Wednesday, November 20, 2013

Cisco Is A Good Value Trade

Shareholders in Cisco Systems  saw their investment crash after lackluster first-quarter results. The stock is now down around 20% from its yearly high in August. With the mid-point of its 2014 guidance implying a 1% fall in earnings, is now the time to give up on the stock, or to buy in?

Cisco's nasty quarter
Cisco beat earnings estimates for the quarter but missed revenue expectations, and its near-term outlook is horrible. Its orders in the quarter were $600 million -- $700 million short of its own expectations -- a problem for a company with 70% of product revenues dependent on new orders each quarter. With this shortfall in place, its second-quarter EPS guidance of $0.45-$0.47 came in nearly 8% below analyst estimates at the mid-point.

There are two key problems.

First, Cisco basically repeated what IBM   said earlier in the earnings season with regard to demand in emerging markets. Both companies had reported some second-quarter weakness in the BRICs, but IBM's disclosure that its Chinese sales declined 22% in the third quarter -- with hardware down 40% -- was a big surprise.

Fast-forward to Cisco's third-quarter results, and the weakness seems to have spread out. Here is CEO John Chambers on the subject:

Every one of our top 10 emerging countries missed their forecast and was off by a fair amount. So it wasn't just that it was down, the last couple of weeks, they kept dropping and dropping... ... it was over half of our shortfall, the last couple of weeks versus forecast.

Frankly, it's puzzling as to why Cisco's performance in emerging markets was so weak across the board. China was down 18% -- in line with what IBM reported -- but why should Russia and Brazil be down 30% and 25%, respectively?

One possible answer can be construed from something that CEO Chambers mentioned in the conference call. He argued that Cisco went into the last month of the previous quarter "a little bit off the numbers we expected." But in the last two weeks of the quarter, its orders came in $300 million more than forecast. It's possible that Cisco's emerging market weakness was exacerbated in this quarter because in the previous quarter its sales people pushed hard to make the numbers.

The second issue was the 14% fall in service-provider video revenues, while orders also disappointed with a 13% decline. Cisco's set-top box sales declined 20%, and since they make up 20% of revenue from service providers -- which makes up more than 8% of total revenue -- the impact was significant.  Cisco's challenge is to manage the transition from traditional set-top boxes toward its set-top boxes that connect with the cloud. In fact, this has been an ongoing issue this year. It seems that sales of its new products were disappointing, and Cisco continued to follow a policy of "walking away" from low-profit deals with the older technology. Good for margins, terrible for revenue growth.

Four reasons to stay positive?
If you can see a clear pathway through the gloom and doom, there are four reasons why the stock looks attractive.

First, Cisco described its U.S. enterprise and commercial growth as being very strong and cited order growth in the high single digits. This matches what Oracle    said at its earnings in September. Oracle saw its new software-license and cloud subscriptions rise 14% in America. This is a sign that the U.S. -- particularly in enterprise -- is the standout region for IT spending growth. It's a good sign for U.S. growth.

Second, the set-top box issue is a structural problem, but Cisco is managing it, and has products in place. Further, plenty of IT companies see some issues when they introduce new products or make transitions in technology. Companies can be reticent to spend on an old system when a new one is available, yet also careful not to rush to buy and integrate a new technology. However, provided the underlying demand is there, these issues can be sorted out in a few quarters. For example, tech companies like F5 Networks and Check Point Software have seen these issues over the last year.

Third, Cisco was obviously disappointed with its performance in emerging markets, particularly late in the quarter. This means it's likely that the updated guidance has been reset with current trading in mind. If BRIC spending picks up, then Cisco could surprise on the upside going forward. In any case, emerging-market demand does tend to be volatile.

Finally, the company has $48.2 billion in cash and cash-like investments, while total debt is only $16.2 billion. In other words, its net cash of $32 billion represents around 29% of its market cap. Cisco has the resources to make earnings-enhancing acquisitions.

Time to buy Cisco?
Cisco is going to attract value hunters. Even on its disappointing $1.95-$2.05 EPS guidance, the stock still sells at a P/E ratio of around 10.5 times forward earnings. It's not the highest-quality technology company out there, but it's cheap, and it has opportunities to turn around its fortunes. Throw in a near-3% dividend yield and you can enjoy some income while you wait.

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