Analysis: CSCO

Cisco Systems (CSCO) reported on Wednesday a top- and bottom-line beat with its fiscal second quarter 2020 results. Revenue of $13.20 billion (-4% YoY) edged past the consensus of $11.974 billion, and adjusted earnings per share of 77 cents (+5% YoY) beat the consensus by a penny.

"I am confident in our long-term growth opportunities as we help our customers build out the networks for the future," chairman and CEO Chuck Robbins said in the release.

Before getting into the quarterly results that look solid against the low expectations that were set with guidance, let's take a look at management's outlook for next quarter.

For the third quarter of fiscal 2020, revenue is expected to decline in the range of 1.5% to 3.5% year-over-year to about $12.5 billion to $12.76 billion -- in line with Street estimates of a 2.5% decline to about $12.616 billion. Moving through guidance, adjusted gross margins are expected range from 64.5% to 65.5% (vs. the Street's expectation of 64.9%) with an adjusted operating margin rate of 32.5% to 33.5% (vs. Street 32.9%). All of this leads to an adjusted earnings-per share guidance in the range of 79 cents to 81 cents, bracketing consensus of 80 cents.

Next quarter's forecast does not offer much to the upside, but it appears management has finally reset expectations to the point that they are no longer offering material downside guidance compared to estimates. We say that because lower than consensus guidance is what plagued the stock over the past two quarters and caused huge swings to the downside. That's not the case this time around, but shares are still off about 4% from Wednesday's close in after-hours trading.

Back to the quarter, adjusted total gross margins, product gross margins, and service gross margins were 66.4%, 65.9%, and 67.7% respectively. All but service gross margins (flat) expanded YoY.

Digging deeper, product revenue fell 6% YoY to $8.671 billion, a miss vs. the $8.788 billion consensus, while service grew 5% to $3.334 billion, stronger than the expected $3.192 billion consensus. 

Breaking products down further, infrastructure platforms revenue fell 8% YoY to $6.528 billion (shy-to-in line with $6.579 billion consensus); application revenue fell 8% to $1.349 billion, below consensus of $1.427 billion consensus; security revenue grew 9% to $748 million, which was slightly higher than $742 million consensus; and "other products" revenue was $46 million vs. $24 million consensus.

Software subscriptions as a percent of total software revenue -- one of the more meaningful metrics for assessing the company's transformation -- now sits at 72%, up a percentage point quarter-over-quarter, and 7 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. 

By geography, revenue from the Americas fell 5% YoY; sales in Europe, the Middle East and Africa (EMEA) fell 3%; and Asia Pacific, Japan and China (APJC) revenue declined by 1% YoY.

Total orders were down 6%. By geography, Americas fell 8%, EMEA was down 1%, while APJC declined 4%. In emerging markets, orders were down 7% with Brazil, Russia, India, China, South Africa and Mexico down 20%. 

In China, management also continues to see a "rapid decline" with orders down over 30% again. However, revenue from China only represents about 2% of the total business.

By customer segment, enterprise fell 7%; commercial dropped 4%; the public sector was flat; while "service provider" fell 11% -- another weak result that's illustrative of the challenges felt over the past several quarters. Still, management is expecting to see a "resurgence" in the Service Provider vertical down the road (pick up starting in 2021) driven by the 400-gig transition and 5G build-out. This is where the company's Cisco Silicone One announcement made here comes into play.

Cisco returned $2.4 billion to shareholders through dividends and buybacks. On the former, Cisco declared Wednesday its next quarterly dividend will be 36 cents per share, an increase of a penny, or 3%, over the previous quarter's dividend. That puts the yield at about 2.9%, based on CSCO's closing price of $49.93. On buybacks, management repurchased 18 million shares of common stock at an average price of $46.71 per share for an aggregate purchase price of $870 million. Management currently has $11.8 billion remaining on its current authorization.

As for DRAM pricing, CFO Kelly Kramer noted that the pricing environment continues to benefit margins, but is becoming "less and less" of a benefit because prices have begun to tick up. Remember, DRAM is Dynamic Random Access Memory, the kind commonly found in personal computers.

Speaking to the macro, Robbins didn't necessarily give an "all clear" sign that big customers are spending again.

Customers, Robbins said on the call, are "just pausing, just trying to see what's going on next."

But his tone sounded much more optimistic compared to the prior conference call, due in part to increased visibility around Brexit, the U.S.-Mexico-Canada trade deal, and the passage of the first phase of the China trade deal. These were offset, however, by some uncertainty related to the coronavirus.

"And we expect that, given some of this uncertainty has now dissipated notwithstanding what we see, obviously from the virus," Robbins added, "that hopefully we'll see our customers pick up again."

Later Robbins added with regards to the environment and customer spending that, "we actually feel really good." This sentiment is much better than what we heard last quarter and offers investors hope that there is a light at the end of the tunnel.

All in, the quarter looks just OK against low expectations. The heart of the issue right now is that Cisco operates in the enterprise space, which is weak compared to consumer-facing businesses. As you can tell by the recent results (with guidance), sales are down year-over-year because the economic environment has been challenging. Buy we think management has done a great job managing its portfolio during this period by focusing on faster growing areas like security and software and being disciplined with price. The software transformation and benefits from pricing are key reasons why Cisco has been able to expand margins and maintain earnings power off less a declining revenue base.

Obviously, a key issue here is that customers are still taking a long time with their decision-making cycles, per management. But as a glimmer of hope, this could change later in the year as we move past the macro uncertainties related to Brexit, China trade and so on.

That brings us to the question: At the current stock price, is the roughly 2.9% yield enough compensation for our patience as we wait for the long-term drivers to materialize and spending to pick up again?

That's our debate and at the time this was written we are leaning towards "yes," because we know Cisco will benefit from several significant secular growth drivers down the road such as 5G, Wi-Fi-6, 400G, and the shift to the cloud. The internet is transforming for the 5G era, and as we know from the innovations management unveiled at its December event here, Cisco's technological innovations will be a part of that. Spending will pick up again to meet these needs.

Plus, at about 15-times consensus earnings, we continue to think CSCO is one tech stock with a reasonable valuation, but stands to benefit from what's in store over the next few years.

And it's worth noting that the financial comparisons will get easier over the next few quarters as the company moves past prior strength in the enterprise and Campus 9K ramp.

Therefore, we will maintain our TWO rating and consider CSCO a hold because we think we will regret it if we sell down here.