Current Price: $42 Price Target: $58 (lowering from $63)
Position size: 3.1% TTM Performance: -18%
Key Takeaways:
· Top line and EPS beat overshadowed by weak top line guidance and CFO departure.
· Macro environment is a headwind but the LT story is intact. Aging network infrastructure needs to be upgraded. Growing use of new technologies and increased data demand places increased importance on this.
· Mix shift to software and recurring revenue should continue as an increasing number of their products are to be offered this way.
· Cost cutting amidst headwinds to help preserve earnings power – mgmt. announced $1B in annual cost reductions to be implemented over next few quarters.
· CEO Chuck Robbins said…” the pandemic has had the most impact on our enterprise and commercial orders driven by an overall slowdown in spending. We are seeing customers continue to delay their purchasing decisions in certain areas, while increasing spend in others until they have greater visibility and clarity on the timing and shape of the global economic recovery.”
Additional Highlights:
· Q4 sales -9% YoY and EPS +22%. FY20 rev -5% and EPS +4%. Q1 revenue guided to -9-% to -11%.
· Generally weaker demand commentary relative to last quarter. For reference, Gartner expects global IT spending to decline -7.3% in 2020. Within this there are pockets of strength, like public cloud spending as companies shift IT budgets to areas of immediate need. For much of Cisco’s products the needs are less immediate, but the LT drivers still exist.
· Advances in technology require updates to networks, but will occur over time and can be subject to the macro environment. CEO says…”I have had a lot of customers who are not at the center of this crisis who realized during this pandemic that they have a fair amount of technical debt, and they have a lot of aged equipment. And so we don’t know what the time frame is, but many of them have said this is a wake-up call, and this is going to actually give us air cover to talk to our senior leadership team about upgrading and building out a more robust, modernized infrastructure.” Right now, this is occurring more w/ public sector customers and larger, well capitalized enterprises and not w/ SMB’s which make up the their “commercial” business.
· Positive commentary points to continued software/services mix shift and strength in new products –This includes strong demand for their Catalyst 9000, security, WebEx and other SaaS-based solutions. Software mix was 31% of revenue in Q4, w/ 78% of software sold as subscription (+8pp YoY). That means almost 1/4 of total sales is from software subscriptions sales (or close to $12B). Additionally, 27% of rev is services with much of that from maintenance/support which tend to be recurring. So overall recurring revenue could be 40% or more (they don’t break it out specifically). So while top line growth has been weak, the mix shift happening w/in their business should be supportive of their multiple and their margins. They intend to grow this mix over time…as they “accelerate the transition of the majority of our portfolio to be delivered as a service.”
· Security is a bright spot. Security rev was +10% YoY. Security is a big and growing TAM for them and should be a key growth driver as this becomes a more meaningful piece of their business. It’s also a differentiator as competitors do not have the integrated security that they do. Their massive installed base is an opportunity to continue to cross-sell their security products.
· Momentum w/ web-scale cloud providers – the positive commentary from last quarter continued. This is an end market where they lost share to Arista in the past, but their positioning is improving w/ new products announced last Dec. That being said, this is still early stages – mgmt. indicated it may take a year or two for this to be a meaningful top line contributor.
· Executive departure is concerning. Kelly Kramer, CFO (52 years old) is “retiring” and staying on until a replacement is found. She joined Cisco in 2012 and became CFO in 2015, the same year Chuck Robbins became CEO. With her departure, and the announcement at the end of June that the head of Strategy (Anuj Kapur) would be leaving – the leadership changes are starting to add up. Kapur only took on that role in 2018. Those changes come after Rob Salvagno, head of Cisco venture and acquisitions unit departed in Jan 2020 and a couple other execs in Dec 2019 that left as well. So there have been significant leadership changes made in the last 7 months or so. These changes coming amidst a strategy shift and continued acquisitions is a little concerning. Not seeing this talked about on the sell-side.
· Valuation: trading at a 7.5% FCF yield on 2021. This is well below S&P average of <4%, for a strong balance sheet, high FCF generative business w/ a growing mix of software and recurring revenue. Despite macro headwinds, fundamentals continue to be supported by business transformation/digitization trends at a reasonable valuation while much else in tech has seen substantial multiple expansion. Additionally, their valuation is supported by a 3.4% dividend yield which they easily cover. They have ~$15B in net cash on their balance sheet, or >8% of their market cap.
Sarah Kanwal
Equity Analyst, Director
Direct: 617.226.0022
Fax: 617.523.8118
Crestwood Advisors
One Liberty Square, Suite 500
Boston, MA 02109