Cisco Systems: The Sell-Off Was Not An Overreaction (NASDAQ:CSCO)


The US stock market has continued its trajectory from the March lows powered by just a few stocks. When we say, just a few stocks, we mean literally 5 stocks. Deadweight 495 index looks about as comatose as a hibernating bear.

This bifurcated market makes investing a tad more complicated than usual. The choices one must make here are whether you want to keep betting on these five, Apple Inc. (AAPL), Facebook, Inc. (FB), Alphabet Inc. (GOOG), Amazon.com, Inc. (AMZN) and Microsoft Corporation (MSFT) getting bigger and bigger, or whether you want to look for ignored companies in a similar space.

Enter Cisco (CSCO)

Cisco retains the unique distinction of being one of the large capitalization technology companies that is still nowhere near its March 2000 peak.

ChartData by YCharts

Obviously, this has drawn scrutiny from analysts looking for the ultimate value play on the digital revolution. Consensus has definitely been sold on the bullish case, both at Seeking Alpha and on Wall Street. Not a single bear case is to be found.

Source: Seeking Alpha

Cisco reported its results in this positive climate and had a rather steep selloff [August 13].

ChartData by YCharts

While we really do empathize with the valuation argument, especially after the selloff, we will not start off with that. Instead we want to focus on the cycle itself and tell you what can go wrong.

The Untold Revenue Story

While Cisco may appear to be the ultimate value stock, it is having a very hard time increasing revenues. Trailing 12 month revenues are currently close to levels seen in 2014. Flat revenues over 6 years is a recipe for getting fund managers to ignore your company.

Chart

If the lack of revenue growth did not seem particularly bothersome for an area that has been growing like weed in general, consider the number of acquisitions that Cisco has made since then. Between 2014 and 2020, Cisco has bought out over 50 companies.

Cisco has a July year-end and leads the charge on guidance. For fiscal Q1 2021 (October 2020 quarter), it is guiding to a revenue decline of 9-11% year-over-year. Here is the real kicker though. Wall Street has been downgrading Cisco’s estimates pretty much regularly for the last 12 months and the company is guiding even below that number.

ChartData by YCharts

Cisco’s revenues are projected to fall to later 2013 levels and we don’t think the decline is over.

The Capex Cuts Have Not Filtered Through

While investors may be embracing the technology landscape, the CEOs of all other companies have a slightly different opinion on their own revenue outlooks. As a result, capital expenditures have been cut heavily for the quarters ahead. With regard to that, there are two key points we want to make. The first being that information technology is not remotely immune to this. We can conclude that by looking at this chart.

The second is that, the chart above has not yet filtered through. The lockdown and disruptions have made planning and execution difficult, but those capex cuts are coming in the quarters ahead. So when Cisco is guiding lower on revenues, take them at their face value and don’t expect a V-shaped recovery. The last time IT Capex guidance was this weak, Cisco’s revenues took almost two years to reach peak levels again.

ChartData by YCharts

More notably revenues declined year over year for two consecutive years, despite Cisco buying multiple companies that added to its revenue base during that time frame.

The Bull Case In Nutshell

With earnings estimates close to $3.00 per share, the stock appears cheap. Certainly 14X EPS is not too much to pay in an era of zero percent interest rates and bloated valuations elsewhere. Cisco is also in the middle of its price to sales ratio range and while we would wait for this to come lower, we don’t see the current ratio as excessive.

ChartData by YCharts

The same logic can be applied to its EV to EBITDA ratio. Cisco appears to be reasonably priced, but not a screaming bargain.

ChartData by YCharts

The strongest bull argument though comes from Cisco’s abilities to maintain its margins even in the face of serious recessions. Note how margins stayed consistent in 2008-2010 while revenues declined by over 15%.

ChartData by YCharts

Interestingly though, we did see a dip in the middle part of this decade. That possibility remains the biggest risk to destroying the bull case. A six point drop in gross margins might not seem like much, but it would drop net profit margins by 40% (21% to 15%) and earnings could drop under $2.00/share. While that may seem farfetched, we would stress that the capex cuts have not showed up yet and when they do, Cisco will be tested.

Conclusion

Price has the biggest impact on sentiment and people continue to buy into the technology story. Overall revenues have been lackluster and for a vast majority (outside of direct e-commerce plays) have declined year over year. None of these revenue numbers have even begun to show the impact of the capex cuts that companies are planning to put through.

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Cisco remains a very interesting play, one we are watching closely for a possible long position. Currently though, the risk reward ratio is not exceptionally good in our opinion and we are neutral on the stock. We would become interested in the sub $35 range. The selloff while intense, only served to discount the problems Cisco is likely to face in the next one to two years.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CSCO over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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