Cisco trades at 7.4 times revenue and 32 times trailing operating earnings. Earnings have been essentially flat over the past five quarters and revenue has been down over the past three quarters compared to the prior year. The stock trades at extremely high valuations, but has no growth. Yesterday's Stock Brief titled What to Look For in Cisco's Earnings Report showed that margin growth has been the key to the stock's rise.
Cisco's comments in its conference call about revenue prospects were only modestly upbeat. The company needs to show more growth to justify the valuation metrics on this stock, or the upside on the stock is limited.
Some very lame reasons were given this morning by various members of the media and guru interviewees. The most common reason was "the street expected Cisco to beat" and since it only met earnings, it sold off. This type of logic did prevail during the bubble era, but few institutions actually trade this way any more. It is simply wrong. The other explanation we heard is that the year-over-year revenue growth was disappointing, as it fell 2.6% compared to a year ago. That's closer to the truth, but the consensus revenue expectation was $4.679 billion and Cisco beat that, although by only $123 million (3%). Frankly, most of the financial media has missed the real issue with Cisco.
If you read the Ahead of the Curve column on Tuesday, "What to Look For in Cisco's Earnings." you already know what went wrong. The margin expansion story ended. For the past three years, Cisco has done a great job of expanding gross margin and cutting infrastructure costs, which improves operating margin and falls to the bottom line. But that trend of 10 quarters reversed itself in this report. That leaves only revenue growth as a driver to justify the stock's current valuation. The trend there is decidedly flat. Earnings have been flat for four quarters now. If revenue is flat, earnings are flat, and margins have stabilized, how can you call the company a growth company? That debate is the one going on now, with the sellers deciding that growth is over. Buyers still feel it is right around the corner, with the only justification being CEO Chambers' strongly optimistic tone on the conference call.
In yesterday's Ahead of the Curve column (on the Stock Brief page), we offered six possible scenarios for Cisco's report and predicted the effect on the stock. For a gross margin decline of any kind, we predicted the stock would fall. For a gross margin decline to the 68% level, we predicted a 10% drop. For revenue above $4.750 bln, we predicted it would offset any effect from a gross margin decline. The revenue reported at $4.702 bln beat estimates modestly and the gross margin only declined to 69.9%. Nevertheless, the stock has fallen more than 4% since yesterday's close. We think this stock action justifies our line of thinking. The market is focused on the margin expansion story at Cisco. Now that driver is gone and the focus will be on revenue trends.
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