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Earnings Need to Re-Inspire Confidence in Cisco Stock

Investors worry that Cisco's transformation has stalled out

In recent years, the question for Cisco Systems (NASDAQ:CSCO) stock has been to what extent the company can transform its business. Cisco’s legacy model of selling networking hardware has been under pressure for years from stagnant demand. And so Cisco has looked to add new revenue and profit streams in a bid to drive growth.

Earnings Need to Re-Inspire Confidence in CSCO Stock
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That effort has worked. Cisco’s adjusted earnings per share increased 20% in fiscal 2019 (ending July) after a 9% rise the year before. CSCO stock responded in kind, gaining 150% from early 2016 lows to 2019 highs.

But shares have since reversed: Cisco shares now sit 20% below their 52-week high. Disappointing guidance after each of the last two quarters has been the key culprit. Cisco stock dropped 8.6% after the fiscal fourth quarter report in August, and another 7.3% following Q1 results in November. In both cases, guidance for the following quarter was the culprit.

Those earnings reports and the resulting decline in Cisco stock set up an important fiscal second quarter report next week. Cisco simply needs to re-inspire investor confidence that the company can drive sustainable growth over the long haul. If it can, Cisco stock can bounce back — because after the declines, that growth no longer is priced in.

Expectations for the Second Quarter

The reason Cisco shares fell so steeply after the November report is that the company guided for a surprising decline in both sales and earnings in the second quarter. Cisco projects that revenue will decline 3% to 5% year-over-year in Q2.

The outlook for adjusted earnings per share, at 75 to 77 cents, admittedly is higher than the 73 cents the company delivered in the second quarter of fiscal 2019. But a lower share count thanks to buybacks is driving that growth: Cisco’s diluted shares outstanding likely will be roughly 6% lower, which suggests the company’s total adjusted net income too will drop year-over-year.

To be fair, there are external factors at play. As CEO Chuck Robbins noted in December, tariffs have had a negative impact on Cisco in several ways. They have directly provided higher prices on imported components. They’ve driven Chinese companies to use in-country suppliers. And they’ve led to a bit of a market slowdown overall, which has also pressured sales.

Meanwhile, it’s important to note that Cisco historically has guided conservatively. It has managed the expectations game well: Cisco earnings haven’t missed Wall Street expectations for either revenue or profits since 2014.

And so the guidance for a year-over-year decline in the second quarter doesn’t itself mean that Cisco’s growth is over. Nor is it guaranteed that sales and/or profits will decline. If history is any guide, Cisco will outperform its guidance. If it does significantly, it’s possible the company could drive at least some net income growth, even if an increase in sales seems more unlikely.

The Worries

That said, even after the declines, Cisco stock trades at over 14x fiscal 2020 consensus EPS expectations. Some level of growth is priced in and investors are worried about that growth long-term.

Again, Cisco did manage to drive accelerated profit increases in recent years. But there were one-time factors at play. Tax reform lowered corporate rates. Repatriation tax changes allowed Cisco to bring billions of cash in from overseas and drove higher-than-usual buyback activity. Both changes boosted reported earnings per share.

Admittedly, Cisco’s Catalyst 9000 switches and a move to bundling software with hardware both helped operating profit growth. But the worry looking forward is that those benefits were relatively one-time in nature. Cisco managed to wring higher earnings out of a relatively stagnant market. It can’t do so forever.

Meanwhile, there’s no sign of improvement in that market. Cisco’s commentary after recent quarters has remained mostly negative. Smaller rival Juniper Networks (NYSE:JNPR) is also struggling. Its shares threatened a three-year low last month. Arista Networks (NYSE:ANET) touched a two-year low late last year.

Networking simply hasn’t been a good business for years now. Indeed, before the acceleration that began in 2016, CSCO stock itself had been dead money for a decade. JNPR stock has been flat for fifteen years.

As I’ve written before, the hope was that software bundling, new switches, and other new products would turn Cisco into the next Microsoft (NASDAQ:MSFT): a giant that managed to drive growth by reinventing itself and its go-to-market strategy. The return of market softness instead raises worries that Cisco is much more like IBM (NYSE:IBM). Even with recent signs of life, IBM stock still has declined over the past five years.

Why Q2 Matters For Cisco Stock

Given history, I’d expect another earnings beat for Cisco with its second quarter results. But given recent trading, I’d expect those results, barring an enormous surprise, won’t matter all that much for CSCO stock.

Rather, as has been the case in the last two quarters, it’s the outlook that’s going to grab investor attention. Cisco doesn’t necessarily need to guide for a return to growth in the third quarter: Wall Street, in fact, currently expects sales to decline almost 3% year-over-year. But Cisco, in either the guidance or on the earnings call, needs to give investors some reason for confidence.

That could be signs of improvement in demand, though it’s hard to see what end market will contribute. (Cisco already has said 5G won’t be a catalyst until fiscal 2021, and the core networking business by all accounts remains soft.) Stronger-than-expected software sales could drive optimism. Given the ~20% decline in CSCO stock from the highs, even a quarter that simply has no bad news could be enough. Guidance for a better Q3 and positive commentary toward fiscal 2021 might get value investors back in the fold.

But this is not going to be a quarter where investors, or even traders, simply can look at the headline numbers. An earnings beat wasn’t enough for CSCO stock after the last two reports, and it won’t be next week, either. Investor reaction will rest on whether Cisco can provide a potential catalyst for growth to accelerate not necessarily in Q3 or Q4, but in fiscal 2021 and beyond. The concern at the moment is that it’s difficult to see exactly what that catalyst could be.

As of this writing, Vince Martin has no positions in any securities mentioned.


Article printed from InvestorPlace Media, https://investorplace.com/2020/02/earnings-need-confidence-csco-stock/.

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