Cisco Posts Solid Results But Macro Uncertainty Limits Visibility

Cisco (NASDAQ:CSCO) announced a yet another set of solid Q4 FY 2013 results Wednesday beating the midpoint of its guidance on almost every operating metric, but shares fell on worries that the macroeconomic recovery may be slower than anticipated. The company saw its revenues for the quarter grow y-o-y by 6.2%, which was towards the higher end of its 4-7% growth guidance given during the previous earnings call. Profits continued to grow faster than revenues as non-GAAP operating margins improved y-o-y by 70 basis points on better gross margins and higher operational efficiency. The sustained strength in the U.S. networking market and a surprise positive growth in Europe was good to see given how much of an overhang the Euro debt crisis has on global infrastructure spending appetite.

However, Cisco’s shares declined as much as 10% in post-market trading as the company guided for a y-o-y revenue growth of only 3-5% for the next quarter, which is towards the low-end of its longer term 5-7% growth guidance. While the U.S. and Europe seem to be recovering well, emerging markets such as China are feeling the heat of the ongoing economic slowdown. As a result, CEO John Chambers believes that the networking recovery will be slow and more ‘mixed and inconsistent’ than others he has seen.

A big portion of Cisco’s future growth is expected to come from the emerging markets so the markets are concerned about the longer-term growth prospects. Although Cisco maintained its future revenue and margin projections, its decision to cut 4,000 jobs in the coming months exacerbated concerns that the macroeconomic recovery is faltering.

However, we believe that the fact that Cisco still derives about 80% of its total revenues from U.S. and Europe should limit the downside from a prolonged emerging market slowdown. We maintain our $27 price estimate for Cisco, about 10% ahead of 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. We expect this to continue as the company benefits from the long-term trends of data growth, mobility and cloud computing which remain strong despite the macroeconomic upheaval. Mobile data traffic continues to grow exponentially with the rapid proliferation of mobile devices such as smartphones, e-readers and tablets. According to a recent Cisco VNI report, data traffic on mobile devices 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)) Data center traffic, which grew to approximately 1.8 zettabytes in 2011, is expected to quadruple by 2016. ^[1] The strong data demand means that networks are running hotter as companies defer their infrastructure purchases, implying that spending on network infrastructure should return as the macro concerns subside.

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)

With the set-top box market increasingly getting commoditized, Cisco is looking to offset the impact by driving the transition to cloud with its recent acquisition of NDS. The move will help increase device-agnostic video consumption, which should drive data 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) The focus on cloud and software-based networking technology is also evident in its acquisition of Meraki, which is helping Cisco drive growth in its WLAN business by reaching small and mid-sized companies. (see Cisco Buys Meraki: Bets On A Cloud-Based Networking Future) These moves also help Cisco shift some of its revenues to a more recurring kind, that might impact margins in the short-term since most of the expenses are incurred upfront but will be more value-accretive to shareholders in the future.

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 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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1. Global Cloud Index Forecast Update, 2011–2016, Cisco, October 23rd, 2012 [↩]