Is Cisco Systems a Value Stock or a Value Trap?

Cisco Systems (NASDAQ: CSCO) is often considered a stable stock for conservative income investors. It’s the world’s largest networking company, its stock trades at just 13 times this year’s adjusted earnings, and it pays a high forward yield of 3.3%.

But over the past 12 months, Cisco’s stock has stayed nearly flat as the S&P 500 rallied more than 20%. Let’s see why Cisco underperformed the market by such a wide margin — and if investors should consider it to be a value stock or a value trap.

Why did the bulls stay away from Cisco?

Cisco’s revenue fell 5% in fiscal 2020 (which ended in July 2020) as the pandemic disrupted its sales of networking hardware and software. But after the pandemic passed, its revenue rose just 1% in fiscal 2021 and 3% in fiscal 2022 as supply chain constraints throttled its sales of routers, switches, and wireless networking devices.

But in fiscal 2023, Cisco’s revenue jumped 11% as it overcame those supply chain issues and satisfied the market’s pent-up demand for big network upgrades. That recovery suggested its could exceed its long-term goal of growing its revenue and adjusted earnings per share (EPS) at a compound annual growth rate (CAGR) of 5%-7% from fiscal 2021 to fiscal 2025.

Unfortunately, Cisco’s growth decelerated over the past two quarters — and its revenue and EPS declined in the second quarter of fiscal 2024.

Data source: Cisco. YOY = year over year.

Cisco claims that slowdown was caused by its customers placing too many orders after its supply chain constraints initially eased in fiscal 2023. After receiving those shipments, its customers deployed their equipment at a slower-than-expected rate as the macro headwinds forced them to rein in their spending on big networking upgrades. As a result, the market’s demand for new networking devices abruptly dropped off a cliff.

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But that pressure won’t ease up anytime soon. Cisco expects its revenue to decline another 16%-17% year over year in the third quarter and drop 8%-10% for the full year. But looking ahead, its planned acquisition of Splunk — which will expand its smaller observability software business (1% of its revenue in the first half of fiscal 2024) — might offset some of those headwinds when it closes the deal in the first half of fiscal 2025.

Analysts expect Cisco’s revenue to rise 2% to $53 billion in fiscal 2025, but that would mark a CAGR of less than 2% from fiscal 2021 and broadly miss its long-term goal for 5%-7% growth.

But its margins are expanding year over year

Cisco’s revenue growth has stalled out, but its adjusted gross and operating margins still expanded year over year in the first half of fiscal 2024.

Data source: Cisco.

Lower freight costs, component costs, and a favorable product mix boosted its gross margins and offset the pricing pressure from its delayed deployments. The company also expects its acquisition of Splunk to be accretive to its gross margins. It expanded its operating margins with aggressive cost-cutting measures — and it plans to lay off another 5% of its workforce this year.

Unfortunately, Cisco still expects its adjusted EPS to decline 14%-16% year over year in the third quarter and 4%-5% for the full year as its declining sales overwhelm its expanding margins. Analysts expect its adjusted EPS to rise 4% in fiscal 2025 — which would represent a CAGR of 4.5% and also miss its long-term goal for 5%-7% growth.

So is Cisco a value stock or a value trap?

Most of Cisco’s problems seem cyclical, but it also faces fierce competition from other networking giants like Arista Networks and Hewlett Packard Enterprise, which recently agreed to acquire Juniper Networks. That competitive pressure could throttle Cisco’s growth, compress its margins, and drive it to make more acquisitions to widen its moat.

Therefore, investors shouldn’t expect Cisco to simply bounce back from its recent downturn after its customers finally deploy their existing orders. But even if the bulls don’t rush back, its low valuation and high yield could limit its downside potential.

I wouldn’t ever call Cisco a value trap because its core business is stable, its dividends are easily sustainable with a low payout ratio of 47%, and it will remain firmly profitable for the foreseeable future. Instead, I think it’s still a decent value stock for investors who want a safe place to park their cash while generating stable dividends.

That said, Cisco’s investors need to temper their near-term expectations. Cisco could continue to underperform the market until its revenue and earnings growth accelerate again, and many income investors might flock to CDs or T-bills as long as they sport higher yields than most blue-chip dividend stocks in this high interest rate environment.

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Leo Sun has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Arista Networks, Cisco Systems, and Splunk. The Motley Fool has a disclosure policy.

Is Cisco Systems a Value Stock or a Value Trap? was originally published by The Motley Fool