Cisco To Ride Data Growth As Macro-Economic Concerns Subside

Cisco (NASDAQ:CSCO) is slated to announce its Q4 FY 2013 results on August 14th. Last quarter, the company saw strong growth in revenues as U.S. spending returned to strength amid sustained demand for networking gear in emerging markets. Europe, which has been a problem area for Cisco due to the Eurozone debt concerns and 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. While sales in Europe may still be lackluster, we expect another quarter of strong U.S. performance to more than offset that impact.

With almost 60% of Cisco’s revenues coming from the U.S., it is the single most important region for the company. At the same time, we will be looking at the company’s routing and switching business results to see if growing traction for Juniper’s (NYSE:JNPR) new products has had an effect on Cisco’s market share in these core areas.

With the macro situation improving, we expect Cisco to benefit from the long-term growth trends of data demand and cloud computing, which continue to remain sharp. 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. Last quarter’s strong numbers as well as optimism surrounding a potential revival in the U.S. business spending has helped Cisco’s stock rise by almost 35% since the start of the year. We maintain our $27 fair price estimate for Cisco, in line with the current market price.

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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 compared to competitors Juniper and Alcatel-Lucent. Its guidance for the future has, however, always been on the conservative side. It is therefore a good sign that the company has given an uncharacteristically optimistic guidance for Q4, saying during the last earnings call that it expects Q4 revenues to grow y-o-y by 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 more 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 big trends like 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) Cisco also recently introduced a new application-centric networking architecture, called Cisco One, that can provide enterprises with more open, scalable and easily programmable networks while keeping Cisco’s position within these networks relevant. The new architecture will help Cisco avoid hardware commoditization by tightly integrating network programmability with its custom hardware and hardware-specific operating systems. (see Cisco Readies For The Macro-Economic Recovery With New Product Refreshes)

Cisco has also shown willingness to embrace software with its NDS acquisition, which will help drive device-agnostic video consumption and 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.

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