The emergence of artificial intelligence (AI) has fueled a transformative growth cycle within the technology sector. There's a lot of enthusiasm for next-generation AI applications that have the potential to revolutionize various industries.
Unfortunately, Cisco Systems (CSCO -0.62%) has been on the outside looking in thus far, not yet capitalizing on these high-level trends. Weak growth over the past year has pressured the stock, which is off about 19% from its 52-week high.
Despite some unimpressive headline numbers, a deeper look does offer some silver linings. Cisco maintains a positive outlook with an expectation that new AI-native networking and security opportunities can jump-start growth.
Following the recent sell-off, could the stock be a good addition to your portfolio? Here's what you need to know.
Mixed financial trends in 2024
Cisco Systems is recognized as a leader in networking connectivity, which traditionally covers hardware such as routers, switches, and wireless access points.
While those products are still a major part of the business, networking segment sales are lower this year against a particularly strong 2023 when Cisco benefited from fulfilling a large backlog. Management notes that customers are working through excess inventory, which led to a firmwide 13% year-over-year decline in total revenue for the fiscal third quarter (ended April 27).
The Q3 top-line weakness was also reflected in non-GAAP earnings per share of $0.88, down from $1 in the prior-year quarter. This volatility helps explain Cisco's poor stock price performance thus far in 2024.
Still, the bigger story and more favorable development is an ongoing shift in the business mix toward related connectivity and security software that unifies the platform. In this case, software currently represents 35% of total company revenue, up from 30% just two years ago. Within that amount, more of the business is moving toward a recurring revenue model where subscriptions now contribute 54% of total revenue compared to 42% last year.
This dynamic is important because it supports higher profitability. Notably, the Q3 non-GAAP gross margin of 68.3% climbed from 65.2% in Q3 2023. The momentum is also evident as annual recurring revenue (ARR) climbed by 22% from Q3 2023, providing visibility for future growth and an increase in earnings.
Overall, the recent numbers from Cisco Systems paint a mixed picture but with enough strong points to build optimism toward the company's long-term strategy.
Image source: Getty Images.
A foundation for long-term growth
Viewing 2024 as a transitional year for the company, management expects conditions to improve. Within networking, the plan is to stabilize core product sales while capturing accelerated demand for the infrastructure side of AI-enabled cloud computing, cybersecurity, and connectivity solutions. Cisco's 2023 acquisition of Splunk, which closed earlier this year, is seen as further enhancing the group's capabilities to deliver a more complete full-stack platform.
The global area network offerings benefit from existing customers and new relationships investing in AI infrastructure and secure networking. On this point, Cisco has partnered with Nvidia to ensure the latest generation of GPU AI chips are compatible with Cisco's servers and data center equipment, which should be captured in company financials moving forward.
Management is citing $1 billion in AI product orders into 2025 in highlighting some early success. In terms of guidance, growth is expected to rebound by next year, with Cisco targeting a mid-single-digit revenue runway into fiscal 2026 and 2027 while EPS is leveraged higher based on expanding margins.
Image source: Cisco Systems.
What's next for Cisco?
The attraction of Cisco Systems as an investment opportunity isn't based on high growth or a perceived technological breakthrough. Instead, what I like about the stock is its increasingly high-quality earnings profile as it transitions more toward a software and services-driven model.
In my opinion, shares of Cisco trading at a forward price-to-earnings (P/E) ratio under 13 times the average Wall Street estimate for 2024 EPS of $3.70 represents good value within the technology sector. Cisco also offers a compelling 3.4% dividend yield, which is well supported by underlying cash flows and a solid balance sheet position.
Ultimately, investors with confidence in Cisco's ability to execute its initiatives -- and possibly even outperform expectations -- can consider owning the stock within a diversified portfolio.
