Thursday, 13 February 2014

Cisco - still that bottoming feeling?

Back in December, after a capital markets day presentation, I wrote a note on Cisco entitled 'Cisco - that bottoming feeling?'.  The key conclusion of that report - as the Cisco share price fell to a near US$20 level - was that:

'The scope for attractive proportional capital returns to the shareholders remain material given a current EV of US$81bn and a pay-out ratio of at least 50%.  Personally I think they can haul back on the acquisitions and pay closer to 75%.  With a 10%+ dividend/buyback return to shareholders and structural growth is tough to go wrong'

That was a good mid-December call.  As shown below the share did not print below US$20 and rallied up to almost US$23 at the close yesterday.  Today however futures are suggesting the stock should open up at about US$22 after the company's latest quarterly earnings update.  What did they say?

Using Seeking Alpha, the headline numbers actually exceeded hopes...the issue was more in the mix:
'Cisco Systems, Inc. (CSCO): FQ2 EPS of $0.47 beats by $0.01.Revenue of $11.2B (-7.4% Y/Y) beats by $170M...Cisco (CSCO) guides on its CC for FQ3 EPS of $0.47-$0.49, in-line with a $0.46 consensus. The company also reiterates FY14 EPS guidance of $1.95-$2.05 (consensus is at $1.98). However, the networking giant adds its orders fell 4% Y/Y for the second quarter in a row'
Orders...back in December I noted the culprit was more the emerging markets, how about this time?
'emerging markets orders only fell 3% Y/Y in FQ2, after dropping 12% in FQ1. However, service provider orders fell 12% after falling 13% in FQ2; that figure likely suggests additional share loss'
So it is a new area...any further detail?
'The main culprits: Switch orders fell 6%, router orders 5%, and (thanks to plunging set-top sales) service provider video orders 20%'
That sounds pretty...core (switch and router revenues are 60% of the overall Cisco revenue mix).  At least though gross margins edged up to 67.8% from 66.3% a year ago helped by a US$270 million reduction in operating expenses. How about the balance sheet?

'Cisco (CSCO) uses its FQ2 report to announce a $0.02/share increase in its quarterly dividend to $0.19/share. Shares now sport a 3.3% yield. Cisco, which added $15B to its buyback three months ago, also says it bought back $4B worth of shares (over 3% of outstanding shares) in FQ2 at an average price of $21.73'

Interesting average price paid...and I like the run-rate: US$16bn annualised would be a good bump up and well on the way to the 75%+ pay out ratio I hoped for in December. 

So here's the challenge, opportunity and threat summary for Cisco.  The challenge (and threat) is clearly to morph the core router/switch business to the opportunity that is 'the internet of everything'.  That's not easy: different requirements, customers, technologies.  My December review of their investor day showed some interesting charts on their high market share and interests in this area.
Meanwhile whilst they do that the underlying business in the low US$20s trades on c. x8 EV/ebit with a 3%+ dividend yield and the potential to easily return 10%+ of market cap.  These are statistics I like.  Back in December I did not think Cisco would go below US$20 and bought accordingly.  I retain that view and will augment accordingly. 
Regarding Cisco shares, I still have that bottoming feeling.

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