Cisco Earnings Preview: Emerging Markets, Margins In Focus

Cisco (NASDAQ:CSCO) is scheduled to announce its Q2 FY2015 results on Wednesday, February 11. In the previous quarter, the company reported modest results, as adjusted net income dropped over 2% year-over-year (y-o-y) to $1.8 billion, while non-GAAP earnings per share (EPS) grew at about the same rate to $0.54, slightly beating the analyst expectations compiled by Reuters. The networking giant saw its revenues grow by just over 1% y-o-y to $12.2 billion, as growth in switches, wireless and security products offset sustained weakness in emerging markets and sluggish spending by service providers in the U.S. The revenue increase was above the higher end of the company’s guidance of 0-1% and marginally better than consensus expectations. ^[1]

The routing and switching transition seems to be going well, and the company expects these business divisions to contribute meaningfully to top line and bottom line growth in the next few quarters. Cisco expects its overall revenue to grow by 4-7% in the second quarter, slightly below market expectations of 8%. On the cost side, the company expects non-GAAP gross margins to be 61-62% in Q2, slightly below those reported in the first quarter (62.5%). Gross margins are impacted by sales growth, product pricing, product mix as well as cost savings. In addition to seasonality benefits, the first quarter saw better than expected switching sales, which helped improve margins, but the company expects the second quarter to have a higher mix of UCS (Unified Computing Systems) sales, which is likely to impact gross margins negatively.

In the coming years, we expect Cisco to be able to defend its overall operating margins better as the 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 cash to buy back shares at attractive valuations. It repurchased 41 million shares of common stock for an aggregate price of $1 billion in the three month period ending October 25 2014.

We have a $27 price estimate for Cisco, which is in line with the current market price.

See our full analysis of Cisco

Emerging Markets And Service Providers 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 first fiscal quarter over the same period last year. Orders in China declined by 33% 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.

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 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 has grown five times over the last three quarters to 900 by the end of Q1 FY2015. 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 eventually translates into revenues.

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 over 6000 last year. We expect the company to focus on cutting costs in the near term as Cisco tries to protect margins in the face of declining revenues.

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1. Cisco Press Release Q1 FY2015 [↩]