Cisco To Maintain Its Industry Leading Profit Margins

  • Cisco stock is cheap on a historic basis. Dividends and a strong balance sheet decrease downside risk.
  • Switching grew by 5% last quarter whereas Routing dropped by 8%. However Routing is expected to bounce back strongly.
  • Internet of Things will ensure top line growth remains strong at Cisco. Margin fears are overdone when one sees the growth of services and other software divisions.

Cisco (NASDAQ:CSCO) hasn't had a good start to the year. Cisco's share price is down by over 6% year to date which is on par with what the Nasdaq has lost in the year so far. Cisco stock is now trading around the $25.30, below its 50 and 200 day moving averages. Nevertheless it's 2015 august low and its 200 day moving average of $22.29 should provide strong support for this Cisco. I just believe the market might be overly bearish on Cisco stock, especially when you take into account the nasty sell-off following the lower than expected guidance for its Q2 2016. Since the market is always forward projecting, any change to perceived earnings in future quarters always impacts the stock in the present.

CSCO stock chart

Cisco stock price chart by

Investors need to understand whether weak guidance will become a sustained trend for Cisco, or if it will be a one-off event. Well "macroeconomic uncertainty" was the reason given for Cisco's weaker order growth for Q2-2016. This implies a "temporary" situation in itself but long term investors will remember what happened in 2007/2008 (when uncertainty gripped the equity markets) when the stock ended up being cut in half.

However, the difference between 2007 (when the stock topped $33 a share) and today are important to understand. Firstly the company had a price to sales ratio of around 5 back then, compared to 2.6 today. Secondly top lines are superior and trailing twelve months earnings are north of $9.5 billion which is far superior to bottom line numbers in 2007 or 2008. To put it into context, if Cisco were to drop to 2008 levels, the stock would have a price to sales ratio of just over 1 which value investors would not allow in this sector. The only years in which Cisco had lower price to sales ratios were in 2011 and 2012 (Average P/S ratio of 2.3) when the stock barely surpassed $20 a share, and if the stock keeps dropping we will be at those ratios soon. The difference now is that a dividend has been initiated, which again brings protection to the downside. Why? Well just look at the company's balance sheet. Over $59 billion in cash against a debt of just $21 billion in its last set of earnings.

Furthermore, its pay-out ratio is only 43% which is understandable when you see its trailing 12 months free cash flows of $11.6 billion (averaging almost $3 billion a quarter). Therefore I'm not surprised the company has raised its dividend so fast since its first dividend in 2011 (from $0.06 a share to currently $0.21). Why does the dividend add protection to the downside? Well its not so much the yield which is 3.31% presently but the staggering growth in its value. Furthermore, the next dividend payment is on the 20th of this month which will cost the company around $1.07 billion. This figure being much lower than the company's free cash flow average quarterly number augers well for the company to keep increasing the dividend at a healthy clip even in the event of stagnant earnings in the near term.

Moreover, I just think the market is overly bearish on Cisco's switching and routing products which make up the majority of sales for the company. While I agree that Cisco's margins will probably decline in these divisions over time (to around 56%), sales should stay elevated especially in the routing division. Routing fell 8% to $1.8 billion last quarter which was a timing issue really (of when orders were placed) and not a fundamental issue per se.  Furthermore this division to a large extent should benefit from growth in the security division as Cisco can bundle its hardware and software products together. Investors should remember that revenues in Cisco's security division grew by 7% last quarter. If these growth rates keep up, expect routing sales to remain elevated going forward.

Another growth factor is the "Internet of Things", which according to the company has the potential to be a market worth $19 trillion over the next 10 years. Its all about software, security and service which is why Cisco's recent acquisitions are software led. Recent partnerships such as the ones with Ericsson and Phillips confirm the company's intent in this area and it's understandable, given that the installed base for Internet of Things products is predicted to go up by a factor of five by 2020.

In the meantime however the bottom line is whether the company's revenues in routing and switching can remain elevated despite margins contracting, which to me looks likely. Last quarter, switching reported 5% growth which was a surprise on the up side, considering results from prior quarters. As Cisco company continues its shift from hardware to software, its hardware divisions need to remain elevated while its other divisions continue to develop. Routing and switching segments accounted for 54% of revenues in its last fiscal quarter despite strong growth in the data-center and collaboration divisions. (see chart). On a different note, the faster you feel the company's service division can grow, the more we will be able to predict EPS growth. This division is very stable has high margins and revenues are extremely stable once established.


To sum up, I feel Wall-Street has taken a bearish view on Cisco stock due to the emergence of white box manufacturers which over time will erode margins in its hardware business. However the company still has plenty of growth triggers (Internet of Things, Data center, security, etc) and the service division which although is increasing slowly brings tons of stability and high margins to the equation. Downside risk in the stock price is limited in my opinion here.

Jack Foley Jack Foley   on Amigobulls :
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  • I do not hold any positions in the stocks mentioned in this post and don't intend to initiate a position in the next 72 hours
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