Analysis: CSCO TWO

After you receive this Alert, we will be initiating a position in Cisco Systems (CSCO) , buying 1,000 shares at roughly $52.79. In addition, we will be exiting our position in Take-Two Interactive Software T (TWO) , selling 200 shares at roughly $178.12. Following the trades, CSCO and TTWO will represent 1.40% and 0% of the portfolio, respectively.

We are bringing CSCO out of the Bullpen and into the portfolio as this sale of TTWO will make room for this additional name. You can read our initial Bullpen Alert on CSCO here. The company's 2020 annual report can be found at this site.

In our Bullpen piece, we discussed why Cisco should not have traded lower after the company reported its fiscal third-quarter results.

The quarter was solid, with revenues growing 7%, year over year, and topping expectations. Adjusted earnings per share grew 5% YoY and exceeded the consensus estimate by a penny.

Cisco also said its total product orders grew 10% YoY, representing the strongest demand in nearly a decade, and this bullish view about the future should not be overlooked. Cisco is in a great position to benefit from the recovery in Enterprise spending and upgrades to support a hybrid growth environment. In fact, hybrid work is one of several growth opportunities in which the company is currently experiencing broad-based demand.

"The next phase of the recovery and the future of work will be heavily reliant on our technology. Cisco's end-to-end portfolio will serve as the foundation for next-generation infrastructure solutions as well as cloud-enabled delivery models and innovation, allowing our customers to move with even greater speed and agility. This will require a significant investment cycle and reinforces the strength of our strategy while driving greater opportunity to create a world that is more connected, inclusive and secure," CEO Chuck Robbins explained on the recent earnings call.

Digital transformation and the cloud represent two other important themes, while the 5G technology represents more of a long-term growth driver.

In addition to positive industry trends, the company's ongoing transition from hardware to more software/subscription sales represents a self-help initiative that we like. In the recent quarter, 81% of software revenue was sold as a subscription, up from 76% last quarter. As more of Cisco's sales become software/subscription based, the volatility of earnings (less cyclicality) should decline while quality of earnings (higher margins) should improve. We expect CSCO's price to earnings multiple to re-rate higher as management executes on this long-term strategy.

Although guidance was underwhelming and the earnings outlook was a few pennies below estimates, we thought it came from a good reason that must be overlooked. As management explained on the earnings call, Cisco is currently experiencing higher input costs related to semiconductor constraints and freight. Instead of passing these higher costs over to its customers, Cisco is instead choosing to be thoughtful with its price increases and prefers to take care of its customers today in order to improve its relationship and positioning with them over the long term. Taking care of customers is always good business. Plus, we like starting our position here when we are nearing the point of peak concentrations within the supply chain and margins because it means things will only improve from here.

Lastly, we like how management consistently returns a ton of cash to shareholders. Cisco just bought back about half a billion dollars worth of shares in the recent quarter, and $8.7 billion remains under the current authorization. Furthermore, the stock offers a healthy 2.8% dividend yield. Management has also increased its payout for seven consecutive years.

We are initiating the position with a $58 price target, which reflects roughly 17x consensus fiscal year 2022 adjusted EPS estimates. That being said, we believe there is more room for upside here, both on further multiple expansion and also on earnings growth should management prove they can execute its ongoing transition toward higher-margin software subscription and services and the recovery in enterprise IT spend proves stronger than anticipated.

Our decision to exit Take-Two Interactive comes after the stock has rebounded about 10% from its lows. We think the story has gotten too hard with video-game spend expected to take a back seat in the summer months as people get outside and enjoy activities they could not regularly pursue during the pandemic. We also consider fiscal 2022 as more of a transition year for the company due to the limited amount of new core titles the company plans to release.

This could be a name to look back to six to 12 months from now after we gain more clarity into the pipeline's immersive core releases and perhaps even the highly anticipated, but incredibly secretive next iteration of Grand Theft Auto. The company's fiscal 2023 and fiscal 2024 years are when the company is really expected to shine, with over 40 titles expected to be released over this period.

But for now we would rather be in a Cisco, which is expected to have better earnings growth over the next four quarters, trades at a cheaper multiple, and pays a very solid dividend.

We are not selling the position at our highest prices. Between Dec. 8 and Dec. 18, 2020 we sold a total of 300 shares at prices ranging from about $184 in our Alert here to as high as around $201 in our Alert here. But we'll still exit the remainder of our position with a solid average gain of about 8%.