Analysis: CSCO LRCX

On Wednesday, after the closing bell, Cisco Systems (CSCO) reported a top and bottom line beat with its fiscal second quarter 2019 results. Revenue of $12.45 billion (up 7% year over year when normalized to exclude a prior divestiture) topped the consensus of $12.41 billion, and adjusted earnings per share of $0.73 (an increase of 15.8% year over year) exceeded the consensus by $0.01.

Cisco shares were rising 3.8% to $49.30 in after-hours trading.

"We are very pleased with our strong performance in the quarter," said Chuck Robbins, chairman and CEO of Cisco. "Our teams are executing incredibly well, aggressively transitioning to a software model and accelerating our pace of innovation. We are redefining and connecting every domain of the networking infrastructure to deliver the agility, operational efficiency and security our customers require to embrace multicloud, edge computing and digital transformation."

Once again, Cisco's results have backed up Robbins statements. On top of the positive financial metrics, software subscriptions as a percent of total software revenue (one of the more meaningful metrics in assessment of the company's transformation) was 65%, up 10 points year over year. Recall, the focus on subscriptions as a percentage of software sales is crucial because it further speaks to the company's transition from a hardware company, which has inherently lumpy sales cycles, to a software/security company with a smoother recurring revenue stream.

As for new billings (which includes the impact of sales realized in the quarter as well as deferred revenue - sales that yet to be realized until the company fulfills its obligations), a metric representative of new business in the quarter and a crucial one for software as a service (SaaS) based companies (which Cisco is increasingly looking to become), results of $12.86 billion outpaced expectations of $12.42 billion.

Digging deeper into the quarter (and excluding the prior divestiture), product revenue increased 7% year over year to $9.273 billion (a slight beat to the $9.151 billion consensus) while Service was up 1% at $3.173 billion (slightly below the $3.246 billion consensus).

Breaking products down further, Infrastructure Platforms revenue increased 6% to $7.128 billion (a beat off the $7.069 billion consensus), Application revenue was up 24% to $1.465 billion (solidly higher than the $1.352 billion consensus), Security revenue grew 18% to $658 million (a very positive result against the $629 million consensus), while Other Products revenue declined 91% to $22 million (well below the $96 million).

By geography, revenue from the Americas increased 7%, sales in EMEA grew 11%, and APJC was up 6%.

By customer segment, Enterprise increased 11%, Commercial grew 7%, the Public Sector was up 18%, while Service Provider was down 1%.

On the capital allocation front, we are watching Cisco turn into a meaningful shareholder return story right before our very eyes. This makes sense because this company was one of the largest beneficiaries of cash repatriation made possible by tax reform. During the quarter, Cisco returned $6.5 billion to shareholders through dividends ($1.50 billion) and buybacks ($5 billion at an average price of $45.09 per share). But out of confidence in ongoing cash flows, Cisco announced a 2-cent, or 6% increase to its quarterly dividend (which will put the yield at an attractive ~3% as of Wednesday's closing price), as well as a massive $15 billion addition to its stock repurchase program that now has $24 billion remaining. The company ended the quarter with $40.4 billion in cash, cash equivalents, and investments, providing them plenty of balance sheet optionality in the future.

In terms of the forward outlook, there was a feeling of general concern that Cisco would disappoint with guidance due to various factors like the government shutdown, slower Security growth, tariffs, etc., we outlined last Friday in our Alert here , however, management still provided upside in their outlook. For their third quarter of fiscal year 2019, management expects revenue to grow between 4% and 6% year over year, implying a range of approximately $12.91 billion to $13.2 billion vs. a $12.8 billion consensus. Adjusted earnings per share is expected to be in the range of $0.76 to $0.78, which at midpoint tops the $0.76 consensus. Closing out guidance, non-GAAP gross margins are expected to be in the range of 64% to 65%, and non-GAAP operating margin is expected to be in the range of 31% to 32%.

When asked about potential headwinds like tariffs, the government shutdown, or even weather, Robbins acknowledged the complexity of the current macro geopolitical environment, however, he reiterated how he saw no difference "from the first day of the quarter to the last day of the quarter," with steady demand throughout. Making the third-quarter guidance beat all the more impressive, while Robbins acknowledged on the call that Cisco saw minimal impact from the shutdown, as only about 25% of government agencies were impacted, we also noted that once some government customers, "had a sense of shutdown, some of them pulled some orders ahead and actually got them in the system." The reason we mention this is because intuitively, this would speak to less business available in the coming quarter (due to it already having taken place), however, despite this dynamic guidance still managed to beat expectations, a factor giving us even more insight into the ongoing demand environment in which Cisco operates.

As for DRAM pricing, an input that impacts gross margins, CFO Kelly Kramer noted how the quarter had a negative headwind from DRAM and component costs, but added that DRAM is expected to turn into a tailwind in the next two quarters and that caused about a 0.5 point pickup in the guide to gross margin. This expectation also fits our thesis in Lam Research (LRCX) (which we initiated today in our Alert here as we anticipate about two quarters of weakness (a factor backing our view that chip manufacturers will reduce capital expenditures to enhance profitability and maintain cash flows), followed by an investment inflection that will lead to increased demand for Lam Research's products in the back half of 2019.

One last point we want to reinforce for members is something we discussed on our members only call earlier today, namely why it so incredibly crucial to do your own homework! As members may recall, on Tuesday, analysts at Morgan Stanley downgraded shares of CSCO to equal weight (Hold equivalent) while reducing their price target, noting that "late January/early February conversations suggest the [government] shutdown is having a follow through effect, slowing the normal seasonal improvement of the April quarter." Now, while some may have viewed the downgrade as a reason to sell (and indeed shares did trade lower today, bucking the trend of the overall market), we chose to view it as a positive, because our homework told us that demand was strong, IT spending robust and that Cisco's revenue stream was resilient to the dynamics negatively impacting other sectors while beginning to show less of correlation to global GDP growth (which we remind member is showing signs of a slowdown) - something Robbins hinted at on the last earnings conference call. In fact, our biggest fear was simply that we would come into the quarter too hot, creating a setup that would lead to a disappointing price reaction unless the results and guidance absolutely blew expectations out of the water on every line - these results were good but we likely would not have seen such a positive reaction had we cone into the quarter hot, so to speak, and instead have been met with profit taking.

Bottom line, homework yields confidence and confidence allows for conviction; our homework told us that trying to "game the quarter" was wrong, that the business was firing on all cylinders and that we should stay the course. Our homework is what allowed us to stay the course into the release and as a result, we are being rewarded with a stock that is on the verge of breaking out to its highest level in over 18 years (since the bursting of the dot-com bubble).

All in, we believe the quarter to support our view that despite fears of a global economic slowdown, IT spending remains robust as company's around the globe (as indicated by the across the board growth in geographic segments noted above) continue to build out their tech infrastructure so as not to be left behind in the age of digitization. We continue to view Cisco as a direct beneficiary of this IT spending dynamic and believe shares will continue to grind higher as margins improve on the back of DRAM price-related tailwinds and as the revenue stream continues to morph into one based more on software sales, especially as those software sales become increasingly made up of subscription sales. We therefore reiterate our One rating and will be taking our price target under review.