Cisco Systems: The Market Expected Too Much

As the market got excited about repatriation of international cash, my investment thesis urged caution on Cisco Systems (CSCO). After all, the tech giant was only growing in the low-single digit range with a lot of the cash encumbered by a large debt load. The story isn’t that impressive to chase the rally of the last year with the stock up at $43.

Slow Shift To Software

Cisco Systems is focused on a corporate shift to recurring software and subscriptions as a move away from lumpy and unpredictable one-time product sales. The downside to shifting to recurring revenues are that revenues are reported over the length of the contract versus upfront like traditional product sales.

As well, the quarterly results are highly confusing not helping the transformative story. Cisco Systems reports revenues as either product or service, but the recurring revenues as part of product aren’t broken out. The end story is that the high-margin service revenue isn’t growing as fast as the product division while the real benefit from recurring software and subscription revenues are hidden in the significant bump in related deferred revenues.


Source: Cisco Systems FQ3’18 presentation

Total revenues grew 4% at the impact of lower gross margins. Gross profits were only up $285 million YoY not helped by higher margin services growing at a slower rate of only 3%. The shift to recurring revenues is very slow with a 2 point benefit over last year, but a dip from 33% of revenues in the December quarter.

In essence, the benefit of deferred revenues for software and subscription services growing by 29% to $5.6 billion is obscured in the financial results. Even as part of deferred revenues, these key metrics are only 30% of revenues. Recurring revenues need to reach closer to 50% before the company will see the real benefits.

Burning Cash Fast

Despite having one of the largest cash balances at the time of the approval of the repatriation tax, Cisco Systems is down to only $54.4 billion of cash on the balance sheet. The amount dipped from $73.7 billion at the end of the prior quarter due to the $1.3 billion payment for cash repatriation and another $7.6 billion for capital returns. As well, the BoardSoft deal cost $1.9 billion in cash and the company paid down debt.

In addition to the burn, the net debt is at $28.1 billion and the income tax payable jumped from $1.3 billion at the start of the fiscal year to $9.1 billion now. A lot of the income taxes aren’t payable for years, but the net cash position is suddenly not that impressive considering the original thoughts that Cisco Systems might have a large influx of cash following the ability to repatriate foreign cash.

The problem with the rally of the last year is that a lot of the gains are based on multiple expansion and not any fundamental improvement in the business. Analysts only forecast 2.9% revenue growth next fiscal year placing the company in the same growth realms of International Business Machines (IBM), but a stock that trades at a 50% P/E multiple premium to IBM.

Chart
CSCO PE Ratio (Forward 1y) data by YCharts

The stock isn’t vastly over rated as one can argue that IBM is too cheap. The bigger issue is expecting Cisco Systems to trade at a 16x or 17x P/E multiple with limited growth and a cash balance that is no longer so impressive. Upside in the stock only occurs if the market is willing to pay a higher multiple on this earning stream.

Takeaway

The key investor takeaway is that the transformation to recurring revenues is a long term plus for Cisco Systems. The stock got ahead of the transformation with expectations for the company producing more than a 2 percentage point shift to software and subscriptions revenue.

Disclosure: I am/we are long IBM.

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: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.

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