The following commentary was originally sent to Action Alerts PLUS subscribers on Aug. 17, 2016, at 7:23 p.m. ET.
Cisco (CSCO) reported a top-line miss and bottom-line beat for its fiscal fourth quarter after Wednesday's close, while issuing what we view as conservative guidance for 2017's fiscal first quarter. We view the quarterly results positively, as the company continued to deliver growth at high margins across its strategically important businesses while shedding costs across its legacy lower-margin, low-growth businesses. (Cisco is part of TheStreet's Action Alerts PLUS portfolio.)
Reports from Tuesday night indicating the company was considering laying off 12% to 20% of its global workforce proved partially true, with management announcing a more modest 7% cut.
Cisco is in full transition mode, several innings in to what has already been a remarkably successful transformation from disrupted toward disruptor. These gains scratch the surface of the market potential, which can be unlocked under the right strategic direction. We appreciate management's ability to facilitate such a complex, multilayered transition in such a cerebral, methodical and thoughtful manner, as well as its transparent, no-nonsense mentality, one marked by laser-focus drive to prioritize, optimize and innovate with strategic clarity and precision. We, like management, are in the name for the long term, and view shares as both undervalued and misunderstood.
Whenever a company pivots to make a strategic shift, the path toward transformation is rocky at best. The sheer magnitude of Cisco's size, combined with myriad moving pieces, all but guarantees interim choppiness along the way. Although the shift is years into the making, this quarter marked a true line in the sand as management spared no attempt to qualify its priorities, which are security, Internet of Things (IoT), collaboration, next-generation data center and cloud. Nor did management attempt to spin the fact that it is shedding costs across its lower-growth, lower-margin businesses (routing and SP video are the most prominent disappointments/declines), reinvesting all cost savings back into the business to "aggressively invest to focus on our areas of future growth."
Within the quarter, Cisco reported EPS of $0.63 vs. $0.60 consensus and sales of $12.64 billion vs. $12.57 billion consensus. Impressively, adjusted gross margins of 64.6% crushed guidance for 63%-64% and consensus of 63.9%, with the increase due to continued productivity improvement along with favorable product mix.
The company issued downside guidance for its fiscal first quarter, calling for $0.58 to $0.60 EPS vs. $0.60 consensus and sales decline/growth of -1%/+1% year over year, below consensus of about 1.5%. We view management's gross margin guidance of 63%-64% as conservative in light of the company's history of conservative margin forecasts (including this quarter, where it beat its own forecast by 110 basis points at the midpoint).
On the call, CEO Chuck Robbins noted that the shift toward software not only offers lucrative margins but is paying off in spades, noting that success related to subscription software sales has a long runway, with deferred revenue +33% but more realistically +43% year over year for the fiscal first quarter when including pre-secured contracts set for monthly billing. The company's ACI business -- essentially the nexus of its hybrid model, which integrates hardware/software and serves as the infrastructure around which its entire ecosystem revolves -- has emerged out of obscurity and into a $3 billion-plus and growing revenue stream. We expect to see more enhancements, advancements and innovation on top of Cisco's existing ACI as it serves as a major growth lever going forward.
We love cash flow generation here at AAP, which is another reason Cisco remains among our favorite investments. For fiscal 2016, the company generated a record of about $14 billion in cash flow (8% year-over-year increase), returning nearly $9 billion of that back to shareholders in the form of dividends and buybacks. Going forward, the company will continue to deploy its massive cash balance ($66 billion with $6 billion available in the U.S.) aggressively yet opportunistically and strategically, through both continued dividend and buyback payments but more notably reinvestments into growth.
Bottom line: We would be buyers on any post-earnings pullback tomorrow and believe Cisco executed well in the face of a difficult backdrop. We appreciate that management remains focused on consistent, solid execution while driving profitable growth, cash generation and operating leverage. By making tough decisions in the short term, the company is laying bricks for the long term, continuing its firm commitment to delivering shareholder value.