Once again, the tech giant Cisco (CSCO) - Get Report reported results above expectations. During fiscal Q3, revenue and GAAP EPS increased by 6% and 13%, respectively. Also, management expressed confidence with strong guidance for the next quarter. Besides the excellent results, here are 7 takeaways to consider from the perspective of making a long-term investment:
1. Strong Security Segment
Revenue growth was consistent across all products, but the "Security" category stood out. The 21% year-over-year revenue growth in the security area is impressive. But management isn't transparent as it didn't specify the contribution of acquisitions. In any case, Cisco is taking important market shares in an IT security market that is expected to grow at a 10.2% CAGR over the next few years. As a comparison, some important competitors in the security area such as Check Point (CHKP) - Get Report , Fortinet (FTNT) - Get Report and Fire Eye (FEYE) - Get Report grew by 4%, 18%, and 6%, respectively.
Security isn't happening only at the perimeter of the enterprise anymore. Due to the development of cloud solutions, users access applications located anywhere from any device. And Cisco is successful in adapting to these broader security requirements.
2. Cloud Is Still a Mystery
Consistent with the previous quarters, management still didn't provide any detail about the strength of the cloud business. But there was a hint towards a solid performance. The fast-growing cloud network vendorArista (ANET) - Get Report disappointed the market by guiding for slower revenue growth due to challenges with some web-scale providers. Also, Juniper JNPR has reported revenue declines over the last several quarters.
By contrast, Cisco indicated no difficulty with its cloud business. Its statement was vague and didn't say anything about Cisco's growth rate in the cloud area.But it's a positive signal in the context of uncertainties around the capital budget of some web-scale providers.
3. Consequences of the Trade War With China
During the previous quarter, management indicated the 10% China tariff had no impact on Cisco's business. With the tariff hike to 25%, the question about the potential impact is legitimate. But the CEO qualified the impact as "very minimal" and "relatively immaterial". Also, the strong expected revenue growth of 4.5% to 6.5% for the next quarter takes into account the tariff increase. This development is an extra indication of the strength of the business.
4. Challenges With Service Providers
The main weakness during fiscal Q3 relates to the 13% revenue drop in the "Service Providers" segment. Over the last several quarters, management repeated the lumpiness of the business due to the small number of huge customers. Juniper and Arista reported similar challenges with service providers.
Management indicated service providers were prioritizing investments in 5G radio stations -- which isn't a Cisco business -- while leveraging their existing core networks. Thus, I expect this segment to be a growth driver in 2020 when service providers ramp up the update of their core networks for 5G. Also, due to the revenue drop during this quarter, the base comparison won't be challenging.
5. Growth at Scale
Beyond the 6% revenue growth at the high end of the guidance, it's worth noting GAAP operating income and GAAP net income increased 12% and 13%, respectively. The impressive bottom line growth wasn't due to one-time events. Instead, Cisco benefited from an 80 basis point gross margin increase thanks to favorable DRAM pricing. And the company controlled its R&D and sales and marketing expenses. As Cisco keeps on gaining scale, I expect the bottom line growth to exceed revenue growth over the next several years.
6. Focus on Share Buybacks
Since cash isn't trapped abroad anymore with the implementation of the Tax Cuts and Jobs Act, the company accelerated its share repurchases. During fiscal Q3, the company spent $6 billion to buy back shares. And, compared to the previous year, the number of diluted shares decreased by about 8.9%. Considering the $10.9 billion net cash on the balance sheet, the strong cash flow, and the reasonable valuation, I expect share buybacks to continue at these levels over the next several quarters. As long as the market doesn't overvalue Cisco, buying back shares is an attractive way to return capital to shareholders.
7. Valuation Remains Reasonable
The midpoint of the guidance implies fiscal full-year 2019 revenue will reach approximately $52 billion. Considering the strength of the business, the valuation ratios are reasonable. For example, despite the 20%+ increase in the stock price since the beginning of the year, the EV/Sales ratio is 4.2x. Also, assuming a GAAP operating income margin of 27% and a 17% tax rate, the PE ex-cash ratio is 17.4x.
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The author is long CSCO.