Cisco To Benefit From Macroeconomic Recovery, Federal Spending And Emerging Markets A Concern

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Cisco (NASDAQ:CSCO) is slated to release its Q1 FY2014 results on November 13. The networking giant has done well in recent quarters, growing revenues strongly on the back of a recovery in enterprise spending in the U.S. and Europe. Last quarter, Cisco was able to beat the midpoint of its guidance on almost every operating metric, as revenues increased year-on-year by over 6% and non-GAAP operating margins improved y-o-y by 70 basis points on better gross margins and higher operational efficiency. We expect Q1 results to have taken a hit due to some unexpected weakness in U.S. federal spending owing to the prolonged budget standoff and the resulting government shutdown. However, the sustained strength in the U.S. networking market, as well as a bottoming out of the European market, have been good to see in recent quarters given how much of an overhang the Eurozone crisis has had on global infrastructure spending appetite.

While the U.S. and Europe seem to be recovering well, emerging markets such as China and India are feeling the heat of the ongoing economic slowdown. Cisco’s CEO John Chambers said during the last earnings call that the networking recovery, while slow and steady, seems more ‘mixed and inconsistent’ than others he has seen. The company’s revenue guidance for the October quarter also betrays this lack of certainty, with growth expectations being set at only 3-5%, which is towards the low end of its long-term 5-7% growth guidance. Since a big portion of Cisco’s future growth is expected to come from emerging markets, a slowdown in these markets is concerning. Although Cisco maintains its long-term revenue and margin projections, its decision to cut around 4,000 jobs, starting in Q1, exacerbated these concerns and contributed to its stock declining by over 10% since the last earnings release.

See our full analysis on Cisco

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However, the fact that Cisco still derives about 80% of its total revenues from the U.S. and European markets should limit the downside from a prolonged emerging market slowdown. Additionally, the company’s focus on software and equipment for data centers and cloud networking positions it well for the upcoming trends in networking. Our $27 price estimate for Cisco is about 15% ahead of the current market price.


Strong data demand despite macro concerns

One of the biggest concerns surrounding the networking sector is the current macroeconomic environment in which customers – enterprises and service providers – have to operate. Due to global macroeconomic uncertainty, enterprises over the past year or so have become extremely cautious with their network spending. This has impacted the top-line growth of the networking sector as a whole.

In this challenging business environment, Cisco has done relatively well compared to competitors such as Juniper and Alcatel-Lucent. We expect this to continue as the company benefits from the long-term trends of data growth, mobility and cloud computing, which remain strong despite the macroeconomic upheaval. Mobile data traffic continues to grow exponentially with the rapid proliferation of mobile devices such as smartphones, e-readers and tablets. According to a recent Cisco VNI report, data traffic on mobile devices grew 70% in 2012 and is expected to grow at a CAGR of about 65% over the next five years. ((Global Mobile Data Traffic Forecast Update, 2012–2017, Cisco, February 6th, 2013)) Data center traffic, which grew to approximately 1.8 zettabytes in 2011, is expected to quadruple by 2016. [1] The strong data demand means that networks are running hotter as companies defer their infrastructure purchases, implying that spending on network infrastructure should continue to grow in strength as the macro concerns subside further.

Cisco prepares for upcoming trends

While the fundamentals of the industry seem strong, Cisco is also addressing the shifting trends in the networking sector. With its recent acquisitions of Intucell and Ubiquisys, Cisco seems to be meeting the SDN threat head-on as well as increasing its exposure to the service provider market (see Cisco Buys Intucell With An Eye On The Service Provider Market And SDN Threat). Cisco also recently introduced a new application-centric networking architecture, called Cisco One, that can provide enterprises with more open, scalable and easily programmable networks while keeping Cisco’s position within these networks relevant. The new architecture will help Cisco avoid hardware commoditization by tightly integrating network programmability with its custom hardware and hardware-specific operating systems (see Cisco Readies For The Macro-Economic Recovery With New Product Refreshes).

With the set-top box market becoming increasingly commoditized, Cisco is looking to offset the impact by driving the transition to the cloud with its recent acquisition of NDS. The move will help increase device-agnostic video consumption, which should drive data consumption and increase the demand for its routers and switches among service providers (see Cisco’s NDS Acquisition Taps Video Demand To Boost Network Equipment Business). The focus on cloud and software-based networking technology is also evident in its acquisition of Meraki, which is helping Cisco drive growth in its WLAN business by increasing its reach to small and mid-sized companies (see Cisco Buys Meraki: Bets On A Cloud-Based Networking Future). These moves should also help some of Cisco’s revenues become more recurring in nature, which might impact margins in the near term since most of the expenses are incurred upfront, but will be more value-accretive in the future.

Overall, we believe that Cisco is executing well on its turnaround plans and should be able to use its newfound focus to further improve its performance (see Cisco Is Still Undervalued Despite Year End Rally). The company’s dominant market position as well as aggressive price cuts have helped it gain market share in an uncertain economic environment so far, and could help it even further when the concerns subside.  However, Alcatel Lucent’s recent foray into core routers poses a downside risk for Cisco, seeing as the former is #2 in edge router market share – a position of strength that it can effectively leverage to provide an end-to-end solution to its customers.

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Notes:
  1. Global Cloud Index Forecast Update, 2011–2016, Cisco, October 23rd, 2012 []