We Add Cisco Systems Back Again, After 20 Years. It's Time
Cisco (CSCO: $50)
Coverage initiated June 1, 2023 at $50 in the Long-Term Growth portfolio
Silicon Valley-based Cisco Systems (CSCO) stands as a shining example of a promising wunderkind that continuously pushes the boundaries of its potential. The four-decades-old company, which was once pegged to be the first trillion-dollar company, still trades below its all-time high of $77 during the dotcom bubble 24 years ago, despite a multifold rise in revenues, profits, and free cash flows during the same period. For years, the company has consistently pioneered groundbreaking new innovations, either via in-house developments, acquisitions, or partnerships, only to lose ground to fresh upstarts in those very segments. A prime example of this is WebEx, its video conferencing solution that was thoroughly outstripped by Zoom, despite having a head start and an established base of enterprise customers.
That being said, however, Cisco is far from the boring tech conglomerate that its valuations currently reflect. While the company is no longer plastered in headlines, or a mainstay in tech conversations as it once was, its products still play a crucial role in the broader ecosystem, particularly in its core networking business. This is precisely what makes the company such a compelling buy, especially at current valuations.
Enviable Product Mix
Cisco makes a broad range of networking and communication equipment that has long been dubbed the ‘backbone of the internet.’ From routers and switches to industrial networking and data center infrastructure, the company is an indisputable giant in this segment, with a market share of over 45% in ethernet switches. Gartner consistently crowns it as the lead in wired and wireless infrastructure.
During its third quarter results two weeks ago, the company posted a robust performance across the board, in the face of headwinds such as inflationary pressures, supply chain issues, unpredictable market dynamics, and economic uncertainties, among other things. We see this as a testament to Cisco’s products and services, which are still the backbone of networking infrastructure across enterprise organizations.
In addition to this, the company is now a sizable player in the hyperscale and AI markets, with its Silicon One Architecture, which is known for its efficient power consumption, which is crucial for hyperscale. Its recent acquisitions of ThousandEyes and AppDynamics have helped further bolster its profile in the observability space, which has since grown to become a vital element of the hybrid work environment. What is hyperscale? Hyperscale describes a system or technology architecture's ability to scale as demand for resources gets added to it. Examples of hyperscalers are Amazon AWS, Microsoft Azure, Google GCP, Alibaba AliCloud, IBM, and Oracle. As you can see, Cisco is right smack in the middle of this huge growth market.
Recurring Revenue
One reason Cisco has continued to underperform its big-tech rivals is its overreliance on hardware. In general, hardware companies come with a lot of baggage and are more prone to macro headwinds such as the present supply-chain constraints and inflationary pressures. Excepting Apple, hardware is a tough spot to be in this day and age.
Over a decade ago, Cisco recognized the importance of this and has since consistently strived for and witnessed a transition towards services and recurring revenues throughout its product range. While hardware still remains at the core of its offerings, starting in 2012, the company has quietly transitioned into a machine for services and recurring subscriptions, and this is precisely what our investment thesis is currently based on.
This was the logical next step for the company in order to build steady revenues. After all, even at large enterprises, it is rather rare to upgrade switches, access points, and firewalls on a regular basis. This transition has since paid off handsomely, with Cisco reporting monumental growth in subscription revenues, and in increasing remaining performance obligations, at $6 billion and $17 billion, respectively.
This shift has fundamentally altered the outlook of this stock, from being a low-margin peddler of utilities to a scalable, predictable, and largely low-overhead operating model. This shift further makes the company more resilient in challenging times, making it less prone to macro shocks, as no matter how dire the situation gets, large enterprises are unlikely to scale back on their wireless infrastructure.
Risk Factors
While this decade-long transformation has been off to a great start, it is not without its risks, or at least certain presumed risks. In recent months, investors have grown increasingly concerned about the company losing market share in its core networking business. Its well-known customers have been leaving in droves in favor of competitors such as Juniper Networks and Arista Networks.
This, however, is largely overblown in our opinion, as the company, being the dominant player in the market, is more prone to macro shocks, and will further bear the brunt of most competitive pressures as opposed to players with a smaller share of the pie. As a result, the stock has remained under pressure over the past few months, but things will subside as better sense starts to prevail.
Financial Analysis
The last four years of revenues have been solid, but flat. The company hit $52 billion in 2019 and then was hurt by the pandemic in 2020 and 2021 reporting $49 billion and $50 billion respectively. Fiscal 2022 ending in July last year saw $51.5 billion, and the company did $14.7 billion in the quarter ending April 30th, 2023, giving it a run-rate of $59 billion. The company is quite profitable, producing $4.1 billion in profits last quarter, a profitability rate of a huge 28% after tax. Very strong. Guidance: The company has predicted future growth rates of revenues at 15%, earnings per share of $1.05 for the quarter, and $3.80 cents for the full year ending July 31, 2023.
From the company in its recent quarterly report: Capital Allocation -- In the third quarter of fiscal 2023, we returned $2.9 billion to stockholders through share buybacks and dividends. We declared and paid a cash dividend of $0.39 per common share, or $1.6 billion, and repurchased approximately 25 million shares of common stock under our stock repurchase program at an average price of $49.45 per share for an aggregate purchase price of $1.3 billion. The remaining authorized amount for stock repurchases under the program is $12.2 billion with no termination date.
Icing On The Cake
Cisco’s core business, products, and fundamentals are beyond reproach, and now comes the icing on the cake, which is the company’s generous capital returns program. Since instituting its dividend program in 2011, it has been increased consecutively for 11 years, marking a 550% increase as of today. This represents an annualized yield of 3.1%, with a payout ratio of 43%, the best among the tech giants.
In addition to this, the company is all the more generous when it comes to its stock buybacks, having repurchased nearly 25% of its total shares outstanding since the end of 2013. During its recent third quarter results, the company similarly announced $1.6 billion in dividends and $1.3 billion in buybacks, with a further $12.2 billion in repurchase authorizations pending, with no expiration date mentioned.
All of this shows management’s confidence in the company’s steady cash flows, especially as it transitions to the subscription-based model. On top of this, the company has made remarkable strides when it comes to profit margins and free cash flow yields, in the face of substantial macro headwinds, ranging from inflation, supply issues, and waning demand.
BMR Take
Cisco is an outlier among the big-tech giants, trading at under 4 times sales, and a mere 12 times its free cash flow. During its third quarter results two weeks ago, the company posted a handy beat on estimates, with $14.6 billion in revenues, up 14% YoY, and a profit of $4.1 billion, or $1.00 per share. This was in addition to the boost in guidance figures, and yet the stock received a somber reception when the markets opened the following day. The company has $23 billion in cash, up from $19 billion last year, and less than $10 billion in debt. Cash Flow from Operating Activities -- $5.2 billion for the third quarter of fiscal 2023, an increase of 43% compared with $3.7 billion for the third quarter of fiscal 2022.
All of this points towards substantial coiled potential that is just waiting to be released, apart from the robust technical factors, with the RSI already above 75 and continuing to gain strength week after week, following the results. The old is forever new again. We believe we have found a diamond in the rough and we will be rewarded in the company years with the continued growth of big tech, electronics, wireless, computing power, networking, mobile and the like. Or, we could have just said we believe in Moore’s Law. Long live Gordon Moore’s legacy.
Added to our Long Term Growth Portfolio today, our initial Target is $60 with a Sell Price of $41. But we can see the day when Cisco hits triple digits.
