Cisco Systems (CSCO)

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Why Cisco Systems is Overdue for a Rebound
By: Motley Fool | December 26, 2019

• Macroeconomic factors have clouded Cisco's recent performance. With those clouds now parting, the stock deserves a second look.

Finding value in a bull market can be a challenge, particularly finding a cheap stock with a strong balance sheet and a record of consistent earnings and dividend growth. And yet, an investor needs to look no further than Cisco Systems (NASDAQ:CSCO), a manufacturer of networking systems and one of the largest technology companies in the world. Cisco's stock has come under pressure for the same factors which are likely to drive it higher over the near term. Value, in this case, could be very fleeting.

Clouds have gathered... and parted
Let's first review Cisco's business. Cisco is the world's largest hardware and software supplier within the networking solutions sector and divides its business into four segments:

• Infrastructure platforms (58% of sales) consisting of software and hardware for switching, routers, wireless and data center applications.
• Applications (11% of sales), which contains collaboration, analytics, and Internet of Things products.
• Security (5% of sales), which contains firewall and software-defined security products.
• Services (25% of sales), which consists of technical consulting and support services.

The company's business is global, with 40% generated outside the Americas region. Given its leadership in critical internet and cloud components as well as its international exposure, it is no surprise then that Cisco's business is very dependent upon global IT spending.

This dependency was reflected in the company's most recent quarterly results. Order growth weakened across the board, as customers delayed their purchase decisions in light of macroeconomic uncertainty. Growth was particularly slack among enterprise and commercial customers (down 5% apiece); regionally, China saw the biggest decline in orders, down 31%.

With global growth ticking down to 3% growth in the second quarter and trade tensions increasing, Chief Investment Officers (CIO) became more conservative with respect to their IT budgets. Morgan Stanley's survey of CIOs in the third quarter confirmed this trend: IT budgets were reduced to 4.4% growth (from initial expectations of 4.9%) for 2019 and ratcheted down to only 3.4% growth for 2020.

What a difference a quarter makes. After a brief spate of weakness the global economy seems to be on the mend, trade tensions have dissipated and equity markets have risen to new records. The cloud of macroeconomic uncertainty has lifted, and this should provide a boost of confidence to CIOs as they formulate their 2020 IT budgets. Cisco's stock will likely rise in lockstep.

Quality at a cheap price
An investment in Cisco, however, should not simply be opportunistic. The stock also has long term appeal, on several grounds. First, its history of earnings growth has been exemplary. Since bottoming out in 2002 in the aftermath of the tech bubble, adjusted earnings per share (EPS) has risen sevenfold. Growth has also been remarkably resilient, with earnings falling only once in the interim (during the Great Recession). This growth is expected to continue for the foreseeable future, although at a slower pace -- consensus estimates forecast adjusted EPS rising at a mid-single-digit pace over the next three years. Factors that will underpin earnings growth are a greater reliance on software and services, a growing emphasis on subscription-based revenues, and a ramp-up of 5G spending, which should take place next year.

Dividends were initiated in 2011 and have grown at a double-digit pace every year -- with the exception of 2019 where they rose by 9.6%. The company has a strong record of returning capital to shareholders and targets 50% of free cash flow as funds to pay dividends and conduct share buybacks. Share count has fallen roughly 10% over the past two years, as Cisco used repatriated funds to buy back shares.

Cisco's balance sheet is very solid, with net cash courtesy of $33 billion in cash and cash equivalents compared to $24 billion in total debt as of fiscal 2019. With capital investment requirements amounting to less than 10% of operating cash flow, the company generates ample free cash flow (FCF) -- at around $15 billion in 2018, FCF was more than double the dividends paid out.

Yet, despite all these strengths, Cisco trades at a price-to-earnings ratio of less than 15, a discount to the market multiple as well as to its own historical trend. On a price-to-free-cash-flow basis, the comparison is even more stark, with Cisco trading at a 40% discount to the sector average and a 25% discount to the market.

As a company whose fortunes are closely tied to the global economy, Cisco's recent under-performance belies the macroeconomic optimism that has recently pushed the stock market to new highs. The long term investor has a rare opportunity to buy a quality company at a decent price. It's time to capitalize on that opportunity with this solid tech stock.

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