Cisco Stock Is A Buy After Q2 Earnings Beat And Strong Guidance

  • Cisco beats on the top and bottom lines. Guidance very strong for its fiscal third quarter of 2016.
  • Routing recovers but switches division declines. Only a matter of time before Cisco's service division becomes the biggest.
  • Big hike in the dividend will please shareholders. Furthermore, the approved extra share buybacks will the stock trading at a historic low earnings multiple is bullish for the share price in the near-term.

The "move to digital" was the main theme on Cisco (NASDAQ:CSCO) earnings conference call on the 10th of February after market close. Cisco produced an impressive set of Q2 earnings (EPS of $0.57 non-GAAP and $0.62 GAAP) beating estimates of $0.54 per share by some distance considering the weak guidance it had for this quarter. Revenue came in at $11.8 billion (excluding a divestiture from the SP Video CPE Business which was $93 million) which also beat estimates of $11.76 billion but it was fiscal third quarter guidance that really made the stock rally hard. Cisco is guiding a jump in year over year revenues of 1 to 4% this coming quarter and if this comes to pass on the high part of the range (like it did in Q2), then top line sales could come in as high as $12.62 billion.

Cisco always is conservative with its guidance numbers so this figure is easily attainable. If there were any lingering doubts that investors had about Cisco's longevity, I believe they were answered in this set of earnings results. Why? Well, routing bounced back this quarter reporting $1.845 billion in revenues and growth of 5% compared to fiscal Q2 in 2015. This was important because of the 8% decline in the first quarter but also because this division and switching make up almost 50% of revenues.

Routing revenue growth has been flagged by some analysts as being at risk due to telecom service providers seeking alternative solutions so growth here definitely was welcome. However, switching revenues dropped by 4% to $3.48 billion which was probably priced into the Cisco stock despite this division growing by 5% in the first quarter. Revenue growth has been poor of late in switching despite management's bullish calls on the new generation switches which are expected to make a difference around the fag end of 2016. Only time will tell whether this division can regain its former glory but the market it seems has priced in lower growth here plus declining margins.

Nevertheless being able to report a quarter with net income of $2.9 billion ($500 million gain on Q2-2015) despite having switching revenues fall by 4% has to be taken as a positive by investors. What was really encouraging was the 3% growth in the service division which brought revenues to $2.94 billion for the quarter. This division has very high margins and should be able to offset many of the competitive pressures the company will undoubtedly come up against in its switching and routing divisions.

Investors are going to become very interested once service revenues overtake switching top line sales which should happen in the near term. Why? Well, this division is less volatile and should become even more profitable in the future due to nature of this business. I have always written that Cisco's ever increasing stable high margin recurring income from its servicing division will eventually put a floor under Cisco stock and now the bottom may be in.

Analysts on the conference call were understandably interested in why Data Center sales fell by 3%. This division was the fastest growing division in the first quarter growing by 24% to $859 million but in Cisco's second quarter, sales dropped by 3% to $822 million. Management stated that macro factors influenced results in the second quarter and that the company's fiscal first quarter always has more demand than other periods of the year.

A lot of investment is being pumped into the rolling out of "next generation data centers" so management is confident this division can keep growing at elevated rates. Despite the decline this quarter, I don't see any need for alarm because this division's percentage of overall revenues is basically flat on a rolling year basis (currently it is 6.9%). Nevertheless, this division produced 24% growth rates last quarter so shareholders will be hoping the macro-economic situation calms down a touch to enable Data Center sales to get to $1 billion a quarter as quickly as possible.

As a result of the strong top and bottom line growth, the company decided to raise the quarterly dividend by $0.05 to $0.26 which is a whopping 24% increase over 2015. Furthermore, the company has authorized an extra $15 billion in stock repurchases which again makes sense considering the huge $3.6 billion the company reported in free cash flow in its second fiscal quarter. Quarterly dividend payments will now rise to $1.32 billion which would give Cisco stock a yield of around 4.33% with the share price at around $24 a share.

Management also announced that it would be borrowing capital going forward which it can do with ease given the strength of its balance sheet. This is common in large caps that return billions of dollars every year to their shareholders. Companies such as Cisco and McDonalds (NYSE:MCD) prefer to return a sizable amount of cash flow to shareholders and then borrow on the strength of their balance sheets to invest in the business.

Finally, management stated that strong execution in the near term would be combined with investment in innovation for the future. Cisco has the balance sheet to consistently reward shareholders and invest aggressively for the long term. The target for operating margin is 30% which is still about 2.4% away from where the company is at the moment but through more quality acquisitions and more productivity, it can definitely get there in time.

To sum up, Cisco produced a very impressive set of earnings results but it was next quarter's guidance that really made all the difference. Best performers were Service revenues jumping by 3%, collaborations by 3%, routing by 5% and security by 11%. Service will top $3 billion a quarter and security $500 million any quarter now which illustrates the company's successful ongoing shift to software and recurring revenue. Furthermore, a now 4%+ yield in the tech industry is bound to attract more investors which will keep Cisco stock elevated over time.

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