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Cisco's Growth Streak Is Coming to an End

Cisco (NASDAQ: CSCO) is one of the world's top networking companies. It leads the Ethernet switch and router markets, locks in customers with ever-expanding hardware and software bundles, and still has plenty of cash to acquire smaller companies, repurchase shares, and raise its dividend.

Cisco has posted slow but steady growth over the past two years. It wisely divested its service provider video software solutions (SPVSS) unit, bought new companies to expand its ecosystem, and repatriated its overseas cash.

Image source: Getty Images.

Fresh demand from enterprise campuses boosted its hardware sales again last year, and its security and application units continued to generate double-digit growth. Those tailwinds, along with its low valuation and a decent dividend yield, made Cisco an easy stock to recommend.

However, Cisco's stock recently fell after it followed up a solid first-quarter earnings report with chilly guidance for the second quarter. Should investors consider its post-earnings drop a buying opportunity?

What spooked the bulls?

Cisco's revenue rose 2% annually to $13.2 billion in the first quarter, which beat estimates by $70 million but marked its slowest growth in two years. Its non-GAAP EPS -- which excludes the divestment of its SPVSS unit for both periods -- rose 12% to $0.84 and beat estimates by three cents, but also marked a slowdown from its previous quarters:

YOY growth

Q1 2019

Q2 2019

Q3 2019

Q4 2019

Q1 2020

Revenue

8%

7%

6%

6%

2%

EPS*

23%

16%

18%

19%

12%

YOY = Year-over-year. *Non-GAAP. Source: Cisco quarterly reports.

Cisco's EPS was also significantly boosted by $768 million in buybacks during the quarter. Without that boost, its non-GAAP net income grew just 5% to $3.5 billion.

Cisco expects its revenue to decline 3%-5% annually in the second quarter, breaking its two-year streak of revenue growth, and for its non-GAAP EPS to rise just 3%-5%. Cisco attributed that slowdown to a weakening macro environment in multiple markets.

During the conference call, Cisco CEO Chuck Robbins stated that "while the main challenges continue to be service provider in emerging markets, this quarter we also saw relative weakness in enterprise and commercial."

Cisco also faces ongoing challenges in China, where its revenue dropped 31% annually in the fiscal first quarter following a 26% decline in the fiscal fourth quarter. Cisco only generates a low-single-digit percentage of its sales in China, but it's being barred from bidding for big contracts in retaliation for the American government's moves against Huawei.

A tough balancing act

Cisco's growing regional markets and business units still offset its weaker ones during the first quarter. Its revenue rose 4% annually in both the Americas and the EMEA (Europe, Middle East, and Africa) regions, which together accounted for 86% of its revenue.

Meanwhile, its revenue in the APJC (Asia-Pacific, Japan, and China) region, which accounted for the remaining 14% of its sales, dropped 8% as plunging sales in China offset stronger markets like Japan.

Image source: Getty Images.

Cisco's infrastructure platforms revenue (57% of its total revenue) dipped 1% annually as weak demand from service providers offset higher demand from data center and enterprise campus customers.

But its applications revenue (11% of its revenue) grew 6%, led by double-digit growth from AppDynamics. Its security revenue (6% of its revenue) also rose 22%, led by strong demand for its identity and access, advanced threat, unified threat, and web security products. Lastly, Cisco's services revenue (25% of its revenue) rose 3% on stable demand for its software support services.

In short, the growth of Cisco's non-hardware businesses indicate that its bundling strategies -- which combine hardware and software products -- still work. Software subscriptions accounted for 71% of its total software revenue during the first quarter, compared to just 59% a year earlier, and indicate that it's still locking in customers and preventing smaller rivals like Juniper Networks (NYSE: JNPR) from gaining ground.

Stable margins and profit growth

Cisco's revenue growth is decelerating, but its gross and operating margins expanded both annually and sequentially in the first quarter.

Metric

Q1 2019

Q2 2019

Q3 2019

Q4 2019

Q1 2020

Gross margin

63.8%

64.1%

64.6%

65.5%

65.9%

Operating margin

31.9%

32.1%

32.2%

32.6%

33.6%

Non-GAAP basis. Source: Cisco quarterly reports.

This indicates that it isn't losing pricing power to its rivals, and that its higher-margin software and subscription revenue are offsetting the lower margins of its hardware business.

For the second quarter, it expects its gross margin to come in at 64.5%-65.5%, and for its operating margin to come in between 32.5%-33.5% -- which would still both mark year-over-year improvements. Juniper, by comparison, posted a non-GAAP operating margin of just 18.3% last quarter.

Still a solid long-term investment

Wall Street expects Cisco's revenue to dip 2% this year, and for its earnings -- buoyed by buybacks -- to grow 5%. Those growth rates look anemic, but the stock trades at just 13 times forward earnings and pays a forward yield of 2.9%.

Cisco's stock won't blast off anytime soon, but its downside potential is limited, and its growth should eventually accelerate again as the macro headwinds dissipate.

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Leo Sun owns shares of Cisco Systems. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.


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