Cisco (NASDAQ:CSCO) announced a strong set of Q3 FY2013 results May 15th, sending the stock up by around 10% in after-hours trading. Revenues increased by more than 5% over the same period last year, and operating profits grew at a faster 7% rate for the sixth quarter in a row. The biggest relief for Cisco’s investors was that the macro-economic situation continued to see a slow and steady recovery, with the U.S. and the emerging markets leading the way.
Specifically, the U.S. market’s return to strength, both in the enterprise as well as service provider segments, is a big positive for Cisco since it derives almost 60% of its revenues from the region. Europe, which has been a concern due to the 20% weight it has on Cisco’s revenues, seems to have bottomed out as well despite continued pressure from the southern part of the continent.
The after-hours rally following the earnings announcement saw Cisco’s stock rise past the $23 mark – a level not seen in over two years. The recently concluded restructuring has helped Cisco regain focus on its core networking areas – a deduction that can also be made from its recent acquisitions which have bolstered its cloud services and carrier portfolio. Cisco’s continued efforts at shoring up its services and software business are paying off as well, offsetting the weakness in the products segment brought about by customers deferring their hardware purchases due to an uncertain macro-environment.
With the macro situation improving, we expect Cisco to benefit a lot more from the long-term growth trends of data demand and cloud computing, which continue to remain sharp. We maintain our $27 price estimate for Cisco, about 15% ahead of the current market market price.
Strong data demand despite macro concerns
One of the big concerns that surrounds the networking sector currently is the macroeconomic environment in which the customers – enterprises and service providers – have to operate. Due to macroeconomic uncertainty caused by the burgeoning debt levels of governments worldwide, corporates over the past year or so have become extremely cautious with their network spending. This has impacted the top-line growth of the networking sector as a whole.
In this challenging business environment, Cisco has done relatively well as compared to competitors Juniper and Alcatel-Lucent. However, its guidance for the future was always on the conservative side. This time, however, the company has surprised with an uncharacteristically optimistic guidance for the next quarter. Cisco said that it expects Q4 revenues to show a y-o-y growth of about 4-7%. Accounting for the recently concluded Linksys divestment, this figure would increase to about 5-8% – a fair clip over the 4-5% growth rates seen in recent quarters. The guidance shows that the company is confident that the recovery in network spending, although slow, will sustain itself in the coming quarters.
As optimism in the macro-environment slowly returns, we expect enterprises to loosen their purse strings more and invest heavily in their network infrastructure. This is because the macro concerns have had little impact on data demand which has continued to remain strong driven by the key trends of mobile Internet and cloud computing. Specifically, mobile data traffic has grown exponentially with the proliferation of mobile devices such as smartphones, e-readers and tablets. According to a recent Cisco VNI report, mobile data traffic grew 70% in 2012 and is expected to grow at a CAGR of about 65% over the next five years. ((Global Mobile Data Traffic Forecast Update, 2012–2017, Cisco, February 6th, 2013)) The strong data demand means that enterprises and service providers will not be able to hold off spending on network upgrades for much longer.
Cisco prepares for upcoming trends
While the fundamentals of the industry seem strong, Cisco is also addressing the shifting trends in the networking sector. With its recent acquisitions of Intucell and Ubiquisys, Cisco seems to be meeting the SDN threat head-on as well as increasing its exposure to the service provider market. (see Cisco Buys Intucell With An Eye On The Service Provider Market And SDN Threat) The move to acquire NDS Corp was made to embrace software and drive device-agnostic video consumption in order to increase the demand for its routers and switches among service providers. (see Cisco’s NDS Acquisition Taps Video Demand To Boost Network Equipment Business) As for the enterprise, the company debuted its virtual cloud-routing and WAN optimization platform under the Cisco Cloud Connected Solution brand to enable businesses that are increasingly looking to move their applications to the cloud at a low cost. (see Cisco’s Worth $23 On Cloud Foray And Enterprise Strength)
Overall, we believe that Cisco is executing well on its turnaround plans and is well-positioned with its new-found focus to gain higher ground going forward. (see Cisco Is Still Undervalued Despite Year End Rally) The company’s dominant market position as well as aggressive price cuts have helped it gain market share from rivals Juniper and Alcatel-Lucent in an uncertain economic environment so far and could help it even further when the concerns subside. However, Alcatel Lucent’s recent foray into core routers poses a downside risk for Cisco seeing as the former is #2 in edge router market share – a position of strength that it can effectively leverage to provide an end-to-end solution to its customers.