Should You Worry About Cisco's Terrible Guidance?

Should You Worry About Cisco's Terrible Guidance?

When networking giant Cisco Systems reported earnings earlier this month, analysts and investors were shocked by the abysmal guidance given by the company. As I mentioned in my earnings preview, commentary from Cisco's management about the state of the industry is just as important as the numbers, and Cisco disappointed on that front.

Predicting a year-over-year revenue decline of between 8% and 10% next quarter, the guidance was the worst that it's been since the financial crisis. Extreme weakness in emerging markets is to blame, much like the recent problems International Business Machines has been having with its hardware business. But while the news certainly isn't good, a single quarter doesn't make a trend, and basing an investment decision on a single three-month period is short-sighted at best.

A decent quarter
Cisco's results for the previous quarter were somewhat mixed. Total revenue grew by 1.8%, below the guidance of 3%-5%, to $12.1 billion. This shortfall was caused by weakness in emerging markets in the last few weeks of the quarter, and is part of the reason why guidance for next quarter is so low.

Non-generally accepted accounting principles earnings per share grew by 10.4% to $0.53, the result of an increase in gross margin and a decrease in operating expenses as a percentage of revenue. Last quarter Cisco announced significant job cuts, and the effect of this combined with the acquisition of Sourcefire has led to the headcount remaining nearly flat compared to last quarter.

During the quarter, Cisco returned about $3 billion to shareholders. It repurchased 84 million shares during the quarter, for a total of $2 billion, and paid out $914 million in dividends. An additional $15 billion was added to the share repurchase program, raising the total available to $16.1 billion.

What's going on in emerging markets?
Cisco's top five emerging markets all saw large revenue declines in the quarter. Brazil fell 25%, Mexico fell 18%, India fell 18%, China fell 18%, and Russia fell a staggering 30%. From the conference call it appears much of this weakness manifested itself toward the end of the quarter, and the weak guidance is the result of assuming that this weakness continues. What isn't clear is what exactly caused these declines. IBM, when it reported its earnings last month, saw hardware sales in Brazil, Russia, India, and China, or BRIC countries, fall by 15%, with China contracting by 22%.

One possibility is the so-called "Snowden Effect." The revelations brought about by Edward Snowden regarding the NSA's various data collection activities could be having a negative effect on American businesses, especially large ones like Cisco and IBM.

With extremely close ties between the NSA and large American tech companies, emerging market countries have a good reason to be wary of the American IT industry. If this is the case, IBM looks to be in better shape than Cisco, as only its hardware business was affected. IBM derives most of its revenue and essentially all of its profits from software and services, and these areas continued to grow.

This effect isn't universal, however. One of Cisco's main competitors, Juniper Networks , has stated that the Snowden effect is not real, and that its business in China is still growing. Cisco's weakness could present an opportunity for Juniper to gain share in emerging markets, although it's still not clear that this weakness is anything more than a temporary blip.

It's clear from both Cisco and IBM's conference calls that neither company knows exactly what's going on in these emerging markets. It could simply be short-lived caution on the part of foreign firms, or it could be a more serious NSA-related problem. Either way, a single weak quarter means little, and I wouldn't start to worry unless this weakness persists for a few more quarters.

Back in value territory
Assuming that the emerging market weakness is temporary, Cisco is an incredible bargain after the post-earnings slump. The company has guided for between $1.95 and $2.05 of non-GAAP EPS in fiscal 2014, putting the forward P/E ratio at 10.7 using the midpoint of that range. This ratio, however, ignores Cisco's pile of excess cash. At the end of the quarter Cisco had $32 billion in net cash, or $5.89 per share. Backing this cash out, Cisco's adjusted forward P/E ratio is just 7.8. Even assuming no growth going forward, Cisco is a bargain.

The bottom line
As a Cisco shareholder the weak guidance is certainly concerning, but it's also not the end of the world. It's unclear whether this weakness is temporary or the result of a more serious problem, but I suspect that the next few quarters will show that the former is the case.

The extremely low valuation gives investors a margin of safety, with a rock bottom P/E ratio creating a buffer against further weakness. The best time to buy a stock is often when pessimism is running rampant, exactly what's happening with Cisco today.

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Timothy Green owns shares of Cisco Systems. The Motley Fool recommends Cisco Systems. The Motley Fool owns shares of International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Originally published