Cisco Earnings Preview: Another Challenging Quarter Due To Product Transitions, Emerging Market Weakness

by Trefis Team
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Cisco (NASDAQ:CSCO) is slated to announce its Q3 FY2014 results on May 14. The networking giant has set very low expectations for the quarter, with revenues predicted to decline by 6-8% over the same period last year due to weakness in emerging markets and reduced spending by service providers. These concerns had weighed on the previous  quarter’s results as well, when revenues declined by almost 8% y-o-y. Cisco attributed the revenue weakness primarily to a mixed and inconsistent macro environment, which caused emerging market orders in Q2 to fall by 3% and service provider orders by 12% due to product transitions in core routing and switching. Its performance in China has been especially disappointing, given the uncertain political situation following the NSA spying uproar last year.

Emerging markets aside, Cisco faces a significant long-term threat from software-defined networking (SDNs) gradually gaining in prominence and cutting into its margins. Compared to Cisco’s higher-margin hardware products that come with embedded software, SDN is potentially much cheaper to implement as it allows enterprises to put third-party software on cheap bare-metal commodity hardware. Cisco is tackling the threat with new products such as Nexus switches, but the transition is impacting sales in the near term. We believe that the predicted revenue decline in Q3 is, to an extent, driven by such product transitions. The tough near-term outlook caused Cisco to cut its 3-5 year annual revenue-growth forecast, from a range of 5-7% to 3-6%. Cisco has also reduced its EPS growth target for the same period from 7-9% to 5-7%. [1]

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Going forward, we expect Cisco to leverage its recent Insieme acquisition to bolster its SDN portfolio and focus on margins to tide over near-term concerns. The fundamental demand for data, cloud computing and mobility solutions remains strong, and Cisco’s continuing investments in emerging markets position it well in high-growth markets when macro concerns subside. Our $26 price estimate for Cisco is about 13% 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 Q2 orders in BRIC and Mexico decline 10% over the same period last fiscal year. China, which saw orders decline by 8% over the prior-year quarter, has been a major weak point for the company in recent quarters.

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. 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 and evaluate the new products before deployment. Last quarter, 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 have been growing as a percentage of product sales 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.

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 program that will cut around 4,000 jobs. 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 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 as it transitions through a tough macro environment should help limit the downside to its bottom line from a prolonged slowdown in emerging markets.

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Notes:
  1. Cisco cuts long-term revenue, earnings targets, Reuters []
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