Cisco (NASDAQ:CSCO) announced a weak set of Q1 FY2014 results on November 13th, as softness in carrier spending and a challenging environment for IT spending in emerging markets caused revenues to fall well short of guidance. The networking giant saw its revenues grow to $12.1 billion, an increase of only 1.8% year-on-year as compared to its projection of 3-5% set last quarter. The company also guided for an unanticipated revenue decline of 8-10% for the next quarter, which spooked the markets and sent its stock down by over 10%. The revenue weakness was attributed primarily to a mixed and inconsistent macro environment, which caused emerging market orders in Q1 to fall by 12% and service provider orders by 13% over the same period last year.
Emerging market woes
While improving macro trends in the U.S. and Europe continued, customers in emerging markets such as China, India and Brazil cut their network spending as the markets sent out mixed signals about economic conditions amid intense currency fluctuations and other factors. Volatile political conditions in the aftermath of the NSA spying uproar was also responsible for some of the sales weakness in China, but the company denied it being much of an issue elsewhere. Emerging markets account for only about 20% of Cisco’s revenues. However, the macroeconomic impact in these markets has been so sudden that Cisco’s revenue growth in these markets declined from positive 13% in the April quarter to negative 12% in the October quarter. This has resulted in a 4-5% hit on revenue growth in the space of only two quarters.
Surprisingly, however, the budgetary stand-off which led to the government shutdown in the U.S. toward the end of the quarter was not such a big issue, with the company estimating an impact of only $50 million, or 0.4% of its Q1 revenues.
Carrier product transitions make matters worse
The impact of the macroeconomic concerns has been exacerbated by the fact that the company is in the midst of product transitions on the service provider side. This has extended delivery timelines and impacted sales as carriers test out the new products before deployment. With competitors Juniper and Alcatel doing much better on this front in recent quarters, Cisco seems to be losing edge router market share to rivals, especially at the low end. However, the company seems much more intent on protecting its margins in this tough macro environment, as evidenced by its focus on the high end with its newly launched NCS and CRS-X routers as well as its acquisition of Insieme. With the set-top box market becoming increasingly commoditized, Cisco has also made a conscious decision to transition its video business to the cloud and not pursue low-profit deals, which caused set-top box sales to fall steeply but helped gross margins improve. We expect the trend to continue in the coming quarters, as the company manages its bottom-line to mitigate the impact of the top-line slowdown.
The product transitions in developed markets, together with the macro concerns in emerging markets, have combined to create growth concerns for the company, albeit mostly in the near-term. We see these as largely near-term concerns because of the robust trends of data growth, mobility and cloud computing, which have remained strong despite several macroeconomic upheavals in recent years. 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.  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 macro concerns subside.
Margin focus limits valuation impact
A sustained recovery in developed markets, which account for 80% of its revenues, will help Cisco limit the downside from a prolonged emerging market slowdown. At the same time, the company’s ongoing restructuring activities have made the company leaner and more able to tide over these near-term concerns, as it grows operating profits at a faster rate than revenues. The company has reduced its workforce in recent years but plans to recruit more in emerging markets as well as in the high-growth areas of data centers, cloud, mobility, software and services. Cisco has also been preparing itself for uncertain times with an increased focus on software and services, which should help make some of its revenues more recurring in nature. This might impact margins in the near term since most of the expenses are incurred up front, but will be more value-accretive in the future.
Keeping the near-term macro concerns in mind, we have reduced our top-line estimates for Cisco in the near-term but continue to be optimistic about its long-term growth opportunity. At the same time, we believe the company’s improving cost structure will help it defend its gross margins as well as control operating expenses. We have slightly reduced our price estimate for Cisco to $25.70, about 25% ahead of the current market price.Notes: