Cisco Earnings Preview: Switching Sales, Gross Margins In Focus

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Cisco (NASDAQ:CSCO) is scheduled to announce its Q3 FY2015 results on Wednesday, May 13. The company reported solid results in the previous quarter as revenue grew 7% year-over-year to $11.9 billion, net income grew 68% y-o-y to $2.4 billion and earnings per share (EPS) grew by about 70% to $0.46, beating expectations. The networking giant’s top line increase was driven by double-digit growth in its key businesses – Switching, Collaboration, Data Center and Wireless. Other important businesses such as Routing and Security also registered growth. The only real challenges reported by the company were lower spending by telecom carriers, resulting in a 19% decline in Service Provider Video sales, and a double-digit drop in sales in China, likely on the back of apprehensions about foreign technology vendors in the country. [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 3-5% in the third quarter, in line with market expectations. On the cost side, the company expects non-GAAP gross margins to be 61-62% in Q3, similar to that reported in the first two quarters. Gross margins are impacted by sales growth, product pricing, product mix as well as cost savings.

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. In the first half of fiscal year 2015, Cisco returned a total of $4.2 billion or 86% of its free cash flow to its shareholders, including $2 billion in the form of dividends. With John Chambers stepping down from the CEO position last week after 20 years at the helm, this will be company veteran Chuck Robbins’ first earnings call as the chief executive. and it will be interesting to hear his thoughts on the performance and future strategy of the company.

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We have a $26 price estimate for Cisco, implying a discount of about 10% to the current market price.

See our full analysis of Cisco

Routers And Switches In Focus

Cisco is facing a tough business environment in regions such as Brazil, Russia and China, where customers are cutting their network spending in response to intense currency fluctuations and other factors. China has especially been a pain point given the volatile political conditions in the aftermath of the NSA spying scandal. Orders in China declined by 19% in Q2 FY15 over the prior year quarter.

In developed markets such as the U.S., where macroeconomic conditions have become less uncertain, Cisco is performing comparatively much better. However, product transitions in routing and switching have delayed orders, as customers review and test the new equipment before deploying it. The slump has been more evident in the service provider market, where the lag in sales is typically greater than the enterprise market, and the company is shifting its video focus from traditional set-top boxes to the cloud. In the fiscal second quarter, Cisco saw its service provider orders decline by 19% 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. Cisco’s SDN strategy, backed by the recently launched Nexus 9000, is gaining significant traction with customers, which was evident from the fact that its client base grew about 100% from the previous quarter. This helped the company register positive growth in switching division sales in Q1 FY15 and double-digit growth (11%) in Q2 FY15, after three quarters of continuous declines. Cisco seems well-positioned to reclaim some of its lost market share as the strong order flow translates into revenues, which is likely to reflect in the third fiscal quarter results.

Will Collaboration Sales Soar Again?

Cisco has slowly but steadily transformed its Collaboration business from a provider of telecom-based services to an integrated architecture combining mobility, software, video and cloud. The highlight of this transition has been its cost-effectiveness and focus on the new dynamics of accessibility and security, enabling people to collaborate and work together from any place using any device. The company offers products under two main categories – TelePresence Systems and Unified Communications. While TelePresence Systems includes products designed to provide high definition video and audio facilities for advanced conference room functionality, Unified Communications is a collective term for various products such as IP phones, call center and messaging equipment as well as web-based collaborative services.

The Collaboration business sales have declined in the last couple of years owing to a decline in public sector spending in the U.S. as well as in Europe. The company’s gradual shift towards recurring revenue channels driven by software-as-a-service (SaaS) offerings also contributed to the decline, since revenue in such cases is deferred and realized over the term of the agreement. In the first fiscal quarter, overall sales in the Collaboration business declined by 10% y-o-y to $1.82 billion with Collaboration sales declining 8% and Service Provider Video sales declining 12%. Although demand for new video products DX70 and DX80 was strong, management stated that there were a lot of pricing pressures which impacted revenues.

In the fiscal second quarter, Collaboration sales grew by 10% y-o-y on the back of strong growth in the Telepresence business, which reported a 60% rise in unit sales and 35% growth in revenue. Going forward, Cisco remains optimistic on this business and expects it to sustain its strong sales growth in the near future as it develops more innovative, converged and secure collaboration products.

Service Sales To Help Improve Gross 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 over 30% in FY2014. 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 4-5% 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 Q2 FY2015, adjusted service gross margins (64.8%) were 400 basis points higher than adjusted product gross margins (60.8%).

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Notes:
  1. Q2 2015 Presentation, Cisco, Feb 11 2015 []