Analysis: CSCO

Cisco Systems (CSCO) reported a top- and bottom-line beat with its fiscal first quarter 2020 results. Revenue of $13.20 billion (+2% YoY excluding the SPVSS divestment) edged past the consensus of $13.08 billion, and adjusted earnings per share of 84 cents (+12% YoY) beat the consensus by three pennies.

"We delivered a solid quarter against a challenging macro environment. We're focused on continuing to drive innovation, transform our business and exceed our customers' expectations," said CEO Chuck Robbins in the press release.

The headline numbers looked solid against a bar that was lowered with the previous quarter, but once again investors were disappointed with what is expected from guidance.

For the second quarter of fiscal 2020, revenue is expected to decline 3% to 5% year-over-year, well below Street estimates of 2.4% growth. Moving through guidance, adjusted gross margins are expected range from 64.5% to 65.5% (vs. the Street's expectation of 64.5%) with an adjusted operating margin rate of 32.5% to 33.5% (vs. the Street's 32.5%). All of this leads to an adjusted earnings-per share guidance in the range of 75 cents to 77 cents, which is light against a 79-cent consensus expectation.

You may recall that on the last earnings call, management pointed to a weak July.

"it just didn't feel like a normal Q4 finish and it felt a little bit like some of the macro issues may be manifesting themselves," said Robbins on the previous call.

Well, it looks like this weakness has been persistent, with customers pausing spending.

"We saw things like conversion rates on our pipeline were lower than normal... We didn't see any incremental loss ratios. It was really just stuff slipping. We saw some large deals get done, but got done smaller," Robbins said on Wednesday's call. "Kelly (Kramer, Cisco's chief financial officer,) and I were involved in a couple personally that we saw that when we began talking to the customers about the transaction. And by the time the get done ,,, they were smaller than when we had begun. So that happened. And then we just saw deals that slipped."

In reaction to the weak guide, Cisco shares were falling about 5% in after-hours trading.

Cisco's Q1 Numbers

Software Switch: Software subscriptions as a percent of total software revenue -- one of the more meaningful metrics for assessing the company's transformation -- now sits at 71%, up 1 percentage point quarter-over-quarter, and 12 percentage points year-over-year. Recall, the focus on subscriptions as a percentage of software sales is crucial. That's because it further speaks to the company's transition from hardware -- which has inherently lumpy sales cycles -- to software. Software tends to be in high demand from customers, has a smoother recurring revenue stream, typically is higher margin, and, importantly, is less driven by shifts in the macro economy.

On the Margins: Adjusted total gross margins, product gross margins, and service gross margins were 65.9%, 66.1%, and 65.4% respectively. All but service gross margins are higher than what Cisco delivered in the same quarter a year ago, when total gross margins, product gross margins, and service gross margins were 64.2%, 63.6%, and 65.8%, respectively. The numbers are also a reflection of the business improvements Cisco has made through the years and limited impacts from price erosion.

Revenue Falls In Line: Digging deeper, product revenue was flat YoY at $9.878 billion but in line with $9.824 billion consensus, while service was up 4% at $3.281 billion -- and in line with the $3.254 billion consensus.

Products Are Up and Down: Breaking products down further, infrastructure platforms revenue fell 1% YoY to $7.538 billion (shy-to-in line with $7.608 billion consensus); application revenue was up 6% to $1.499, in line with $1.476 billion consensus; security revenue grew 22% to $815 million, which was strong compared to $723 million consensus; and "other products" revenue fell to $26 million, vs. a $36 million consensus.

Around the World, Some Gains and Dips: By geography, revenue (excluding the SPVSS divestiture) from the Americas grew 3% YoY; sales in Europe, the Middle East and Africa increased 2%; while Asia Pacific, Japan and China (APJC) fell 9% YoY. But total orders fell 3% in both Americas and EMEA while APJC dropped 5%. This is a pretty big contrast from the previous quarter when orders grew mid-single digits. Total emerging markets was really weak with orders down 13%. Looking specifically at Brazil, Russia, India, China and Mexico, orders fell 26%. And in China, orders dropped 31%, an accelerating decline from last quarter's 26% fall.

Customers Mixed: By customer segment, enterprise fell 6%; commercial dropped 6%; the public sector was up 6%; while "service provider" fell 13%, another weak result that's illustrative of the challenges felt over the past few quarters. Additionally, Robbins added that the decline in commercial orders "was one of the big signals to us that...there's definitely something going on, because the commercial business is usually fairly resilient."

Buy Backs Go on, Dry Powder Piles Up: Cisco continues to return $2.3 billion to shareholders via buybacks and dividends. The pace of buybacks is consistent with the previous quarter, with management repurchasing 16 million shares of stock, worth about $1.5 billion. Management still has plenty of dry powder available, with a remaining authorization of stock repurchase worth $12.7 billion.

And if management wants to dive back into acquiring, it certainly can with the cash hoard it's built up. Cisco ended the quarter with $28 billion in cash, cash equivalents, and investments. But Cisco closed four deals in the quarter (all in the applications area), contributing a positive 50 basis points to revenue.

DRAM Dip: As for DRAM pricing, CFO Kelly Kramer expects to continue to see a favorable impact next quarter. But after that, the benefits of lower prices will begin to wear off a year later, and you can expect to see a less-pronounced impact.

Guidance Miss Not Whole Story

All in, the quarter looked fine against previously muted expectations, however management had to lower numbers for the second quarter in a row. You may remember how management previously cautioned about the negative dynamics impacting visibility, and as Robbins said on this conference call, "there's been lack of clarity for so long that I think it finally just came into play." 

Even so, there are still positives to point out, such as how well products like the Catalyst 9000 with the campus switching cycle are selling, as well as security services. But what Cisco can hang its hat on is the portfolio transformation story. Previously, management laid out the tall task of that by the end of fiscal 2020, 30% of revenue will be software and software and services will be half of total revenue. Management is on track to hit these targets, and it has already outperformed in terms of how 71% of the software sales are now subscription-based -- the goal was 66%.

Plus, Cisco offers a big dividend yield of about 3% that is supported by the balance sheet and consistent cash returns through buybacks. We do not want to downplay the cautious nature of this conference call and the pause Cisco is seeing from customers, however, the characteristics just mentioned should help the valuation of this reasonably priced stock find support.

But we won't see it Wednesday, because investors are likely surprised right now to see top-line guidance go negative, despite a transforming business model that would suggest a more consistent revenue trend. Shares are expected to trade lower at the open Thursday, but this one may not be a buy on the immediate dip as we want to see spending around Cisco's longer-term opportunities across cloud, automation, 5G, security, and collaboration pick up.