Why Cisco’s Recent Stock Rally Appears Overdone

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Cisco (NASDAQ:CSCO) has reported mixed results this year, with revenue declines across major product segments. The trend has sustained in recent years due to low demand for standalone hardware and falling hardware prices. In order to battle stagnating hardware sales, Cisco has made large investments in fast-growing networking domains such as software-defined networking, and has also increased its revenue dependence on its network security, data center and collaboration segments.

Over the last three months, Cisco’s stock has risen by almost 20%, with the stock jumping 7% after the company announced its Q1 fiscal year 2018 earnings earlier this month. The company gave positive guidance for the current quarter, with an expected 2% revenue growth after nearly 8 successive quarters of revenue declines. In this article we take a look at Cisco’s performance for the year and why the recent stock rally might be overdone.

We have a $33 price estimate for the company’s stock, which is around 10% lower than the current market price.

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Financial Performance

Cisco has reported little or no growth in core product revenues in recent years, driven by pricing pressure on hardware and a shift in consumer preferences from standalone hardware products. This trend has been evident this year, with low single digit revenue declines across most product streams. Net revenues have fallen 2% y-o-y to $36.2 billion for the first three quarters of the year.

In addition to revenue declines, gross margins have compressed for the product segments in recent years. This trend has continued this year, with the company-wide gross profit margin falling by 150 basis points to 62.1% for the first three quarters of the year. With pricing pressure, increased competition from white-box hardware vendors and lower demand for standalone hardware expected to continue, we forecast Cisco’s margins to remain subdued going forward.

Segment-Wise Performance

Cisco has realigned its segments in order to club all core hardware segments into a consolidated ‘Infrastructure Platforms’ segment (comprised of routers, switches and wireless equipment). As shown below, Infrastructure Platforms revenues fell 4% y-o-y to just under $7 billion in the most recent quarter. This was in line with expectations, since routing, switching and enterprise WLAN revenues have shown limited growth in recent quarters. Comparatively, applications (collaboration and unified communications) and network security solutions have performed well in recent years. These segments reported mid to high single digit revenue growth, as shown below. Moreover, service-based revenues have also grown at a steady pace to offset the stagnating revenues from hardware sales.

In recent quarters, market leader Cisco has demonstrated strength in the network security domain. The company added around 6,000 new customers in this space in the previous quarter, which was over three times its nearest competitor. Cisco now has over 80,000 customers for its network security solutions. As a result, network security revenues have continued growth spree in the most recent quarter as well. Cisco’s management expects this trend to continue through 2018 as well.

Positive Guidance For Current Quarter

Cisco’s management gave robust guidance for the current quarter, with revenues expected to rise by around 2% to $11.8 billion. Although gross margins are expected to remain subdued, disciplined expense management could help improve the operating profit margin.

Based on the positive guidance for the January-ended quarter and our own estimates, we forecast full year revenues to be just under $50 billion. Additionally, we forecast Cisco’s adjusted operating profit to increase 3% over the previous year to nearly $15 billion.

You can modify the interactive charts in this note to gauge how a change in individual drivers can impact Cisco’s price estimate.

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