Cisco Executes Well in 1Q; Stock Still Cheap
Given Cisco's balance sheet strength, improved execution, still-solid competitive position and attractive valuation, we continue to find the shares compelling at their current market price.
Market Update
Cisco Systems (CSCO) executed well in its fiscal first quarter, demonstrating for the second consecutive quarter that recent initiatives to refocus on its core businesses are showing early signs of success. Revenue came in slightly ahead of our expectations, while operating margins were significantly higher than we had anticipated as Cisco continued to steadily improve gross margins across its switch portfolio. Importantly, Cisco generated double-digit year-over-year order growth across each of its key customer segments and geographies, suggesting that end market demand is well balanced and holding up relatively well.
Services was an area of particular strength, making up for lackluster product revenue growth in the quarter. Cisco delivered its seventh consecutive quarter of double-digit service revenue growth while maintaining service gross margins of 65.1%, and this segment accounted for 20.5% of the firm's $11.3 billion in first-quarter revenue. We expect services to account for an increasingly large portion of total revenue over our five-year explicit forecast, partially because of management's increased focus on this business and partially because of the increasing maturity of the router and switch industries. This would be a welcome mix shift, in our view, as service engagements are more predictable, lead to stickier customer relationships, and are less likely to succumb to significant pricing pressure than hardware sales.
Cash generation was once again healthy. The firm produced $2.1 billion in free cash flow, and its cash balance, net of debt, remains at nearly $28 billion, or $5 per share. The company bought back $1.5 billion in stock at an average price of $15.37 per share and paid out $322 million in dividends. In aggregate, Cisco returned nearly 90% of free cash flow generated in the quarter to shareholders, and we believe that management should continue to aggressively repurchase shares while they remain undervalued.
Management expects year-over-year revenue growth of 7%-8% in its second quarter, which would represent a positive first step toward its three-year annualized revenue growth target of 5%-7%. Moreover, the firm expects earnings per share growth to outpace revenue growth during the second quarter, a welcome departure from previous quarters' disappointing results. Although Cisco is on track to outperform our 2012 earnings estimate, we believe our five-year forecast adequately captures the firm's long-run opportunities, and we are maintaining our $26 fair value estimate.
Cisco still faces a number of long-run threats to its core franchises of switches and routers, and we believe increasing competition from Huawei and an ongoing shift toward cloud computing will pressure Cisco's competitive advantage--and product gross margins--over time. Still, given Cisco's balance sheet strength, improved execution, still-solid competitive position and attractive valuation, we continue to find the shares compelling at their current market price.
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