A Note About Yesterday's Broad Market Sell-Off

Yesterday was yet another gut-wrenching sell-off that investors experienced. The Dow Jones declined more than 1000 points in a single day, the biggest one-day decline since 2020. We attribute the sell-off to be driven primarily by weak earnings results and guidance from retail giants Walmart and Target. Their quarterly misses on top and bottom line made clear to market participants that the economy, which has been relying so heavily on consumer strength, now has a broad consumer issue: inflation is slowing down buyers' activity. Inflation is also eating away at profit margins. The market has been undergoing a P/E multiple compression which effectively reduces P (price), but there is another way the P can go down and that is the earnings to go down. The market is now worried that the consumer is slowing down because of inflation (because the best way to cure high prices is high prices), earning estimates are too high and will have to come down, therefore stock prices will have to come down.

Now Back To Cisco

Cisco Systems (CSCO) reported a mixed quarter and lower forward guidance after the closing bell Wednesday.

• Revenue was flat year over year at $12.8 billion in Cisco’s fiscal third quarter, missing estimates on FactSet of $13.37 billion. Adjusted quarterly earnings per share increased 5% year over year to $0.87, beating estimates by a penny.

• Dow stock Cisco, which fell sharply in Wednesday’s market plunge, lost another nearly 13% in after-hours trading following the release.

One part of the revenue shortfall can be explained by Cisco stopping business operations in both Russia and Belarus in March due to Moscow’s unprovoked war in Ukraine. This negatively impacted revenue by approximately $200 million, or 2 percents. 

Also, since Cisco’s quarter ended in April, while Covid lockdowns in China began in late March and added stress to an already strained supply chain shortage of certain critical components. These supply chain challenges prevented Cisco from getting things like the power supplies it needed to ship products to customers. In total, the challenges stemming from the lockdowns were a $300 million headwind to revenue.

Despite the big revenue miss and lower volumes, Cisco’s effective pricing actions and spending discipline translated into stronger than anticipated margins and a record quarterly earnings-per-share print. Adjusted gross margins were 65.3%, above prior guidance of 63.5% to 64.5% and estimates of 64.2%, while adjusted operating margins of 34.7% exceeded guidance of 32.5% to 33.5% and were stronger than the 33.12% expected.

Lower guidance

• For its current fiscal fourth quarter, Cisco expects revenue to decline between 1% and 5.5% year over year, implying a number around $12.69 billion, which was well below estimates of $13.87 billion. 

• Adjusted gross margins for fiscal Q4 are expected to be 64% to 65% and adjusted operating margins are expected to be 31.5% to 33.5%.

• Adjusted quarterly earnings per share are expected to be $0.76 to $0.84. At a midpoint of $0.80, this is well below estimates of $0.92.

At first glance, you may look at these numbers and think that Cisco must be seeing order cancellations come in as customers rethink their spending plans amid the macro uncertainty. This is not the case and CEO Robbins stressed on the call that there was zero demand impact in the fourth quarter guide. It was 100% supply-related, and these challenges could last another 90 days before mitigative actions take hold.

For the full fiscal year, which ends in July, management now sees revenues growing 2% to 3% year over year, down from a previous view of 5.5% to 6.5% growth.

On the bottom line, management now sees full-year company earnings of $3.29 to $3.37 per share, down from their previous view of $3.41 to $3.46 and below estimates of $3.44.

Companywide Q3 results

Total Product revenue increased 3% year over year to $9.45 billion in the quarter, missing estimates of $9.8 billion. Cisco breaks down its product revenue into five main buckets: Secure Agile Networks, Collaboration, End-to-End Security, Internet for the future, and Optimized Applications Experience.

• Secure Agile Networks — which includes sales of campus and data center switches (hardware used to connect devices within a network), enterprise routing, and wireless products — saw revenue increase 4% year over year to $5.87 billion but miss estimates of $6.1 billion.

• Collaboration — Webex video conferencing and contact center — saw revenue fall 7% year over year to $1.13 billion, edging estimates of nearly $1.13 billion.

• End-to-End Security — cybersecurity — saw revenue grow 7% year over year to $938 million, edging estimates of $931 million.

• Internet for the future — routed optical networking, public 5G, and silicon — saw revenue grow 6% year over year to $1.32 billion, missing estimates of $1.44 billion.

• Optimized Applications Experience — including some software as a service-based offerings — saw revenue increase 8% year over year to $183 million, missing estimates of $189 million.

Services revenue fell 8% year over year to $3.39 billion, missing estimates of $3.54 billion.

Here are some other key items we think are worth mentioning.

• Total product orders in fiscal Q3 grew 8% year over year, breaking the streak of three straight quarters with 30% or higher growth but still a healthy result overall. 

• Despite the broader economic uncertainty, Cisco’s product backlog continues to grow and sits at a record. The company ended the quarter with a product backlog well over $15 billion and a software backlog of more than $2 billion. Both were up 10% sequentially.

• Total software revenue fell 3% year over year to $3.7 billion. The company said total software revenue for the quarter would have been 5 percentage points higher, excluding the combined negative impact of the extra week in the quarter in the prior year and Russia’s war in Ukraine. Keep in mind that a lot of Cisco’s software sales are connected to a piece of hardware, so if hardware isn’t shipped to customers due to supply chain challenges, then software revenues take a hit too.

• Total subscription revenue for the quarter was $5.5 billion, down 4%. Subscription revenue would have been 7 percentage points higher, excluding the combined negative impact of the extra week last year and the Ukraine war.

• Total Q3 subscription revenue represented 43% of Cisco’s total revenue; 83% of Cisco’s total software revenue was subscription based, an increase of 1 percentage point year over year.

• Annualized recurring revenue, or ARR, a subscription metric that represents the annualized revenue run-rate of active subscriptions, term licenses, and maintenance contracts, increased 11% to $22.4 billion.

• The Remaining Performance Obligation, or RPO, which helps shows how much future revenue is under contract, increased 7% to $30.2 billion. The total short-term RPO, meaning this is revenue the company expects to recognize this revenue in the next 12 months, increased 9% to $16.2 billion.  

Why do software and these stats all matter? We focus on these metrics because they help us gauge the health of the business and the progress made on the company’s business transition from lumpy hardware sales, which are a low price-to-earnings multiple business, to higher-margin, more predictable software sales, which are something investors typically are willing to pay a premium for.

Capital allocation, cash flow

• Cisco generated $3.5 billion of free cash flow in the quarter, down 4% year over year and a miss versus estimates of $4 billion.

• Management bought back approximately 5 million shares in the quarter at an average price of $54.20 for a total purchase price of $252 million.

• The company has plenty of dry powder available to take advantage of the recent decline in stock price with $17.6 billion remaining under its current buyback authorization.

• The company also paid out $1.6 billion in its quarterly cash dividend.

Bottom line 

All things considered, the quarter looked OK to us when you factor in the challenges related to external events like the lockdowns in China and the decision to stop all operations with Russia and Belarus. Although it was a big quarterly revenue miss, we were pleased to see Cisco make up for it with higher-than-expected margins, as those price actions management put through this year supported profits.

While the outlook may raise some eyebrows, we’re encouraged by how Cisco’s issues are almost 100% supply-chain related. We would be more worried if Cisco were seeing demand soften and cancellations increase amid the macro uncertainty. However, we got zero inclination toward this after listening to the conference call.

Of course, those supply chain challenges will not be fixed overnight. It may take a couple of quarters for it to play out. But that’s where the dividend comes into play. At a yield of roughly 3.6% based on Cisco’s after-hours plunge to around $42 per share, we think that’s a pretty solid incentive that pays us as we patiently wait for the supply chain pressures to alleviate and for Cisco to take full advantage of a record order backlog that it’s sitting on.