Cisco Earnings Preview: Emerging Markets In Focus

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Cisco (NASDAQ:CSCO) is scheduled to announce its Q1 FY2015 results on Wednesday, November 12. The IT giant announced a mixed set of Q4 FY2014 results in August, as revenues declined marginally but the company beat guidance on stronger than expected demand for new products in developed markets. The networking giant saw its revenues drop year-over-year (y-o-y) by about 1% to $12.36 billion, as sustained weakness in emerging markets and sluggish spending by service providers weighed on results. The revenue decline was at the lower end of the company’s guidance of 1-3% and better than consensus expectations of 2%. [1]

The routing and switching transition seems to be going well, and the company expects these divisions to contribute meaningfully to top-line growth in the next few quarters. Cisco expects its overall revenue growth to return to positive territory in the fiscal first quarter, ranging between zero and 1%. With revenues remaining almost flat, gross margins are unlikely to recover in the near term given the long sales cycles associated with launches of new networking products. In the coming years, we expect Cisco to be able to defend its overall operating margins better as new high-end products start gaining traction and the company’s cost-cutting measures take hold.

The company continues to generate strong cash flows, and has been opportunistic in deploying the cash to buy back shares at depressed valuations. The company returned $13.3 billion to shareholders in FY2014 and it will be interesting to see if Cisco continued with the pace of its buyback program in Q1 FY2015.

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We have a $27 price estimate for Cisco, which slightly ahead of the current market price.

See our full analysis of Cisco

Emerging Markets In Focus

Cisco is facing a tough business environment in regions such as Brazil, Russia, India and China (BRIC), 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 by 12% in the quarter over the same period last fiscal year. While orders in Brazil and Russia declined by 13% and 30%, respectively, orders in China declined by 23% over the prior-year quarter, driven by the volatile political conditions in the aftermath of the NSA spying scandal.

In developed markets such as the U.S., where macroeconomic conditions have become less uncertain, Cisco has performed relatively better. However, product transitions in routing and switching have delayed orders as customers review and test out the new equipment before deploying them. The slump has been more evident in the service provider market, where the lag in sales is typically more than the enterprise and the company is shifting its video focus from traditional set-top boxes to the cloud. Last quarter, Cisco saw its service provider orders decline by 11% over the same period last year.

It is therefore a good sign for Cisco that its new routers and switches are seeing a good number of orders flow in, which should bolster revenue growth in the coming quarters. The newly launched NCS and the CRS-X core routers helped high-end routers post growth in orders last quarter, with orders of about $50 million each. On the switches front, Cisco’s SDN strategy backed by the recently launched Nexus 9000 also gained significant traction with customers. The number of customers more than tripled from 180 in Q3 to 580 in Q4 FY2014. However, there is typically a lag of at least a quarter before the orders translate into revenues. We therefore expect Cisco to continue to lose market share in the near term to rivals such as Juniper (NYSE:JNPR), which is further ahead in the sales cycle of its new products. However, Cisco seems well-positioned to reclaim some of its lost market share as the strong order flow translates into revenues, possibly towards the latter half of calendar year 2014.

Cost-Cutting Measures To Protect Margins

The company has successfully defended 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, Collaborate and Assemblage 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.

In addition, the company is working hard to take fixed costs out and become more cost-efficient to navigate the macro environment. Cisco has cut about 18,000 jobs in the last few years, including 6000 in the last quarter. Adjusted for restructuring costs and other expenses, Cisco’s operating expenses declined by about 1% in the last quarter over the same period last year. 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.

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Notes:
  1. Cisco Press Release Q4 FY2014 []