Monday, January 6, 2014

Cisco Upgrades Guidance For 2015-2017

Cisco's recent financial analyst conference wasn't taken well by the market, but many commentators missed the fact that Cisco's guidance implied an upgrading of expectations for 2015-2017. It's time to look at what its management actually said about future earnings growth, and decide whether you believe Cisco can hit its targets.

Cisco upgrades guidance for 2015-2017
Cisco's management previously outlined its expectations for 5%-7% revenue growth on a compound annual growth rate, or CAGR, for the next three to five years. Fast-forward to the recent analyst conference, and management seemed to downgrade expectations by lowering projections for three-to-five-year growth to 3%-6%.

It sounds bad, but actually it's a hike in expectations post-2014. Playing with these assumptions and the updated analyst forecast for a disappointing 2014 gives the following table. The mid-point of Cisco's guidance is taken as the base scenario.

Revenue ($bn) 2011 2012 2013 2014 2015 2016 2017 CAGR from 2013-2017
 Old guidance  43.2  46.1  48.6  51.5  54.6  57.9  61.4  6%
 Growth (%)  7.9  6.7  5.4  6.0  6.0  6.0  6.0  
 Old adjusted  43.2  46.1  48.6  46.4  49.2  52.1  55.3  3.3%
 Growth (%)  7.9  6.7  5.4  -4.5  6.0  6.0  6.0  
 New guidance  43.2  46.1  48.6  46.4  50.0  53.8  58  4.5%
 Growth (%)  7.9  6.7  5.4  -4.5  7.7  7.7  7.7  

Source: Google Finance, company presentations, author's analysis

"Old guidance" refers to what Cisco would have achieved had it hit the 6% CAGR target from 2011. "Old adjusted" is what Cisco would have achieved if management had said something like, "2014 is a bad year, but after that we are sticking to our 5%-7% long-term growth target."

In fact, the new guidance is for revenue growth of 3%-6% CAGR from 2013. When CFO Frank Calderoni was questioned on this matter, he categorically replied, "Yes, it's certainly 2013 as a base year."  

Foolish investors will note that the "new guidance" implies higher revenue in 2015-2017 than if Cisco had left its post-2014 targets at 5%-7% revenue growth.

Do you believe in Cisco's numbers?
No one is obliged to believe that Cisco will hit this guidance, but if it does, then the stock certainly looks cheap. Cisco has approximately $5.45 billion in net cash, and stripping it out of the market cap means the stock trades on just 7.7 times forward earnings estimates of $1.99.

Cisco's guidance relies on a two-track process of slow growth in its core business (switching and routing), and faster growth in non-core areas like cloud, mobility and wireless, and security. Services growth is contingent upon hardware sales, so it can't be considered in isolation.

Growth Driver  3-5 year CAGR
 Core  0% to 1%
 Data Center  20% to 25%
 Mobility & Wireless  9% to 13%
 Security  10% to 15%
 Services  7% to 10%
 Total  3% to 6%

Source: Company presentations

Why the market is skepticalIts valuation suggests that the market is skeptical. One reason is possibly because investors are tired of seeing management's failure to generate significant shareholder value.

Cisco's management hasn't covered itself in glory with its acquisition policy in recent years. For example, Cisco bought Pure Digital Technologies in 2009 for $590 million, only to close its Flip video camera business two years later as smartphones started integrating video cameras. Moreover, Tandberg (video conferencing) was bought in 2010 for $3.3 billion. Below is the segment's revenue since Tandberg was integrated. Although the former Tandberg operations are not broken out, the numbers don't suggest it's been a success. In addition, its videoconferencing rival, Polycom, has struggled, too. In other words, it wasn't a great industry for investors.

Source: company presentations.

Another example is the $6.6 billion acquisition of set-top box manufacturer Scientific-Atlanta in 2006. Cisco is now facing problems with its set top boxes. Service provider revenue fell 13% in the first quarter, with 6% due to the 20% decline in set top box sales.  Essentially, Cisco is transitioning its traditional set-top boxes toward cloud-enabled ones. The result was a delay in the purchasing of new products by customers while Cisco decided to keep margins up by rejecting low profit deals on the older technology. This sort of transitional problem is typical in technology and usually tends to be sorted out in a quarter or two. Nevertheless, some analysts are calling for Cisco to exit the business altogether. Again, it doesn't suggest the acquisition was a particularly strong move by Cisco.

Where next for Cisco?Cisco is definitely facing some structural growth issues, and management has struggled to generate shareholder value for some time now. On the other hand, the stock is so hated by Wall Street that its valuation has become compelling.

Cisco just implied better growth from 2015-2017, and the market seems to have (initially, at least) chosen not to believe it. The market has cause to be skeptical, but provided Cisco hits its revenue projections, the stock is a good value on a risk/reward basis.

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