Cisco Earnings Preview: Emerging Market Slowdown, Product Transitions In Focus

by Trefis Team
Rate   |   votes   |   Share

Cisco’s (NASDAQ:CSCO) is slated to announce its Q2 FY2014 results on February 12. The networking giant has set very low expectations for the quarter, with revenues predicted to decline by 8-10% over the same period last year due to macroeconomic weakness in emerging markets. These concerns had weighed on the previous  quarter’s results as well, as the company saw its revenues grow by only 1.8% y-o-y as compared to its earlier projection of 3-5%. Cisco attributed the revenue weakness primarily to a mixed and inconsistent macro environment, which caused emerging market orders in Q1 to fall by 12% and service provider orders by 13% over the year-ago quarter. Its performance in China was especially disappointing, as an 18% drop in revenues there contributed significantly to the overall decline of 21% in emerging market sales.

Emerging markets aside, Cisco faces a significant long-term threat from software-defined networks (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 could delay orders in the near term. We believe that the predicted revenue decline in Q2 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]

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 continues to be 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.

See our full analysis of Cisco

Software and services assume more significance

Cisco faces 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. On the other hand, it has been benefiting from a strong networking recovery in developed markets such as the U.S. and Europe. However, despite the fact that emerging markets account for only about 20% of Cisco’s revenues, the macro impact has been so sudden that Cisco’s revenue growth in these markets declined from positive 13% in the April quarter to negative 12% in the October quarter. This alone resulted in a 4-5% hit on revenue growth in the span of only two quarters. One of the major weak points for Cisco here is China, where volatile political conditions in the aftermath of the NSA spying uproar are likely to depress order flow in the coming months.

However, the company has been looking to navigate the tough macro environment with an increased focus on software and services, which have higher margins than the company average. Cisco’s service revenue as a percentage of product revenues has been growing steadily over the last few years, increasing from around 24% at the end of 2010 to an expected 28.5% in 2013. We expect this to continue going forward, as the company leverages its recent acquisitions of NDS, Meraki, Intucell, Ubiquisys 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. Cisco’s non-product gross margins are about 6% higher than its traditional product solutions, by our estimates, and an increased revenue contribution from software and services should help the company defend its overall margins better.

Cisco looks to tackle SDN threat with Insieme

The focus on software and services can be seen in Cisco’s efforts to meet the SDN threat head-on as well. In a bid to protect its core networking business, the company recently acquired the remaining stake in its spin-in SDN startup, Insieme Networks. Following the acquisition, Cisco unveiled Insieme’s first products which include a software controller called the Application Policy Infrastructure Controller (APIC) and the Nexus 9000 family of switches. While the Nexus switches are available for shipping to customers currently, the controller will go on sale in the coming months. By using its custom hardware with the programmable software controller (APIC), Cisco said that customers could realize long-term cost savings of as much as 75%, as compared to other software-only networking solutions.

The Insieme acquisition prepares Cisco to battle the upcoming SDN trend, which threatens to break Cisco’s network dominance by making it easier for customers to go with cheaper commodity hardware instead of Cisco’s costlier proprietary solutions. However, the switching transition in data centers to the high-end Nexus 9000 could cause customers to extend their delivery timelines as they test out and evaluate the new products before deployment. On the service provider side, Cisco recently updated its CRS line of core routers to CRS-X and NCS, which is likely to have a similar impact on top-line growth in the near term. Cisco also seems to be losing edge router market share to rivals Juniper and Alcatel Lucent, especially at the low end.

Margin focus important in an uncertain environment

However, we are encouraged by the company’s intent to defend margins in this tough macro environment than look for short-term market share gains. Not only is Cisco looking to increase the revenue mix of services and software but also moving its commoditized set-top box video business to the cloud instead of pursuing low-profit deals. While this has caused set-top box sales to decline, Cisco is looking to run the business for profit and not growth.

The company is restructuring its operations currently in a bid to make itself leaner and more able to tide over near-term concerns, as it grows operating profits at a faster rate than revenues. It has reduced its workforce in recent years but is also recruiting actively in emerging markets as well as in the high-growth areas of data centers, cloud, mobility and services, which continue to show robust upward trends 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, together with a sustained macro recovery in developed markets, should help limit the downside to its bottom-line from a prolonged emerging market slowdown (see Cisco Suffers From Emerging Market Slowdown, But Margin Improvement Is Promising).

See More at TrefisView Interactive S&P Capital IQ Analyses (Powered by Trefis)

  1. Cisco cuts long-term revenue, earnings targets, Reuters []
Rate   |   votes   |   Share


Name (Required)
Email (Required, but never displayed)
Be the first to comment!