51% excluding the $3.7 billion AppDynamics acquisition. Eight quarters ago, Cisco had $2 billion on the balance sheet related to deferred revenues in software and subscription -- now this sits at nearly $4.4 billion. 

While there were some questions about slowing recurring revenue growth for services in the quarter, management noted that this is actually not the case if we adjust for the 13-week quarter versus a 14-week quarter in the prior year. "So if you adjust for that, it's up double digits in total," they said. 

More broadly, Switching revenue (the company's largest business) rose 2% year over year in the fiscal third quarter. Routing (second-largest business) fell 2% and Collaboration was down 4% while data center (servers) were down 5%. Wireless and security were bright spots, up 13% and 9%, respectively. Revenue by geographic segment was: Americas flat, EMEA flat, and APJC down 2%. On the call, Robbins noted specific weakness in Mexico orders (down 49% year over year) as well as in U.S. federal businesses, where uncertainty regarding budget allocation caused a drop in demand. Again, sticking with the theme we mentioned above, today is simply bad timing to discuss global and macro uncertainty as investors rethink the year-to-date rally. 

Regarding capital allocation, CSCO paid a quarterly dividend of $1.16 a share annualized and repurchased 15 million shares of stock in the fiscal third quarter. The company still has approximately $12.9 billion remaining under its authorized repurchase program and noted on the call that it remains "very committed" to capital deployment. 

All in, we want to allocate significant time toward reviewing the conference call and we want to hear additional commentary from Robbins tomorrow before we make any definitive decisions. While we are of course disappointed to see the stock pull back after hours, we also recognize that these hiccups can happen when a massive company like Cisco undertakes a long-term transition plan (which, by all accounts, was beloved by investors just a quarter ago) -- again, this is why we have kept the name at Two. That being said, the stock experienced a similar pullback two quarters ago when investors questioned the transformation plans and the company had guided for a weak outlook on the coming quarter -- shares ended up clawing their way back up until and through the next quarter. 

We are not saying this is the exact same situation, and we are, of course, discouraged by the outlook for the coming quarter, but we believe management may have decided to come out conservative, keenly accounting for uncertain trends in the marketplace. Any turn in the macro uncertainty that management discussed would result in upside to the guidance. Although we are actively considering upgrading the name, we want to be sure we are able to fully review the numbers and the call and also that we have enough time to evaluate the action tomorrow (and perhaps over the next couple of days). 

In the end, at $31 (which the stock had touched after hours), CSCO shares offer a 3.75% dividend yield as well as a long-term transition strategy in which the company can leverage its massive scale to play in the hottest areas of tech. Adding to this, Cisco would be a major beneficiary of any repatriation holiday and continues to have optionality with regard to share repurchases. The name has a lot going for it long term, but the question is how quickly the short term can turn around.