Shares of Cisco Systems (Nasdaq: CSCO) were under heavy selling pressure late last week, falling as much as 6.2% to a session low of $29.61 even though the company reported fiscal first-quarter results that beat Wall Street’s estimates on both the top and bottom lines.
The problem? The network equipment giant spooked investors with weak guidance for the fiscal second quarter.
[ad#Google Adsense 336×280-IA]But does the guidance justify the punishment?
If you recall, Cisco in July basically telegraphed the level of weakness within the telecom sector by issuing a combination of mixed fiscal fourth-quarter earnings and downbeat order metrics.
Cisco hinted that telecommunication companies such as AT&T, Inc. (NYSE: T) and Comcast Communications (NYSE: CMCSA) were delaying purchases, and in some cases, not buying anything at all.
These headwinds culminated on what Cisco announced on November 16.
For the three months that ended October, the San Francisco-based company reported fiscal first quarter adjusted earnings per share of 61 cents, marking a 3% rise year over year, on revenue of $12.35 billion, which climbed about 1% year over year. Both measures surpassed analyst estimates of 59 cents per share on $12.33 billion in revenue, according to analysts polled by Thomson Reuters.
The beat on revenue was driven by 7% jump in the services segment. Services growth is an important aspect of the results. Likewise, Cisco showed strength in the security business, which grew better than 11% year over year. Not only do these businesses generate higher profit margins but, when combined with product subscriptions revenue, they are a part of CEO Chuck Robbins’ many initiatives to implement a recurring revenue model at Cisco.
Cisco also reported a 12% rise in deferred revenue, which reached $17 billion, while Cisco’s total-product deferred revenue grew a healthy 19%, driven by 48% surge in the subscription businesses. Deferred revenue of that size means Cisco will be able to realize those revenues in the quarters ahead. Likewise, Cisco’s earnings beat was driven by higher profit margins. The bottom line saw a boost in total company non-GAAP gross margin, which rose 30 basis points to 65.2%, thanks to — as I highlighted a moment ago — a revenue-mix shift toward services.
The Outlook Is Better Than It Sounds
These improvements boosted Cisco’s operating margin up to 31.6%, topping last year’s mark by 20 basis points. But the beat on both the top and bottom lines weren’t enough to offset the projected declines in the second quarter. Not only did Cisco guide for fiscal second quarter revenue to decline between 2% to 4% versus estimates for 2% growth, the company also forecasted adjusted earnings per share to be in the range of 55 cents to 57 cents per share, below consensus estimates for 59 cents.
While the downbeat guidance seem discouraging, Cisco is known for issuing conservative, if not dreadful, outlooks. The result has been twelve straight quarters of earnings beats, including topping analysts EPS estimates by at least 2 cents in five straight quarters. In other words, under-promising to over-deliver is one of Cisco’s many traits. And while the company knows its business, it also understands the unpredictable nature of its customers.
For instance, during the quarter, orders from Cisco’s enterprise customers rose 5%, marking two-percentage point acceleration from the fourth quarter. But commercial orders were up only about 1% during the quarter, down from 5% in the fourth quarter. Plus, as disappointing as the 5% decline in orders it received from telecoms in fourth quarter was, things were worse in the first quarter as telecom orders declined 12%.
Given these trends, Cisco, despite the downbeat outlook, doesn’t want to set itself up to fail and miss earnings in the second quarter, especially since there are no guarantees that orders from telecoms vendors will pickup. What we do know is that the company still makes a boatloads of money, as evidenced by $2.7 billion in reported cash flow from operations, which bodes well for future dividend payment increases and stock buybacks.
A Good Buying Opportunity
Combined with the fact that profit margins continuing to expand and Cisco’s core routing business still showing signs of life, it’s tough to ignore the buying opportunity this selloff in the stock has created. Cisco shares are now priced attractively at just 12 times fiscal 2017 estimates of $2.43 per share, which is a five-point discount to the S&P 500 Index.
Assuming the stock was priced on par with the rest of the market, it would trade today at around $37, or 23% higher than current levels. On top of that, Cisco’s 26-cent per share quarterly dividend yields a robust 3.28% annually, besting the 2.00% average yield paid out by companies in the S&P 500 Index.
Risks To Consider: Despite solid management, Cisco continues to deal with an unpredictable and often gloomy environment in telecom. Combined with pressures from foreign exchange currency that devalues its sales in overseas markets, Cisco will be forced to spend more to find growth, which may pressure EPS in the near term.
Action To Take: If you’re an existing shareholder, rest assured, the stock will bounce back as you collect the 3.3% yield. New investors considering Cisco should buy half of their expected position now and wait for President-elect Donald Trump to implement pro-business policies before taking more action.
— Richard Saintvilus
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Source: Street Authority