- Returns in CSCO have deteriorated as growth has slowed to a crawl
- Solid Q1 earnings, restructuring plan suggest the company can get back on track
- It’s difficult to see the stock as compelling, but the mid-term outlook might be good enough for some investors
Looking backward, Cisco Systems (NASDAQ:CSCO) stock has been solid, if hardly spectacular. Ten-year returns, including dividends, are almost exactly equal to those in the S&P 500, running at about 13% annualized. Performance has slowed of late, however, as Cisco has underperformed the index: over three- and five-year periods, Cisco has returned 5.3% and 8.2%, respectively. That includes a 22% loss year-to-date (again including dividends), during which time the stock has underperformed the S&P.
The slowing returns and the poor performance so far in 2022 highlight both the potential rewards and the potential risks. After the decline, CSCO is trading more cheaply, and at an earnings multiple that implies relatively little growth from this point. But the stock is trading more cheaply, and has lagged tech peers in recent years, precisely because it hasn’t generated much growth, even when times ostensibly were good.
Between fiscal 2019 and fiscal 2022, Cisco’s adjusted net income rose by just 1.4% — total. Essentially, all of that modest increase came from lower interest expense.
As cheap as CSCO is at the moment, that kind of performance isn’t good enough. But the good news is that Cisco itself sees improvement on the horizon. So do investors: the stock has bounced nicely in recent weeks, including a rally following this month’s fiscal first-quarter report.
If that improvement continues, the rally should as well. However, that remains a big ‘if’ at this point.
Not Enough — Yet
On its face, Cisco’s Q1 seems strong. The adjusted earnings-per-share figure topped analyst estimates. And the company raised its full-year EPS outlook.
Looking closer, however, the news isn’t quite that impressive. Most notably, the higher guidance simply incorporates the Q1 beat. Cisco topped its own outlook for the quarter by two cents, and raised its full-year projection by the same amount.
More importantly, even that higher outlook doesn’t suggest a massive acceleration in growth. The midpoint of the revised EPS guidance implies year-over-year growth of about 5.5%. But the diluted share count for Q1 was down about 3%. More than half of the projected increase in EPS, therefore, is coming from the lower share count, rather than higher overall earnings.
With CSCO trading at under 14x the midpoint of EPS guidance, roughly 3% profit growth doesn’t seem all that exciting. Rather, that kind of growth leads to a profile like that of CSCO: a relatively low multiple to earnings and a 3.2% dividend yield.
Cisco’s Long-Term Outlook
So this does need to get better for CSCO to get back to outperforming the market as it did coming out of the financial crisis. One key reason for the rally in the stock is that investors seem more confident in that possibility post-Q1.
That makes some sense. The multi-year plan to move to a recurring revenue model continues to make progress. Subscription revenue increased 6% year-over-year in the quarter, and accounted for 43% of the total figure.
Demand appears intact. Backlog levels “continue to far exceed historical levels,” per the Q1 conference call.
And potentially there’s some room for improvement thanks to a restructuring announced along with the quarter. Cisco’s headcount will come down, and the company will “optimize” its real estate holdings, closing offices to better align to a hybrid remote/office work environment.
So the case for CSCO’s post-earnings rally is that the move isn’t really about the quarter. Rather, the quarter shows progress in a broader strategy that aims to revitalize the company’s growth. That, in turn, should lead to both higher earnings and a higher multiple, a combination that can move CSCO sharply higher.
The Case for Caution
Again, there’s some logic behind that case. And in a volatile market, the relative consistency of results here should be attractive. Owning CSCO with a 3%-plus dividend and continued share repurchases, plus the optionality of growth accelerating, seems like a solid option.
That said, it’s hard to get that excited just yet. Earlier this year, I was somewhat skeptical toward the turnaround, and there are reasons to maintain that posture after Q1.
Most notably, Cisco still has a lot left to prove. Backlog is elevated, yes — but Cisco also has dealt with supply-chain problems for some time, which has provided a tailwind to that figure.
Demand is intact, but there, too, the external environment plays a role. The same move to hybrid work that is driving Cisco’s real estate optimization is driving demand for networking equipment. There’s still a very real chance Cisco results will weaken in calendar 2023, as that demand moderates and the impact of IT spending cuts starts to take hold.
And, again, guidance doesn’t suggest a notable acceleration yet. Nor does the restructuring plan really move the needle. As management pointed out on the Q1 call, the headcount reduction is not a huge cost-savings plan: the number of employees at the end of 2022 should be about equal to where it was at the beginning.
All told, there’s still a lot of work left to do, and some notable potential speed bumps on the way in calendar 2023. Cisco’s Q1 shows progress, but it’s only a single quarter in what will be a multi-year process.
Disclaimer: As of this writing, Vince Martin has no positions in any securities mentioned.