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Income, Investing, Stocks  | February 18, 2019

Free cash flow cow and technology giant Cisco Systems, Inc. (NASDAQ:CSCO) just reported earnings for the second quarter of its 2019 fiscal year that clearly caught the attention of Wall Street, with the market bidding its shares up by almost 2% on Thursday. Decent sales growth combined with rising gross and operating margins indicates Cisco is adeptly navigating the volatile global landscape in light of ongoing trade war concerns. Let's go over some of the key highlights in Cisco's report.

Margin Expansion Means Sales Growth is Sustainable

Cisco saw its gross margin for the first two quarters of fiscal year 2019 rise to 62.38% from 62.17% in the same period during FY2018. Its revenue climbed by 6.2% to $25.8 billion during this period, and due to its rising gross margins, it is clear this is organic growth and not the result of price reductions or promotional gimmicks. When analyzing changes in revenue, always check the gross margin to get a glimpse of the quality of that sales growth.

Another key metric to look for right away is the firm's operating margin, as that highlights how scalable its business model is. If revenue growth is outpaced by sharp operating expense increases, that is a cause of concern. Cisco Systems didn't have that problem during the first half of FY2019 as its operating expenses fell compared to the year-ago period. A 2.1% decrease in its operating expenses enabled its operating margin to expand by 320 basis points to 27.49% during the first half of FY2019.

Sales growth and margin expansion are part of the reason why Wall Street liked Cisco System's Q2 FY2019 results so much. Year-over-year net income comparisons aren't useful in this circumstance because the company recorded an enormous $11.1 billion tax charge related to America's 2017 tax cut/reform law getting passed (writing down the value of its deferred tax assets). During the first half of FY2019, Cisco generated $6.4 billion in net income.

Shareholders a Key Priority

Management is enabling shareholders to share in the spoils by increasing its dividend by 6% to $0.35 per share, equal to an annual payout of $1.40 and good for a 2.9% yield as of this writing. A rising dividend is a sign of management's growing confidence in the company's ability to generate cash flow and ensures that internally generated funds will be spent wisely (capital allocation decisions are better made when there is an option to simply return cash to shareholders).

Furthermore, Cisco added $15.0 billion to its existing share repurchasing program, bringing its total capacity to buy back stock to ~$24.0 billion. Share buybacks reduced diluted outstanding share count by 9% from Q2 FY2018 to Q2 FY2019, which helped push its EPS up to $1.40 on a diluted basis.

The company retains ample firepower to continue buying back its stock as its balance sheet is rock solid. Total current assets of $53.1 billion outpaced the current liabilities by $23.6 billion at the end of Q2 FY2019, giving the firm a current ratio of 2.25x. Even better, Cisco System's long-term debt load stood at just $15.9 billion at the end of its last fiscal quarter, which gives CSCO a net cash position of $24.5 billion due to $40.4 billion of its current assets being represented by cash and investments. Note that there will be an ongoing transition tax as part of the 2017 tax law change, and Cisco paid $0.8 billion in taxes relating to that change last quarter. During its conference call management stated:

"And again, that 750 that we paid out that's, you know, we'll be paying that - those charges and it escalates in the later years or the next eight years, right. That was just part of the transition tax."

Tax issues aside, Cisco Systems retains ample firepower to continue repurchasing shares as market conditions dictate. The company generated $7.6 billion in net operating cash flow during the first two quarters of FY2019, up 5.7% from the same period last fiscal year. The company spent just $0.5 billion on capital expenditures and $1.6 billion on acquisitions and divestitures on a net basis during that period.

With plenty of free cash flow in hand ($7.1 billion when viewing FCF as net operating cash flow minus capital expenditures), Cisco spent $10.1 billion buying back its stock and $3.0 billion paying out dividends during the first half of FY2019. The company's cash pile still rose by $0.9 billion during that period due to some of its investments maturing. Note Cisco's investment balance on its balance sheet dropped by $7.1 billion at the end of Q2 FY2019 from the end of Q2 FY2018 to fund share buybacks.

Final Thoughts

Cisco Systems posted a great quarter, which may give its stock price rally significantly longer legs. Management has clearly found a way to ride out trade war turbulence as Wall Street hangs on every rumor coming out of the ongoing trade talks between the US and China. Beyond trade tensions, Cisco has shown the ability to win over market share in the security business with management touting double-digit growth in the space last fiscal quarter. Let's see where the company goes next. Thanks for reading.

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