Cisco (NASDAQ:CSCO) announced a soft set of Q2 FY2014 results on February 12, as weakness in emerging markets and product transitions caused revenues to decline by almost 8% over the same period last year. While emerging market orders were down 3% over the same period last fiscal year, service provider orders declined by 12% due to weakness in set-top boxes and core routing. Cisco’s core businesses in routing and switching felt the impact of the ongoing transitions towards the newly launched CRS-X and NCS routers, and Nexus switches, which typically take around 4-8 quarters to ramp-up and meaningfully contribute to overall revenues. Sales in the routing and switching divisions declined by a combined 11.6% over the year-ago quarter. Operating leverage in the business – due to substantial fixed costs - caused gross margins to decline by over 170 basis points sequentially and 100 basis points year-over-year. However, these results were mostly in line with the guidance that management had given during the previous earnings call.
The company expects the top-line weakness to continue in the near term, with revenues in Q3 expected to decline by 6-8% over the same period last year. While the macroeconomic uncertainty in emerging markets is likely to persist in the near term, ongoing routing and switching product transitions mean that customers will defer their infrastructure purchases until they have reviewed and tested out the new products. With revenues declining, gross margins are unlikely to recover in the near term given the long sales cycles associated with launches of new networking products. Going forward, however, we expect Cisco to be able to defend its overall operating margins as the new high-end products start gaining traction and the company’s cost-cutting measures take hold. Cisco recently announced that it is planning to trim its workforce by about 5% in a bid to make operations more efficient. We maintain our $26 price estimate for Cisco, which is about 15% ahead of the current market price.
Emerging Market Weakness Accentuated By Product Transitions
Cisco is facing a tough business environment in regions such as China, India and Brazil where customers are cutting their network spending in response to intense currency fluctuations and other factors. The company saw orders in BRIC and Mexico decline 10% over the same period last fiscal year. China, especially, has been a pain point given the volatile political conditions there in the aftermath of the NSA spying scandal. Orders in China declined by 8% over the prior-year quarter.
The fact that emerging markets account for about 20% of Cisco’s revenues would have limited the downside if not for the ongoing product transitions in routing and switching, which are having an impact on the company’s performance in developed markets such as the U.S. The company recently launched the NCS and CRS-X high-end core routers to invigorate service provider sales, but this has extended delivery timelines from customers as they test out and evaluate the new products before deployment. Service provider orders in the U.S. declined by about 11% year-over-year. As a result, Cisco seems to be losing router market share to rivals such as Juniper, which is further ahead in the sales cycle of its new products. Cisco’s recent launch of Nexus 9000 data-center switch, with which it expects to leverage Insieme’s acquisition and fight the growing SDN trend, is having a similar impact on switching revenues as well. Switching sales declined by about 12% y-o-y, while orders fell by about 6%.
However, we are encouraged by the strong initial bookings that Cisco is seeing for the new products. The Nexus 9000′s booking volumes in its first shipping quarter nearly tripled since the start of the quarter. Cisco also announced that NCS has bagged big reference customers in Telstra, KDDI and BSkyB. However, with the sales cycles for routers being usually longer than switches, we expect service provider sales to lag data centers in the near term. The company expects orders for the core routers, NCS and CRS-X, to significantly ramp towards the back half of 2014.
Margin Focus Important In An Uncertain Environment
We are also encouraged by the company’s intent to defend margins in this tough macro environment with an increased focus on software and services. Cisco’s service revenues as a percentage of product sales has been growing steadily over the last few years, increasing from around 24% in 2010 to about 29% in 2013. We expect this trend to continue going forward, as the company leverages its recent acquisitions of NDS, Meraki, Intucell 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. We estimate that Cisco’s non-product gross margins are about 6% higher than its traditional product solutions, and an increased revenue contribution from software and services should help the company defend its overall margins better. At the same time, it is moving its commoditized set-top box video business to the cloud instead of pursuing 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.
The company is also restructuring its operations currently, in a bid to make itself leaner and better able to tide over near-term concerns, as it grows operating profits at a faster rate than revenues. It has reduced its workforce substantially in recent years, and is in the midst of another restructuring that will cut around 4,000 jobs in the coming months. As a result, Cisco’s SG&A expenses have been declining sequentially over the last few quarters. Last quarter, Cisco saw its non-GAAP SG&A expenses decline by 9% year-over-year and 6% sequentially. We expect the declining trend to continue in the near term as Cisco manages its operating costs to protect margins in the face of declining revenues.
At the same time, the company has been investing and recruiting actively in emerging markets as well as in the high-growth areas of data centers, cloud, mobility and services, which continue to show momentum despite several macroeconomic upheavals in recent years. The strong data demand means that networks are running hotter as customers in emerging markets defer their infrastructure purchases, implying that demand for Cisco network infrastructure should recover as macro concerns subside. Cisco’s margin focus, together with a sustained macro recovery in developed markets, should help limit the downside to its bottom line from a prolonged slowdown in emerging markets.