Cisco Stock Needs a Catalyst to Thrive in 2020 and Beyond

Cisco Systems (NASDAQ:CSCO) stock admittedly looks attractive at the moment. Cisco is a wonderful company, the dominant player in networking. And Cisco stock looks cheap. Shares are valued at just 14x the fiscal 2021 consensus earnings-per-share estimate. That’s a valuation that prices in little in the way of growth.

Cisco Stock Needs a Catalyst to Thrive in 2020 and Beyond

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The problem of late is that Cisco isn’t posting much of that growth. Two consecutive earnings reports have disappointed investors and sent Cisco stock tumbling. Shares have recovered a 7.3% decline after the fiscal first-quarter report in mid-November. But CSCO stock still sits 18% below its 52-week high.

If that growth can return, Cisco stock can and likely will rally. But at the moment, that’s a big “if,” and near-term upside will be limited unless and until Cisco can generate some optimism from the market.

The Key Question for CSCO Stock

CSCO has tumbled after each of its last two earnings reports. The November selloff followed an 8.6% decline in August resulting from the company’s fiscal fourth-quarter release.

In both cases, the actual report wasn’t the culprit. Cisco beat analyst estimates on both lines in both quarters. In fact, the company hasn’t disappointed relative to Street expectations since 2014. Rather, Cisco’s outlook was the issue. Second-quarter guidance was particularly weak: Cisco expects revenue to decline 3% to 5% year-over-year. Earnings per share should increase by roughly the same amount, but all of that growth and then some is coming from share repurchases.

The question at the moment is whether the weakness seen in recent quarters simply is a short-term phenomenon. There’s some reason to believe that it is. The trade war has disrupted demand from China. After the first quarter report, Chief Financial Officer Kelly Kramer told Barron’s that orders from that country had declined 31% year-over-year.

5G wireless provides an opportunity, but not yet. CEO Chuck Robbins said on the Q1 conference call that those networks wouldn’t drive sales until the second half of fiscal 2021. Those sales should deliver some of the growth for which Cisco is looking. More broadly, networking demand simply seems soft, but should rebound at some point thanks to 5G and other factors.

The bull case, in short, is that the current situation will pass. Growth will return, and the multiple assigned to Cisco stock will expand. Something like 17x $4 in EPS — up from an expected $3.24 this year — gets CSCO stock near $70. Add in a 3% dividend yield, and total return equals roughly 50% in a matter of years.

The Risk to Cisco Stock

But the core worry is that recent quarters aren’t just the result of short-term factors. Rather, they’re the sign of a reversion to the mean.

After all, end market growth for Cisco, particularly in the core networking business, remains minimal. Cisco has added software revenue to hardware sales with products like the Catalyst 9000 series of switches, but even that hasn’t been enough to drive real growth of late. Rival Juniper Networks (NYSE:JNPR) has been one of the S&P 500’s worst stocks over the past six years, gaining less than 9% total. Demand weakness is a key reason why.

Cisco has alleviated that pressure through software development and acquisitions. In fiscal 2019, for instance, applications revenue increased 15%. Security sales climbed 16%, thanks in large part to the purchase of Duo Security. Infrastructure platforms revenue, however, climbed just 7% — and that was a good year. That category actually saw sales decline in the first quarter.

If the software tailwind, in particular, fades, then perhaps Cisco’s growth stalls out. 5G is a help, but it’s not a panacea, as the travails of Nokia (NYSE:NOK) show. And this is a stock that has struggled in the recent past. In fact, from 2007 to 2017, CSCO stock basically had a lost decade, with annual share price appreciation in the 1% range.

One of the core questions here, as I noted last year, is whether Cisco is something closer to Microsoft (NASDAQ:MSFT) or more akin to IBM (NYSE:IBM). Can it, as Microsoft did, leverage a massive user base and the shift to the cloud to jumpstart growth? Or, as with IBM’s mainframes, is the customer demand problem simply too intractable for Cisco to change its profile?

Investors have reacted so strongly to the last two earnings reports because those questions still hover over Cisco stock. Cisco needs to give an answer to those questions for its shares to rebound.

The Case for CSCO

To be sure, there’s an interesting case that it’s worth waiting for the answer. Cisco’s dividend yields almost 3% at a time when the 10-year Treasury bond yields less than 2%. For those of us who lived through 2000 and 2008, it’s difficult to think of a tech stock as “safe.” But given Cisco’s dominant position, it may well be safer than many old-line “blue chips.”

The one catch, even below $50, is that it’s tough to see that case as compelling. Growth concerns are real. Valuation is attractive, but there is no shortage of fellow Dow Jones components at low forward multiples: Walgreens Boots Alliance (NASDAQ:WBA), Pfizer (NYSE:PFE) and even fellow tech titan Intel (NASDAQ:INTC). Those companies admittedly have their own challenges, but investors looking for “cheap” stocks have options.

The issue at the moment is that Cisco still needs to prove that it’s the best of that bunch, and thus at least deserves the modest valuation premium it currently receives. The company hasn’t been able to do so over its last two quarters, and until it does, sideways trading will persist.

As of this writing, Vince Martin did not hold a position in any of the aforementioned securities.

 


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