I've said it before, and I'll start off this article on Cisco (Nasdaq:CSCO) by saying it again - investors don't reward value-priced tech companies that are rich in cash flow generation but poor in revenue growth. It's still an open question as to just how much top-line growth potential Cisco still has, but management seems to have acknowledged that hoarding cash on the balance sheet isn't going to do shareholders much good. I'm still skeptical about how readily investors will embrace Cisco, but I do still see a lot of value in the shares.
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A So-So End to the Fiscal Year
With enterprise and carrier demand both pretty soft this summer, it's not surprising that Cisco reported a so-so fiscal fourth quarter.
Revenue rose 4% from the year-ago quarter and 1% from the fiscal Q3. On a sequential basis, the large switching and routing businesses saw low single-digit revenue declines, while security was a little stronger and wireless was up nicely (mid-teens growth). All in all, this was a basically in-line quarter for Cisco, though analysts had been trimming numbers slightly on the basis of what companies like IBM (NYSE:IBM), F5 (Nasdaq:FFIV) and Juniper (NYSE:JNPR) have said with their reports.
Margins were likewise so-so. Gross margin weakened on both an annual and sequential basis, with less than one point of product margin erosion. Operating income performance really depends on the number you look at - GAAP operating income soared 63% from last year, while non-GAAP operating income (the number used by almost all analysts and likely most investors) rose 14% from last year and declined 3% sequentially on well-controlled R&D and SG&A spending.
SEE: Understanding The Income Statement
Caution is the Watchword
Cisco certainly was not rambunctious with its guidance - looking for 2-4% year-over-year growth for the next quarter. Likewise, Cisco basically echoed the caution that companies like F5 and Riverbed (Nasdaq:RVBD) expressed on Europe, and also mentioned the ongoing uncertainty in the enterprise market.
Cisco's 20% revenue decline in optical was a little anomalous, what with JDS Uniphase's (Nasdaq:JDSU) quarter outlook, and that could be a positive for Ciena (Nasdaq:CIEN). Elsewhere, Cisco's strong wireless performance should encourage Aruba Networks (Nasdaq:ARUN) shareholders.
On a longer-term basis, though, it's worth wondering if Cisco can really generate the kind of revenue growth that some analysts and investors still seem to expect. VMware's (NYSE:VMW) acquisition of Nicira ups the threat from software-defined networking and may be a sign that the company's formerly solid relationship with EMC (NYSE:EMC) and VMware may not be solid. Likewise, companies like Palo Alto (NYSE:PANW) certainly covet the same real estate in security.
A White Flag, or an Acknowledgment of Reality?
Arguably the biggest development from Cisco's Q4 earnings release is the company's new attitude regarding its capital management philosophy. It is now looking to return a minimum 50% of annual free cash flow to shareholders, and it has hiked the dividend by 75% as part of that. That puts Cisco's yield around 3% and makes it one of the more appealing yields in tech (at least when factoring in the sustainability of it).
I can see a lot to like about this move. For starters, it guarantees that long-term shareholders get a reward for the company's success that is independent of Wall Street's ever-shifting moods. It also should soak up excess free cash flow that might otherwise tempt the company into poorly reasoned expensive mega-deals.
Keep in mind, too, that this move won't really constrain management much. There's over $30 billion in net cash on the balance sheet, and the company should continue to add billions to that total every year. Consequently, it won't surprise me if Cisco looks to find deals to augment its business - not unlike how IBM has continued to build itself.
SEE: 5 Must-Have Metrics For Value Investors
The Bottom Line
Those thinking that Cisco is on the path to resemble IBM or Microsoft (Nasdaq:MSFT) need to remember that Cisco does not have IBM's enormous service business, nor Microsoft's entrenched businesses like Windows and Office. That said, Cisco has more than ample resources with which to remain a major player across a variety of IT hardware markets.
Cisco's valuation puzzles me, as even conservative estimates drive an impressive fair value. If Cisco can manage 4% free cash flow growth (on a compounded annual basis) for the next decade, fair value is north of $30. At today's price, below $20 as of pre-market trading, it looks as though the Street is forecasting ongoing free cash flow erosion of 5% - a level of pessimism that simply seems excessive. Although I think it will be tough for investors to see full value in these shares, they just seem too cheap today to ignore.
At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
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