Cisco’s (NASDAQ:CSCO) stock has taken a beating over the last few months, losing more than 15% of its value on concerns that the company will have a hard time penetrating emerging markets. A bulk of the concerns surfaced during the company’s Q1 earnings call when Cisco missed its revenue guidance and guided for an unanticipated revenue decline of 8-10% for the next quarter. Cisco’s performance in China was especially disappointing, as an 18% drop in revenues there contributed significantly to the overall 21% drop in emerging market revenues. The company attributed its revenue weakness 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.
As a result, the company recently cut its long-term 3-5 year revenue forecast, from a range of 3-6% to 5-7%. Cisco has also reduced its EPS growth target for the same period from 7-9% to 5-7%.  These estimates are in line with our already conservative forecasts for Cisco, thereby not necessitating a change to our price estimate. While the emerging markets weakness will continue to put pressure on top-line growth in the near term, Cisco’s relatively small presence in these markets and its focus on margins should help it tide over near-term concerns. The fundamental demand for data, cloud computing and mobility solutions continues to be strong, and Cisco’s continuing investment in emerging markets position it well in high-growth markets when macro concerns subside. Our $25.70 price estimate for Cisco is about 20% ahead of the current market price.
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Increasing Mix Of Software and Services
While Cisco continued to benefit from improving macro trends in the U.S. and Europe in Q1, 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, among other factors. Volatile political conditions in the aftermath of the NSA spying uproar were also responsible for some of the sales weakness in China, but the company has denied it being much of an issue elsewhere. Emerging markets account for only about 20% of Cisco’s revenues, but 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 alone resulted in a 4-5% hit on revenue growth in the space of only two quarters.
However, we remain positive about the company’s long-term prospects as it navigates a tough customer environment with an increased focus on services and software. Cisco’s service revenue as a percentage of product revenues has been growing steadily over the last few years, increasing from around 24% at the end of 2010 to an expected 28.5% in 2013. We expect this to continue going forward, as the company leverages its recent acquisitions of NDS, Meraki, Intucell, Ubiquisys and Collaborate to improve its mobility and cloud service offerings. The increasing business mix of services should not only help Cisco prepare for uncertain conditions by bringing in steady and recurring revenues but also contribute to its bottom-line growth. Cisco’s non-product gross margins are about 6% higher than its traditional product solutions, by our estimates, and an increased revenue contribution from software and services should help the company defend its overall margins better.
Product Transitions A Near-Term Concern
We also believe that the macroeconomic impact on Cisco’s top-line has been exacerbated by the ongoing product transitions in Ethernet switching and routing. Cisco recently updated its CRS line of core routers to CRS-X and NCS, which may have caused service provider customers to extend their delivery timelines as they test out and evaluate the new products before deployment. The switching transition in data centers to the high-end Nexus 9000, which is supported by Cisco’s recently launched Insieme SDN platform, could potentially have a similar impact on top-line growth in the near term. Cisco also seems to be losing edge router market share to rivals Juniper and Alcatel Lucent, especially at the low end.
However, we are encouraged by the company’s intent to defend margins in this tough macro environment than look for short-term market share gains. The company operates in an industry that has strong fundamentals owing to 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 demand for Cisco network infrastructure should recover as macro concerns subside.
Margin Focus To Help Tide Over Concerns
Another reason for Cisco’s recent top-line weakness has been declining sales in its set-top box business, which contributes less than 10% of its total revenues. With the set-top box market rapidly becoming commoditized, Cisco has made a conscious decision to transition its video business to the cloud (leveraging NDS’ solutions) and not pursue low-profit deals. While this has caused set-top box sales to decline, Cisco is looking to run the business for profit and not growth. 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.
Overall, we expect Cisco’s margin focus, together with a sustained macro recovery in developed markets – which account for 80% of its revenues – to help limit the downside to its bottom-line from a prolonged emerging market slowdown. At the same time, the company’s ongoing restructuring activities have made it 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 is also recruiting actively in emerging markets as well as in the high-growth areas of data centers, cloud, mobility and services. This is a good sign as the company is diversifying and positioning itself well for future potential in growth markets.Notes: