Shares of Cisco Systems (NASDAQ: CSCO) have almost doubled over the last five years. It did this with the help of efforts to connect its hardware with a subscription component and expansion of the software and services. This has enabled Cisco to position itself for the next major trends in networking and Internet communication.
Recently, the stock has retreated somewhat after the fourth-quarter earnings report and guidance published in August. The network giant now trades in the region 14.5 times expected revenue for the year – a level that looks cheap compared to where it has been in recent years.
CSCO PE ratio (forward) data of YCharts.
While the stock has seen strong gains over the past half decade, the movement has been supported by similar earnings growth, free cash flow and dividends. Cisco's valuation does not look unreasonable, even in light of any long-term headwind, and long-term investors seeking a solid dividend yield and a market-consuming growth potential can see strong returns from the stock at current prices.
What to do with Cisco's long-term policy guidelines
Cisco's fourth-quarter sales rose about 6% to $ 13.4 billion, and non-GAAP (adjusted) earnings per share (EPS) rose 19% year-over-year before the year which comes in at $ 0.83. This brought the company's full-year revenue to $ 51.7 billion (up about 7% annually) and adjusted EPS for the period to $ 3.10 (up about 20%). The results in the fourth quarter actually topped the average analysts' estimates on both the top and bottom lines. But guidance for the first quarter overwhelmed investors, raising concerns that the broader tech sector is heading for a slowdown.
The company expects sales to reach between flat and 2% year over year growth in the current quarter, and the midpoint guidance for adjusted EPS of $ 0.81 represents a growth of about 8% over the prior period. This is a significant decline compared to the company's recent sales and earnings trajectories. And it comes even as it withdrew $ 4.5 billion in shares through buybacks last year and has spent billions on strengthening its position in fields such as cloud services, cybersecurity, analytics and wide-power wide area networks.
In a market that is trying to weigh the stresses caused by US-China trade conflicts and signs of weakening economies in other key markets such as Germany and the UK, Cisco's policies reflected concerns about potentially weakening macroeconomic conditions. Even in the midst of major growth trends for data transmission and Internet communications services, an economic downturn can be expected to weaken demand for Cisco products and services.
Management's statements on macro-level shifts in key markets that may contribute to softer demand in its service provider category can be worrying when taken together with a 21% drop in sales the previous year in Q4 in that category. But the long-term picture looks less worrying.
Image Source: Getty Images.  Get ready for the next big network press
Cisco's service provider segment has taken a hit in recent quarters, and the company expects some weakness for the segment to continue in the near term. But management suggests that much of the decline is due to companies raising the cost of radio equipment for the transition to 5G. It also said it would see a sales boom in the category when these businesses have basic technical equipment in place to support their transition to the new network technology.
Speaking below the company's third-quarter revenue (a period that was down 13% from the previous year for service provider orders), CEO Chuck Robbins had this to say about the macro spending trend and the company's outlook in 5G:
No. 1, the capex data we saw last quarter and even the forecast don't look incredibly healthy for these guys. But where they spend money primarily on 5G today, they build the macro radio part of their networks first. And they are leveraging their existing core network to run the early trials they have on 5G, basically. And we believe that sometime in the future when they have it – as the number of connections increases and capacity gets to a point – they will obviously start to expand in these new backbones dedicated to the 5G infrastructure, which is where we generally want to get into the picture.
Cisco was eventually going to get a significant boost from 5G, but it is worth noting that the company's router and switch hardware have long-standing pressure as more and more online networking capabilities may be capable of being performed through software. Companies including AT&T Amazon.com and Facebook have adopted white box router and switch solutions that recreate many of Cisco's own hardware capabilities for uploading cloud server tasks – and they are available to businesses at a significantly lower price upfront than the network giant's overall device and service offerings.
Cisco itself admits that current switching systems are outdated and that the move is toward a more software-driven network environment where connectivity hubs are virtualized rather than cross-physical. Still, the company maintains a dominant position in its core exchange and exchange hardware markets, and it appears to be taking smart steps to reorganize to meet changing realities and customer needs in the network area.
A strong balance sheet and smart capital use
Cisco ended last year with $ 33.4 billion in cash and debt investments of about $ 25 billion – good for a net cash position of about $ 8 billion. This has been significantly reduced from the average net cash position over the past five years, mainly due to share repurchases. But it still has a healthy balance to work with and room to pursue further acquisitions to supplement the growing ecosystem of burgeoning services.
Its long-standing dominance of the router and barter markets allowed it to build a massive balance sheet, and recent acquisitions and moves to return value to shareholders through buybacks and dividends were helped by the opportunity to repatriate $ 67 billion in offshore cash to lower price with permission from the tax reform proposal for 2017. Concerns that money for share repurchases could have been better utilized in other areas does not seem very urgent in light of the large expenditures that have also gone towards acquisitions and preparations for the next generation of network technologies.
The company has found success in building the recurring revenue side of business, transferring customers and adding new customers to software-as-a-service plans that tend to be more reliable and profitable over time. Along with buybacks, continued success on these lines should help Cisco increase revenue and free cash flow per share.
CSCO Free Cash Flow Per Share (TTM) ) data from YCharts. TTM = subsequent 12 months.
The stock also comes with a significant dividend, providing a roughly 3% return. It has an eight-year history of subsequent annual dividend growth, and a reasonable payout ratio of 54% despite having increased its dividend by 84% over the past five years and more than 480% since it began to pay dividends in 2011. Management plans to retain its share of the free cash flow returned to shareholders through share buybacks and dividends of at least 50%. As long as things continue to work out on that front, investors can probably look forward to substantial dividend growth.
Those who are concerned about a major setback in the technology space amid a potential recession or other cause of broader stock market sales may not see much reason to jump into Cisco at current prices. On the other hand, the stock offers an attractive dividend and is supported by a healthy balance sheet and a relatively solid business, and there is a good chance that long-term investors will see strong returns.
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