Cisco's stellar quarter, guidance raise overshadowed by investor concerns about its backlog
Computer networking giant Cisco Systems (CSCO) on Wednesday delivered a beat on revenue and profit for its fiscal second quarter, while significantly raising its guidance. But the impressive results were overshadowed by lingering questions about the state of new orders for its hardware, leaving us cautious about the future of the Club holding. Revenue increased 7% year-over-year, to $13.6 billion, outpacing analysts' expectations for $13.43 billion in revenue, according to estimates compiled by Refinitiv. Adjusted earnings-per-share (EPS) grew 5% year-over-year to 88 cents, ahead of analysts' forecasts for EPS of 86 cents, Refinitiv data showed. Shares of Cisco climbed about 3% after hours, to nearly $50 per share, in a move that would push its gains to about 5% since the start of the year. Bottom line Cisco unveiled a stellar fiscal second quarter after the closing bell on Wednesday, and its ability to dramatically raise guidance came as a surprise to most investors. The company was primarily able to lift its guidance for revenue and earnings due to the increased availability of supply. Cisco shares had been punished last May when its supply chain issues reached a tipping point, with shares falling from around $50 apiece to the low $40s. But now that its supply chain constraints have eased — allowing it to deliver a beat and raise — the company's shares should be rewarded at a price above those levels. We expect Cisco to ultimately receive more credit than what the market is currently offering. However, questions remain about when exactly Cisco will reach the peak of its backlog. It's no doubt encouraging to hear from management that demand trends are stable sequentially and cancellations are below pre-Covid levels. But until we have a better sense of the company's growth prospects for next year, we're remaining on the sidelines with a 2 rating . Quarterly commentary Cisco's quarterly results beat analysts' expectations nearly across the board, with revenue growth driven by the secure agile networks division, whose products include networking hardware and software for data centers. The company also made good progress on its goal of increasing software sales. Cisco is still in the midst of a transition from lumpy hardware sales, which are cyclical, to focus more on subscription-based software — a higher-margin business with more predictability. And higher margins, combined with visibility, is the sweet spot for enticing investors to pay a premium. Cisco's software sales increased by 10% on an annual basis in its fiscal second quarter, while software-subscription revenue grew by 15%. Recurring revenue now represents 44% of the company's total revenue. The health of Cisco's software business is often assessed by measuring its annualized recurring revenue (ARR) — a subscription metric that represents the annualized revenue run-rate of active subscriptions, term licenses, maintenance contracts and remaining performance obligations (RPOs) — which helps show how much future revenue is under contract. In the quarter, ARR increased 6%, to $23.3 billion, and the RPO increased 4%, to $31.8 billion. Meanwhile, shares of Cisco started to give up some of their big gains in afterhours trading — the stock had initially rallied roughly 8% on the results — following tough questions from analysts Wednesday evening about the company's orders. Cisco had in recent years built up a record backlog through multiple quarters of surging order growth, aided by supply-chain constraints during the Covid-19 pandemic. But analysts and investors remain uncertain about the health of the company's orders once that backlog dries up. The bear case on Cisco is that the company is living off its backlog, and when it starts to deplete there won't be enough new orders to replenish it. So, when management noted that its total product orders were down 22% year-over-year last quarter, and that the backlog fell 6% sequentially, the stock started to lose some steam. Cisco management argued that the 22% annual order decline is only relative to one of the company's largest quarters for product orders in history, distorting the results. Indeed, on a quarter-over-quarter basis, total product order growth in the fiscal second was in line with the company's historical rate. The backlog, meanwhile, still grew on a year-over-year basis, and management believes it will end the fiscal year at roughly double the size it normally is at the end of a given year, between $4 billion and $5 billion. Additionally, as hardware gets shipped to customers, more software is attached. Much of that software revenue is ratable, meaning revenue is spread out over a long period and not recognized immediately. Cisco on Wednesday announced it will increase its quarterly dividend by 1 cent, or by 3%. Management also said the company repurchased $1.26 billion worth of shares in the fiscal second quarter, at an average price of $47.72 apiece. With the stock hovering around $50 per share this evening, this was a good use of cash. Guidance Cisco's quarter may have been better than what the Street expected, but where it really shined was guidance. In the company's third quarter of fiscal 2023, management expects revenues to increase by 11% to 13% year-over-year, well ahead of analysts' forecasts for a 6% increase. Management also guided for adjusted EPS of 96 cents in its fiscal third, ahead of expectations for 89 cents a share. For the full year of fiscal 2023, management raised its revenue growth outlook to the range of 9% to 10.5% year-over-year, up from a previous estimate of 4.5% to 6.5%. Management also raised its adjusted EPS outlook for fiscal 2023 to be in a range of $3.73- to $3.78 a share, up from $3.51- to $3.58 a share. The main reason why the company is able to deliver more revenue and higher earnings than it expected previously is due to the improving availability of supply. The company is also working through its backlog and delivering the hardware and software its customers need. Nonetheless, the market isn't giving Cisco the full credit it deserves for this earnings beat and guidance raise over concerns the company is simply depleting its backlog, without replenishing it fast enough with new orders. And despite management insisting the overall demand environment from the prior quarter hasn't shifted, we, too, remain cautious about the state of the backlog going forward. 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A man passes under a Cisco logo at the Mobile World Congress in Barcelona, Spain February 25, 2019. Sergio Perez | Reuters