EUR 850.00 For Business Accounts Only

Morningstar | 3Q Showcases Another Quarter of Broad-based Growth for Cisco; Strong Guide; Raising FVE to $52. See Updated Analyst Note from 15 May 2019

Narrow-moat Cisco's 4% year-over-year growth in the third quarter (6% excluding the SPVSS divesture) was driven by strength across all product categories. Cisco's operating metrics were in line with our expectations for the quarter and we have increased our projections for next quarter. We posit that Cisco's unique advantage of being one-stop-shop is becoming stronger as it offers platform solutions that integrate the aspects of wired and wireless networking plus security together. In our view, high growth areas like software-defined networking and security to protect hybrid-cloud ecosystems and users should provide a sustainable period of robust growth. With an elevated expectation on revenue growth while projecting margin expansion taking place as Cisco moves toward selling more subscriptions and software, we are raising our fair value estimate to $52 per share from $49, and we continue to advise investors to hold this security.

Compared with last year and excluding the SPVSS business, Cisco's infrastructure platforms business grew by 5%, applications by 9%, security by 21%, other products by 3%, and services by 3% in the third quarter. The infrastructure growth was broad-based, driven by the Catalyst 9000 series ramp continuing and customers adopting Cisco's Application Centric Infrastructure (ACI); routing growth was attributed to SD-WAN strength; data center grew due to hyperconverged infrastructure and servers; while wireless had robust growth across the portfolio. Applications growth was led by unified communications software, telepresence products, AppDynamics, and WebEx solutions continuing to grow as Cisco updates customer platforms. Robust growth in security was due to identity access, advanced threat, and unified threat solutions as customers move from securing individual components of network security and into holistic security platforms for their on-premises and clouds. Service revenue increased due to more software and solutions support demand.

In the quarter, GAAP gross margins increased by 80 basis points year over year to 63.1% (non-GAAP increased to 64.6% from 63.9%). Product gross margins grew by 60 basis points year over year to 73.8% while service gross margins increased to 66.3% from 65.8%, on a GAAP basis. DRAM pricing was a tailwind for Cisco, and we expect the shift toward more software and subscriptions to help grow the gross margin line. GAAP operating margin increased by 200 basis points year over year to 27.1% (non-GAAP grew to 32.2% from 31.5%) due to gross margin improvements and revenue growth outpacing operating expenditure increases. In the quarter, Cisco repurchased $6 billion worth of shares and paid out $1.5 billion in dividends. Cisco still has about $18 billion of authorized funds remaining for share buybacks and we opine Cisco's shareholder-centric nature is a key aspect of holding this name.

Excluding the divested SPVSS business, management's guidance for next quarter includes 4.5%-6.5% year-over-year revenue growth, 64%-65% non-GAAP gross margin, non-GAAP operating margin of 31%-32%, and non-GAAP EPS of $0.80-$0.82. With strong momentum coming into next quarter, we expect Cisco to be at the high end of its revenue range while slightly exceeding its non-GAAP operating margin and EPS guidance values. Cisco management commented that any impacts of tariffs are baked into the guidance values. The company has decreased its reliance on having infrastructure in China and its operations were prepared for tariff escalations.

We expect nascent areas like SD-WAN, higher performing switches, wireless systems with Wi-Fi 6, and a consolidated security architecture to drive the top line. In the quarter, subscriptions made up 65% of software revenue, a 9% year over year increase, and management commented that Cisco is well on its way to achieving its goals surrounding software that were discussed at the 2017 analyst day. As the company continues to move toward selling more subscriptions and software products, we expect gross margin and operating margin to continue the positive momentum.

Product order growth, compared with the prior year, included enterprises increasing by 9%, the public segment expanding by 10%, commercial growing by 5%, and service providers declining by 13%. The service provider business is lumpy for Cisco and management commented that the results were impacted mainly because of the Americas. Whereas the CSPs equipment providers are seeing strength due to radio network sales in the Americas, Cisco's 5G growth will come as the service providers upgrade their routing and network backbones. Management commented that the service providers are using the existing network backbone architecture during trials, and Cisco expects this business to ramp in 2020 due to 5G.