Cisco Sell-Off Offers Buying Opportunity
We think long-term-oriented investors seeking dividend yield with income growth potential should consider buying into market price weakness.
Cisco Systems' (CSCO) first-quarter results were a bit disappointing, although gross margin came in moderately above our full-year forecast and operating cash flow was solid. Management's second-quarter guidance for revenue to decline 8%-10% year over year was shockingly disappointing, however, and reopens key questions surrounding management's execution, Cisco's competitive position in emerging markets, and ongoing pressures from cloud computing.
After incorporating management's outlook and slightly increasing our gross margin forecast, our key five-year explicit model inputs include 2% annualized revenue growth (3% previously), 61% average GAAP gross margin (60% previously), and 20% net income margin (19% previously). The net effect is no change to our $26 fair value estimate, and we are maintaining our wide economic moat rating. The shares are likely to come under significant pressure, and we think long-term-oriented investors seeking dividend yield with income growth potential should consider buying into market price weakness.
Cisco is facing three primary headwinds to revenue growth. First, it faces much stronger competition in China and emerging markets than it does in North America, as Huawei is dominant in China and very strong in emerging markets. Macroeconomic weakness and ongoing political tension between the U.S. and China with respect to national security issues have exacerbated Cisco's challenges in the region. We don't see any clear way for Cisco to be competitive in China for the foreseeable future. These issues cut both ways, however, as the U.S. House Intelligence Committee has recommended that U.S. service providers and enterprises direct networking equipment purchases away from Huawei. We estimate that North America accounts for more than 50% of Cisco's total revenue, while China accounts for less than 10% and emerging markets in total account for 22%. We think Cisco will remain dominant in North America, Huawei in China, and competition will be most intense in Western Europe, Latin America, and emerging economies.
Second, management is working through product cycle transitions and business model transitions, and the firm is struggling to find a steady cadence as it evolves its product portfolio. For example, Cisco is walking away from low-margin set-top box hardware business, while migrating its service provider video business to a cloud-based recurring revenue model built around its 2012 acquisition of NDS. We view this as an appropriate strategy, given our view that the set-top box industry is fully commodified and manufacturers face meaningful obsolescence risk. Moreover, NDS gross margins are well above Cisco's corporate average and the firm has multiyear agreements in place that provide better revenue visibility. Still, we estimate that the shift is resulting in about a $400 million loss of low-margin hardware revenue, or more than a 3-percentage-point headwind to revenue growth. Cisco is undergoing similar transitions across its unified communication business, video conferencing business, and security business, and it is generally looking to shift more of its revenue from a product/license model to a subscription model.
Third, we believe cloud computing is beginning to have a more pronounced effect on Cisco's operating model. While we maintain our view that the majority of IT workloads will remain in traditional enterprise data centers, rather than public clouds, there is little question that an increasing number of workloads are shifting to public clouds provided by companies like Amazon (AMZN), Microsoft (MSFT), Google (GOOG) , and Rackspace RACK. This affects Cisco and other hardware suppliers in two ways. First, these cloud service providers are generally more sophisticated and have more negotiating leverage than most traditional enterprises. They are forcing Cisco to adapt its product portfolio and will demand ongoing price concessions. Second, many traditional service providers, and to a lesser extent large enterprises, pay close attention to how these CSPs design and operate their IT infrastructure, essentially looking at these customers as leading-edge data center operators. To the extent that an increasing number of firms look to emulate the large cloud service providers, Cisco could face increasing competition in other customer accounts.
Despite all of these pressures, we think Cisco is well positioned to post modest free cash flow growth over the next several years, and this quarter included some positive data points. First, first-quarter free cash flow grew 6% year over year to $2.3 billion, and management's full-year non-GAAP net income guidance suggests to us that free cash flow may be resilient this year even as full-year revenue declines moderately.
Second, management remains committed to returning capital to shareholders. The firm paid out $914 million in dividends (compared with $744 million a year ago), and we expect Cisco's board will moderately increase the dividend again within the next six months. Net share repurchases consumed $1.4 billion, and management expects diluted share count to fall next quarter. We observe that Cisco's diluted share count has declined 12% since 2008.
Third, management continues to invest in its business while controlling expenses. The firm has spent $9.2 billion on acquisitions over the past five quarters, and research and development expense is at an all-time high. Despite this investment, Cisco's net cash position remains at $32 billion, approximately $5 billion above 2011 levels, while its first-quarter GAAP operating margin of 20% is one of the highest among its peers. We think the firm is doing a much better job of allocating capital and managing its portfolio, and we expect these efforts to pay off over the longer term.
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Grady Burkett does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.