Cisco (CSCO) Drops 8% – Buying Opportunity for Dividend Investors or Value Trap?

Cisco (CSCO) announced quarterly earnings results after the market closed on Wednesday, May 17, causing its stock price to drop by approximately 8% in after-hours trading.

If Cisco’s current stock price holds, shares will have a dividend yield near 3.7% when the market opens. That’s much higher than the broader market’s dividend yield, which sits near 2%.

Cisco’s dividend yield looks even more appealing for income investors after considering the company’s impressive three-year annual dividend growth rate of 15%, which includes the double-digit dividend raise management announced earlier this year.

However, many large technology companies face serious challenges that could erode their businesses over time. One example is International Business Machines (IBM), a company Warren Buffett poured more than $10 billion into only to begin selling the stock from his dividend portfolio earlier this year after acknowledging the challenging future IBM faces.

Let’s take a closer look at why the market was so disappointed with Cisco’s latest earnings report and evaluate if the stock’s dip could be a buying opportunity for investors seeking the best high dividend stocks or signs of a value trap.

How does Cisco make money?

Cisco has been in business for more than 30 years and is one of the most important technology companies in the world. The company’s products (74% of sales) and services (26%) are sold to businesses of all sizes, and most of its offerings connect computing devices to networks or computer networks with each other.

Switches and routers are the company’s largest product categories and are primarily used to connect devices on computer networks and move data across the internet. However, Cisco has increasingly invested into faster-growing areas such as security, wireless, and other types of recurring software and services revenue.

Cisco’s business is also very global with around 40% of its total revenue coming from outside of the Americas region.

Source: Cisco Annual Report

Cisco maintains dominant market share positions in many of its core offerings, driven by the company’s scale and ability to to provide customers with an entire suite of solutions with its network equipment and services.

The company has evolved over the years from selling basic networking hardware to providing higher-value packages of complete architectures and solutions that improve customers’ businesses.

Selling architectural solutions is much more profitable for Cisco and allows its customers to deal with fewer vendors and potentially enjoy a lower total cost of ownership.

Most of Cisco’s competitors do not have the same breadth of products and services (e.g. security, switching, wireless, routing, collaboration), making them less of a factor in these lucrative deals.

Investors interested in learning more about Cisco’s competitive advantages and key risks can review my original thesis here.

Why did Cisco’s stock drop?

Cisco’s fiscal third-quarter results actually exceeded expectations. Sales were down 1%, and non-GAAP earnings per share increased 5%. Both measures slightly beat analysts’ expectations.

However, Cisco’s guidance for the fourth quarter spooked the market. The company expects non-GAAP earnings per share between 60 and 62 cents, roughly in line with analysts’ expectations for 62 cents, but it guided sales to decline 4% to 6%. Analysts were expecting revenue to decline only 1% next quarter.

Cisco also announced it would be laying off another 1,100 employees, adding to its August 2016 announcement to slash 5,500 jobs, which represented 7% of the company’s total workforce. The job cuts are being driven by customers’ increasing desire for software solutions rather than traditional networking hardware.

As a result, Cisco is restructuring its business by reducing headcount in its legacy hardware business units and adding more workers in its software and services divisions.

The drop in Cisco’s stock essentially reflects worries over management’s forecast for disappointing growth next quarter, which could be an indication that software is eating the company’s networking hardware businesses faster than expected.

Cisco’s stock had also returned 31% over the past year, nearly doubling the S&P 500’s 18% total return. In other words, expectations were somewhat high heading into the quarter, so it didn’t take much of a guidance miss to cause the market to punish the stock.

Is Cisco’s stock price decline news or noise?

There’s no doubt that many of Cisco’s core markets are experiencing structural changes, driven largely by the continued rise of software. I prefer to own businesses that operate in industries characterized by a slow pace of change, which generally allows a company to generate more predictable cash flow over the years.

While Cisco’s major markets are characterized by a faster pace of change than other industries such as trash collection or packaged food, their importance should not be overlooked.

For example, Cisco’s networking products are very important for almost any infrastructure environment and are necessary investments for most businesses. Much of the country’s communications infrastructure would not function without Cisco.

Furthermore, it seems likely that billions of connections will be added to the global network over the coming years as the use of data and bandwidth continues to grow exponentially. More networking infrastructure will be needed as this occurs, providing Cisco with a long stream of demand across its existing installed base.

In other words, I would be surprised if Cisco’s networking hardware businesses see a sharp, structural decline in revenue anytime soon.

While these issues are murky, I tend to think the market is overreacting to Cisco’s disappointing revenue guidance. On the company’s earnings conference call, management noted several seemingly transitory factors behind the expected revenue decline.

First, orders were a little weaker during the third quarter, driven by softness in certain emerging markets and a pullback in public sector business spending, which resulted from political uncertainty in the U.S. Soft public sector spending detracted about 1 percentage point from revenue guidance.

Neither of those issues seem like a threat to Cisco’s long-term earnings power. More importantly, fourth quarter revenue guidance was reduced by another 1.5 to 2 percentage points thanks to Cisco’s ongoing transition to more software and subscriptions, which recognize revenue over time rather than all upfront.

The impact from temporary macro headwinds and Cisco’s shift to a subscription model combined to reduce sales growth guidance by 2.5 to 3 percentage points. Neither of these issues concerns me, and excluding them would have put Cisco’s guidance closer to analysts’ expectations.

Stepping further back, Cisco’s continued investments in its recurring software and subscription businesses continue to bear fruit.  The company noted that recurring revenue increased to 31% of its overall sales, up 2 percentage points from the third quarter of last year.

Deferred revenue grew 13% year-over-year, including 57% growth in its recurring software and subscription businesses, which now account for 25% of Cisco’s overall deferred revenue.

Cisco’s business transformation will take time, but it should result in a much more resilient and predictable business, if successful. It could mean that organic growth remains soft for at least a few quarters given the stagnation in hardware products and the lengthier revenue recognition of software, but it’s good to see Cisco being proactive and focusing on the long-term.

The company is also sitting on a boatload of cash it can use to accelerate its business transformation to more software and recurring revenue. Cisco holds approximately $36 billion in net cash, which is equal to about 20% of the company’s market cap. The company would be a major beneficiary of any repatriation tax break.

Closing Thoughts on Cisco

Assuming Cisco’s stock remains down about 8% tomorrow and fiscal 2018 earnings estimates remain steady, CSCO trades at a forward P/E ratio of 13.8. If Cisco’s net cash is deducted, the stock’s forward P/E ratio falls to 10.6.

The market’s expectations strike me as being reasonable for such a financially healthy business that is taking the necessary steps to remain relevant. Cisco is in the middle of a major business transformation, investing heavily into recurring software and services while working hard to maintain its cash cow networking hardware segments.

The company’s results were already noisy from one quarter to the next based on unpredictable order trends over short periods of time, but Cisco’s software and subscription businesses appear to be heading in the right direction.

When combined with ongoing growth in the number of network connections and security applications needed around the world, I continue to believe Cisco will play a core role in the technology sector for many years to come.

The company’s dividend also remains in great shape. I expect Cisco will continue to boast a high Dividend Safety Score, indicating that its payout remains very secure, and its dividend growth prospects are also bright.

Combined with a seemingly fair valuation after the market’s latest punishment, Cisco appears to be a reasonable income investment as part of a diversified dividend portfolio.

The company’s continued shift to more recurring revenue won’t be linear and will almost certainly experience some bumps along the way, but I like the direction Cisco is headed for the long-term.