Cisco Earnings Preview: Product Sales Likely To Continue To Struggle

by Trefis Team
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Networking giant Cisco (NASDAQ:CSCO) is scheduled to announce its Q2 fiscal year 2017 earnings on Wednesday, February 15. [1] The company reported a decline in net revenues through 2016, 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. As a result, Cisco’s core hardware product sales – including network switches and routers – have witnessed limited growth over the last few years.  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.

We have a $32 price estimate for Cisco’s stock, which is in line with the current market price.

Weak Outlook For Q2 FY 2017

Cisco’s management gave conservative guidance for the upcoming quarters, with revenues and margins expected to decline. [2] Low product sales could continue to be a challenge for Cisco, with Q2’17 revenues expected to be 3% lower on a y-o-y basis to $11.6 billion. Among the product divisions, routing and switching revenues could witness limited growth, while data center products and collaboration segments combined with Cisco’s strength in cloud capabilities, network security, IoT, Software-as-a-Service (SaaS) and analytics could help drive revenues.

csco_q1_e3

Stagnation in Product Sales

According to Gartner, global IT spend declined by around 0.3% to $3.3 trillion in 2016, and the industry-wide growth is expected to be only around 2% in 2017. [3] This trend is evident in revenue growth reported by most large IT hardware vendors. Cisco reported a similar trend in product sales through the first three quarters of 2016.

Combined revenues generated from sales of routing products and network switches through the first three quarters of the year were roughly flat over the comparable prior year period to around $17 billion, as shown below. Revenues from network switches were down 1% to $11 billion while routing product revenues were flat over the comparable prior year period to just under $6 billion. Collaboration revenues were around 1% higher than the year-ago period to $3.3 billion through the first three quarters of the year. Similarly, revenues from data center products and wireless products have also suffered this year after showing robust growth in previous years.

csco_q2_ep1

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. Cisco also acquired cloud security firm CloudLock in August with the intent to further improve its presence in this domain. [4] More recently, Cisco acquired Appdynamics for $3.7 billion in January in an attempt to increase mix of revenues derived from software and cloud rather than hardware. [5]

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.

Cisco’s Service Provider Video segment revenues fell by 57% year-over-year to $1.2 billion, 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 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. [6] Secondly, Cisco sold off its low-margin SP Video CPE business in order to improve its overall profitability.

csco_yir1

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 up by 4-5% for the three quarters combined as shown in the table above.

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Notes:
  1. Cisco Schedules Conference Call for Q2 Fiscal Year 2017 Financial Results, Cisco Press Release, January 2017 []
  2. Cisco Q1 2017 Earnings Call Transcript, Seeking Alpha, November 2016 []
  3. Gartner Says Global IT Spending to Reach $3.5 Trillion in 2017, Gartner Press Release, October 2016 []
  4. Cisco completes its acquisition of CloudLock, Cisco Press Release, August 2016 []
  5. The New Cisco Is All About Software, Software, Software, Fortune January 2017 []
  6. Cisco Q4 FY 2016 Earnings Call Transcript, Seeking Alpha, August 2016 []
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