Cisco’s 2016 In Review: Higher Profits Despite Revenue Slowdown

Networking giant Cisco (NASDAQ:CSCO) has reported a decline in net revenues this year, driven by stagnating core product sales. Over the last few years, IT hardware manufacturers have observed a slowdown in product sales due to low global demand. According to Gartner, this trend is expected to continue in the near term, with global IT spend likely declining by around 0.5% to $3.49 trillion in 2016. ^[1]

Cisco’s core hardware product sales – including network switches and routers – have witnessed limited growth over the last few years. These revenue streams combined formed roughly 60% of Cisco’s product revenues last year. Through the first three quarters of the year, Cisco’s major revenue streams witnessed a similar trend. Comparatively, Cisco has witnessed growth in its services revenues and other fast-growing revenue streams such as Collaboration and Network Security. In this article we take a look at how Cisco has performed this year.

Product Revenues Stagnate

Combined revenues generated from sales of routing products and network switches through the three quarters of the year have been roughly flat over the comparable prior year period to around $17 billion, as shown above. Similarly, revenues from data center products and wireless products have also suffered this year after showing robust growth in previous years.

On the other hand, Network Security solutions and Services revenues have continued to grow at a steady pace. Network security revenues were up by 4% y-o-y to $1.6 billion through the first three quarters of 2016. Over the years, it has become an increasingly important component of networks, as enterprises look to safely share data between geographically separate individuals and teams. Cisco’s expertise in network and data center security includes advanced threat protection, web and email security, access and policy, unified threat management and managed services, while the company sells equipment like Virtual Private Networks (VPNs) and firewalls. Cisco also acquired cloud security firm Cloud Lock in August with the intent to further improve its presence in this domain. ^[2]

Comparatively, Cisco’s services have grown at a consistent pace over the years due to the increasing mix of service and subscription-based solutions on offer. Post-sales services and subscription-based revenues are more beneficial to Cisco since they are annually recurring revenues, compared to the lumpy demand caused by product life cycles extending for multiple years.

Comparatively, Service Provider Video revenues have fallen by 19% year-over-year primarily due to the the company selling off the SP Video CPE business in November last year. On a positive note, spinning off this business has led to a significant improvement in the company-wide product gross margins. As shown in the table above, Cisco’s combined Product gross margin in 2016 thus far has improved by almost 3 percentage points to over 63%, while its Services gross margin has improved by 140 basis points over previous year levels to 65.7%. There are two key reasons for an improvement in both Product and Services gross margins this year. Firstly, the company’s business is transitioning to more software and SaaS-based solutions, which typically have higher margins compared to hardware products. ^[3] Secondly, Cisco sold off its low-margin SP Video CPE business in order to improve its overall profitability.

Higher gross margins through the year were complemented by roughly flat operating expenses over the comparable prior year period. Cisco’s R&D expenses through the first three quarters were up by 2.5% year-over-year to $4.8 billion, while SG&A expenses were down 1% to $8.7 billion. Consequently, Cisco’s net income and earnings per share were u by 4-5% for the three quarters combined as shown in the table above.

We maintain our $32 price estimate for Cisco, which is in line with the current market price.  You can modify the interactive charts in this note to gauge how a change in individual drivers can have on our price estimate for Cisco.

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1. Gartner Says Worldwide IT Spending Is Forecast to Decline 0.5 Percent in 2016, Gartner Press Release, April 2016 [↩]
2. Cisco completes its acquisition of CloudLock, Cisco Press Release, August 2016 [↩]
3. Cisco Q4 FY 2016 Earnings Call Transcript, Seeking Alpha, August 2016 [↩]