Cisco shares Q4: Massive job cuts with stronger focus on AI, cloud and security (Upgrade) (CSCO)

I presented a sales thesis for Cisco (NASDAQ: CSC) in my previous article from March 2024, where I highlighted their internal problem of inventory reduction and weak demand from the telco/cable markets. The company published its Result on 14 August^th showing a 10.3% decline in total revenue. The stock price has underperformed the S&P 500 since my last article. The company has announced a second round of job cuts this year and a shift in focus to growth areas such as AI and cybersecurity. I believe these initiatives could act as near-term catalysts for Cisco's earnings growth. Since the stock price is below its intrinsic value according to my DCF analysis, I'm upgrading the rating to Buy with a fair value of $55 per share.

Job cuts and strategic realignment towards AI and security

Cisco announced a comprehensive restructuring Plan that cuts 7% of the total workforce and brings total estimated pre-tax savings of $1 billion. CallManagement emphasized a strategic focus on growth areas such as AI, cloud and cybersecurity.

I believe the restructuring plan makes strategic sense for the following reasons:

• As mentioned in my previous article, Cisco has a significant amount of legacy networking and other hardware equipment that has grown very slowly over the past few years. As shown in the table below, Cisco's average revenue growth was only 1.6%. The significant headcount reduction could allow the company to reallocate capital from low-growth business areas and invest more in high-growth areas.

• The estimated cost savings will represent approximately 2.4% of total operating expenses. Once Cisco fully realizes these cost savings, I estimate the company could achieve more than 220 basis points of margin expansion in fiscal year 2025.
• Cisco has some business portfolios in growth areas such as AI, cloud and cybersecurity. The restructuring efforts could potentially redirect more internal resources to these growth markets, thereby accelerating revenue growth in the future.

Robust growth in product orders

As reported in the quarterly report, product orders increased 14% year over year. Excluding Splunk, product orders increased 6% year over year. As mentioned in my previous article, Cisco experienced inventory depletion in its distribution channels last quarter. The strong order growth this quarter suggests that the inventory depletion problem is likely behind the company.

The strong recovery in product orders is broad-based and includes both the US market and the Asia-Pacific region. Management pointed to robust growth in the public sector.

As inventory reduction slows, I expect Cisco to achieve normalized order growth in the coming quarters. In addition, Cisco's investments in AI, cloud computing, and cybersecurity could further boost overall order growth.

Outlook and valuation update

Cisco forecasts revenue for fiscal 2025 to be between $55.0 billion and $56.2 billion, representing year-over-year growth of around 4.1%. I consider the following moving parts:

• Although Cisco is shifting internal resources toward AI, management expects only $1 billion in AI-related revenue for fiscal 2025, which is less than 2% of total revenue. It is obvious that AI will not have a significant impact on overall revenue growth in the near future.
• Services accounted for around 27% of total revenue and are recurring in nature. I expect the services business to grow at 5% in the near future, which is in line with the historical average. The growth rate includes 2% to 3% from price increases and 2% to 3% from product sales growth.
• Networking: I expect the on-premises networking business to experience a structural decline going forward, but this will be offset by growth in AI networking. I expect Cisco to grow its networking business by 3%.
• For other growth areas such as cybersecurity, observability and collaboration, I forecast an additional 1% contribution to overall revenue growth.
• Because Cisco uses acquisitions to expand its portfolio, I expect the company to spend 5% of its total revenue on acquisitions, contributing 170 basis points to revenue growth.

Taking all these factors into account, I expect Cisco to achieve 5.7% revenue growth in the near future.

Thanks to restructuring and cost savings, I expect Cisco to deliver 220 basis points of margin expansion in fiscal 2025. Starting in fiscal 2026, I expect margin expansion to be only 10 basis points, driven primarily by growth in the services business and price increases.

The DCF summary:

The WACC is calculated at 7.5% under the following assumptions: risk-free interest rate 3.8% ((yield on 10-year US Treasury bonds)); beta 0.7 (SA); cost of debt 7%; equity risk premium 7%; equity 45.5 billion US dollars; debt 30 billion US dollars; tax rate 19%.

Taking into account all future FCF, the fair value of Cisco's share price is calculated at $55 per share.

Downside risk

I think the near-term risk for Cisco is the Splunk integration, which Cisco has completed in March 2024. Cisco plans to fully integrate Splunk's product and distribution in the near future. Although Cisco has extensive experience with acquisitions, Splunk is a big deal, and it remains uncertain whether Cisco will face integration issues.

Although Cisco has invested in cybersecurity, observability, and AI, these growth areas represent only a small portion of total revenue, so it is unlikely that these investments will generate a significant growth spurt in the near future.

Endnotes

Although I view Cisco as a low-growth company, I recognize the company's efforts to reduce operating costs and invest in growth areas such as AI, cybersecurity, and cloud computing. For this reason, I am raising my rating to Buy with a fair value estimate of $55 per share.