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Read This Before Selling Your Shares of Cisco Systems

Leo Sun, The Motley Fool

Cisco's (NASDAQ: CSCO) stock tumbled last week after the tech giant posted its fourth-quarter numbers. Revenue rose 6% annually to $13.4 billion, beating estimates by $40 million. Adjusted earnings per share grew 19% to $0.83, also clearing expectations by a penny.

Those headline numbers looked solid, but Cisco's guidance spooked the bulls. It expects its revenue to rise just 0%-2% annually in the first quarter, and for its adjusted EPS to grow just 7%-9% -- down from its double-digit growth throughout fiscal 2019. Analysts expected Cisco's revenue and earnings to go up 2% and 11%, respectively.

Cisco's softer guidance was surprising, and the stock's post-earnings drop to a seven-month low likely rattled investors. However, investors should consider a few key points before selling their shares.

A lit-up web of networking connections across the globe.

Image source: Getty Images.

Why investors fell in love with Cisco

Cisco's rally over the past two years was sparked by three main catalysts: rising demand for upgrades from enterprise campus customers, the growth of its software and services (buoyed by acquisitions of smaller companies), and the repatriation of its overseas cash at a lower tax rate to fund new acquisitions and repurchase more shares. Those factors enabled Cisco to post impressive top- and bottom-line growth over the past year.

Metric

Q4 2018

Q1 2019

Q2 2019

Q3 2019

Q4 2019

Revenue

6%

8%

7%

6%

6%

Earnings per share*

15%

23%

16%

18%

19%

*Non-GAAP. Data source: Cisco quarterly reports.

Cisco was also considered a defensive play for the trade war, since it only generated about 3% of its sales from China. Regulatory scrutiny of Huawei could also boost sales of Cisco's competing products.

Cisco's gross and operating margins consistently expanded sequentially over the past year, indicating that it still commands superior scale and pricing power against smaller rivals like Juniper Networks (NYSE: JNPR).

Metric

Q4 2018

Q1 2019

Q2 2019

Q3 2019

Q4 2019

Gross margin

63.2%

63.8%

64.1%

64.6%

65.5%

Operating margin

30.9%

31.9%

32.1%

32.2%

32.6%

Non-GAAP basis. Data source: Cisco quarterly reports.

Moreover, Cisco's low forward P/E of 13 and its forward yield of 3% seemed to set a floor under the stock.

Why investors suddenly abandoned Cisco

Cisco's forecast for the first quarter indicated that its growth was decelerating for two main reasons: tougher year-over-year comparisons and softer enterprise spending in China, the U.S., and the U.K. as the trade war and other macro issues (like Brexit) dragged on.

An unplugged ethernet cable with a Chinese flag in the background.

Image source: Getty Images.

Cisco only generates a sliver of its sales from China, but its revenue in the region plunged 25% annually during the fourth quarter as Chinese customers stopped buying its products -- a likely response to the trade war and the U.S. government's crackdown on Huawei.

The company also admitted that it was now barred from bidding on any contracts for China's state-owned enterprises. In other words, losing China's single-digit share of Cisco's revenue still matters, since Cisco usually only generates single-digit sales growth.

But did investors overreact?

Cisco's weak guidance and a gloomy outlook for China overshadowed its other positive numbers. Its security and applications units (16% of its revenue) both generated double-digit revenue growth during the fourth quarter, while 70% of its software revenue now comes from stickier high-margin subscriptions -- up from 58% a year earlier.

Cisco's upcoming takeover of optical equipment maker Acacia Communications (NASDAQ: ACIA) -- one of its major suppliers -- could also help it cut costs, enable it to sell upgraded networking devices to more hyperscale data center customers, and establish a new revenue stream by selling components to other companies.

Cisco also expects its adjusted gross margin to stay at 64%-65% in the fourth quarter and for its adjusted operating margin to hold steady at 32%-33. By comparison, Juniper expects its adjusted gross and operating margins to come in at just 60% and 17.5%, respectively, for its current quarter -- mainly due to its weaker revenue growth and heavier exposure to China.

Cisco ended the quarter with $33.4 billion in cash, equivalents, and short-term investments -- which gives it plenty of room for more buybacks, dividends, and acquisitions. It stated that it would allocate "at least" 50% of its free cash flow to buybacks and dividends, so investors who stick around should expect tighter valuations and a higher yield.

It's just a speed bump

Cisco's earnings report wasn't great, but the sell-off was an overreaction. The company remains the 800-pound gorilla in networking hardware, and it still has plenty of ways to expand its business and lock in customers. Therefore, investors should be accumulating some more shares of Cisco at these levels instead of stampeding toward the exits.


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.

This article was originally published on Fool.com