Right now, Cisco is very attractively valued and has too much negativity priced into its valuation.
However, that aside, Cisco has very high gross margins, while it trades for just 14x free cash flow, with approximately 5.6% shareholder return via dividends and buybacks.
Macroeconomic Uncertainty Is Weighing on Cisco
The global economy continues to cause headwinds for Cisco, with management stating that supply chain and component constraints are having an impact on Cisco's near-term. However, management believes the aspects are temporary.
Given that close to 70% of Cisco revenues are hardware-based, this impact is understandable. Indeed, it echoes the narrative of many Fortune 500 companies, including the biggest tech companies, such as Apple (AAPL) - Get Report and Microsoft (MSFT) - Get Report.
Having said that, a large portion of these headwinds have already been priced into its shares, and I believe there’s too much negativity been priced into Cisco.
Cisco’s Operations Become Increasingly Subscription-Based
Cisco derives close to 30% of its revenues under its Service Segment. Within this segment, approximately 74% is now subscription-based, compared with just 65% a year ago.
The more of Cisco’s Services segment that becomes subscription-based, the more predictable Cisco’s revenue stream becomes, and the more efficient Cisco can become with planning its expenses. This translates to Cisco’s already high margins becoming higher in time, as Cisco can be run as lean as possible.
In fact, we already saw this occurring this quarter, where Cisco’s Services non-GAAP gross margins reached 68.9% versus 67.3% in the same period a year ago. This is impressive, particularly when we note that these high margins are taking place during a period when Cisco’s total revenues are falling.
On the other hand, the details here are crucial. According to Cisco’s management, its Service segment lags the rest of Cisco’s performance. Consequently, although Cisco’s Service segment was a strong performer this quarter, over the coming quarters, Cisco expects that trend to reverse in its upcoming quarter, and for Services to be under pressure.
In fact, according to Cisco’s CFO Kelly Kramer within its Services unit, Cisco’s ability to upsell to existing enterprises will be limited in the upcoming quarters, seeing that many companies are hesitant to adopt long-term subscriptions, and Cisco’s ability to sell value-added and consulting services become hindered. But Kramer argues that its Service business is attractive, resilient, and has been through cycles before and came out strong.
Valuation - Very Attractive Investment
Cisco remains committed to returning approximately 80% of its free cash flow to investors via dividends and share repurchases.
Indeed, despite its revenues contracting during the quarter, together with its unimpressive guidance on top of the overall global uncertainty, Cisco continues to return to shareholders huge sums of capital.
Specifically, despite its total revenues contracting by 8% during the quarter, Cisco didn’t shy away from returning $2.5 billion to shareholders. At the present run rate, Cisco will return to shareholders close to 5.3% of its market cap via a combination of dividends and repurchases over the coming twelve months.
Presently, investors are only being asked to pay 14x its free cash flow, thus being presented with a very attractive investment opportunity. Note, this is free cash flow, which is more attractive than earnings.
The Bottom Line
Large and established tech companies are rarely cheaply valued, particularly when they have strong competitive advantages, as is the case with Cisco.
Considering Cisco’s high gross margins, strong returns of capital to shareholders and compelling business model, Cisco's stock is not likely to remain priced at 14x free cash flow for too much longer.