Strengthening economic pressures and competitive threats will take their toll on Cisco, but the firm's prodigious cash-flow generation and inexpensive valuation make it attractive today, says Morningstar's Grady Burkett.
Jeremy Glaser: For Morningstar, I am Jeremy Glaser. Among the market volatility, it's sometimes easy to forget that we're still getting some earnings. Cisco is a company we've been following pretty closely during the last few quarters, and it reported after the bell today. I'm here today with Grady Burkett. He is an associate director of technology here at Morningstar, and we're going to take a closer look at Cisco's earnings.
Grady, thanks for joining me today.
Grady Burkett: Thanks for having me, Jeremy.
Glaser: So, let's get the, just kind of a big-picture view of Cisco's earnings this quarter. How did they look?
Burkett: Yeah, I mean overall it was a solid quarter for the company. It slightly beat on revenue. The outlook looks reasonably healthy for where Cisco's at, and I think it's important to keep in mind, this company generated about $2.6 billion in free cash flow in a quarter where it was challenged. So, the company looks healthy, it's buying back shares, and it's paying dividends now. So, it was a good quarter overall.
Glaser: So Cisco is not seeing any effects of an economic slowdown or the potential of a slowdown that we've seen, you kind of discussed, elsewhere in the market?
Burkett: Well, I think when you look at its orders in the quarter they looked fairly healthy, other than the public sector. So, the public sector looks fairly weak. I think, if you look at enterprise, service provider, commercial, and other segments, yeah, things look fairly strong. Now, I think kind of maybe in October there may have been some deceleration in orders and so, we'll see how that plays out through the next quarter. Certainly, public sector is an area of uncertainty, and the company has been cautious in its outlook going forward relative because of that.
Glaser: You recently cut your fair value estimate somewhat. Can you walk us through some of your reasoning behind that decrease in the fair value estimate?
Burkett: We did. So, Cisco has been a name we've been recommending for quite some time now. It's been in 5-star territory; it still is. So, we took the fair value estimate down a little bit, and a lot of this is really about the structural pressures in the switch business. And so this is a mature business, there is competition moving in, and it was really just a matter trimming expectations in switches. That said, there is a lot of uncertainty around capital spending and budgets, and we've seen some of Cisco's peers, such as Juniper, come out and talk about maybe some weakness potentially in the service provider budget. So there's a lot of uncertainty out there. Certainly what's happened over the past week or so isn't going to help things in terms of business spending. So we think it as a time to really kind of think about you being little conservative or cautious in your near-term projections.
Glaser: So if we think about competition in this space. We know it's an area that you've talked about Cisco's with moat before. Do you see that competitive advantage being under pressure over time, or do you think the firm is still going to be able to carve out that economic moat?
Burkett: Well I think what Cisco's been doing over the last six months or particularly in the last three months is actually kind of contributing to helping to strengthen its moat. Certainly it's a wide-moat company, and the moat is under pressure at times. We recognize that, but the company has done a lot of restructuring in terms of consolidating its software development teams, consolidating its hardware development teams, and cutting some noncore businesses. So I think the business is going to be slightly lower returns in the switch business going forward, but I still think it will generate pretty healthy returns in gross margins from that business.
Glaser: Do you have confidence in the current management team with John Chambers, or do you think that there's need to be a change there, to really get this cash flow generation, put it to good use to really get those returns back to shareholders?
Burkett: Well, so far the steps that they've taken, coming out of some of the issues they had over the previous quarters, they've been really positive steps. So, I think again, this is a company that returned $1.6 billion of the $2.5 billion it generated in free cash flow to shareholders. So I think you can kind of check the capital-allocation box a little bit and say, "OK, we can be comfortable there." It's a company that's cutting, its non-essential workforce, that is the workforce that really hasn't been maybe contributing or hasn't been as productive as it could have been. So I think you can kind of check that box. And it's moving out of consumer space which is our biggest area of concern for a long time. So it's hard to say there's obviously execution risk going forward, but it looks like management is doing the things it needs to do.
Glaser: OK, let's take a look at valuation for a moment then. It's still a 5-star stock, why are you comfortable owning these shares right now?
Burkett: Again, it's a company that is right now trading about 7 times our forward free cash flow estimates net of the $5 per share in cash it has. So, this is a company that every time it buys back shares, that move is now value accretive for the company, and it's way too cheap for a company with durable competitive advantages.
Glaser: Sounds great. Grady, thanks for talking with me today.
Burkett: Thanks for having me, Jeremy.
Glaser: From Morningstar, I'm Jeremy Glaser.
