Was The Selloff In Cisco Stock Justified?

Cisco stock (NASDAQ: CSCO) lost nearly 30% – dropping from $49 at the beginning of the year to nearly $34 in late March – then spiked 25% to around $42 now. But that means the stock is still 14% lower than where it started the year while the broader market is up 4%.

Why is Cisco under-performing the broader market? Cisco primarily operates in the telecom industry and the telecom business has remained relatively immune from the impact of Covid-19. Cisco was going strong before the company released its Q4 2020 (ending July) results late last week. Cisco’s stock fell by more than 11% despite reporting a strong performance. This can be primarily attributed to the weak guidance provided by the company for Q1 2021 where it expects its revenues to fall in the range of 9-11%. But was the reaction of the market justified? It seems to be that the market overreacted to the news. Trefis estimates Cisco’s valuation to be around $49 per share – 16% higher than the current market price – based on upcoming triggers explained below and one major risk factor.

The triggers are a stable income margin for Cisco and a strong balance sheet. Cisco’s net margins are expected to remain close to 26% in FY20201 with the figure further improving to around 27.2% in FY2022. Cisco expects its gross margins to be in the range of 64-65% likely to be driven by its software business which accounted for more than 29% of the company’s total revenue in FY 2020. Moreover, Cisco derived more than 50% of its revenues from software and services in FY 2020, with software subscription making up 78% of these revenues. The software business by nature is a higher margin business and should help Cisco to maintain a steady margin. Notably, though, Cisco’s hardware business will suffer as major companies cut their capital expenditure to preserve cash in a bid to weather the tide of the Covid-19 pandemic.

The second trigger is a strong balance sheet. Cisco ended FY 2020 with more than $11 billion in cash and reported operating cash flows of more than $15 billion. Cisco’s strong cash flow position coupled with its strong cash conversion ability gives the company considerable leeway in its capital allocation strategy. Notably, Cisco’s dividend payments have increased in each of the last six years and the company’s share count has declined from more than 5 billion in 2015 to less than 4.3 billion in 2020. Moreover, the management intends to return a bulk of its free cash flow annually to its shareholders through cash dividends and repurchases of common stock which is likely to boost Cisco’s valuation going forward.

Overall, Cisco is likely to report an EPS of around $3 in FY2021 as a fall in profits due to shrinking hardware revenues is likely to be partially offset by improving software profits. Finally, how much should the market pay per dollar of Cisco’s earnings? Well, to earn close to $2.93 per year from a bank, you’d have to deposit about $293 in a savings account today, so about 100x the desired earnings. At Cisco’s current share price of roughly $42, we are talking about a P/E multiple of almost 15x but we think a figure close to 17x is appropriate.

That said, telecom hardware is a slow-growing business. Growth looks less promising, and long-term prospects are less than rosy. What’s behind that?

The economic downturn could cause significant losses for businesses, and companies will cut their IT spending which could significantly impact Cisco’s revenues, as the company derives a bulk of its revenues from its hardware business. Moreover, the company’s infrastructure business has been struggling due to a slump in demand across switching, routing, data center, and wireless, driven primarily by the weakness we saw in the commercial and enterprise markets. However, despite weak growth prospects, Cisco looks cheap given its strong profitability and an even stronger balance sheet.

So, Cisco might see a modest rise from the current level. But, what if you are looking for a more balanced portfolio instead? Here’s a top quality portfolio to outperform the market, with 170% return since 2016, versus 55% for the S&P 500. Comprised of companies with strong revenue growth, healthy profits, lots of cash, and low risk. It has outperformed the broader market year after year, consistently.

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