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Cisco Beats Estimates On Strong New Product Sales In Developed Markets
Cisco announced a mixed set of Q4 FY2014 results on August 13, as revenues declined marginally but the company beat guidance on stronger than expected demand for new products in developed markets. The networking giant saw its revenues drop year-over-year (y-o-y) by less than 1% to $12.36 billion, as sustained weakness in emerging markets and sluggish spending by service providers weighed on results. The revenue decline was at the lower end of the company's guidance of 1-3% and better than consensus expectations of 2%.
Although emerging market orders fell by 9%, with China, Russia, Brazil and Thailand contributing to a bulk of the weakness, the company was able to offset some of the pressure with a strong showing in the U.S., where commercial and enterprise orders grew by 17% and 16% y-o-y, respectively. Cisco's new high-end routers and switches continued their strong momentum from the previous quarter, as orders for the NCS and CRS-X grew above expectations to about $50 million each in Q4 and $100 million each in the full fiscal year. The Nexus 9000 and Cisco's SDN strategy also seems to have resonated well with customers, as the number of clients jumped from 180 in Q3 to 580 at the end of the fiscal fourth quarter.
The routing and switching transition seems to be going well and the company expects these business divisions to contribute meaningfully to top-line growth in the next few quarters. Cisco expects its overall revenue growth to return to positive territory in the next quarter, ranging between zero and 1%. With revenues remaining almost flat, gross margins are unlikely to recover in the near term given the long sales cycles associated with launches of new networking products. 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 the cash to buy back shares at depressed valuations.
We have a $26.50 price estimate for Cisco, which is about 5% ahead of the current market price.
Switching Transition on Right Track
Cisco is facing a tough business environment in regions such as Asia-Pacific, Japan, China and Russia where customers are cutting their network spending in response to intense currency fluctuations and geopolitical factors. The company saw orders in Asia-Pacific and Japan decline 7% over the same period last fiscal year. 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 23% over the prior year quarter.
In developed markets such as the U.S., where the macroeconomic situation has become less uncertain, Cisco is performing comparatively much better. However, product transitions in routing and switching have delayed orders as customers review and test out the new equipment before deploying them. The slump has been more evident in the service provider market, where the lag in sales is typically more than the enterprise and the company is shifting its video focus from traditional set-top boxes to the cloud. Last quarter, Cisco saw its service provider orders decline by 11% 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 tripled from the previous quarter. This helped the company in slowing down its switching revenue decline to about 4%, compared to over 6% in Q3. However, there is typically a lag of at least a quarter before the orders translate into revenues. We therefore expect Cisco to continue to lose market share in the near term to rivals such as Juniper, which is further ahead in the sales cycle of its new products. However, Cisco seems well positioned to reclaim some of its lost market share as the strong order flow translates into revenues, possibly towards the middle of the next fiscal.
Collaboration Sales Beginning to Improve
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 functionalities, 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.
Overall sales in the Collaboration business declined by 4% y-o-y to $934 million in the fiscal fourth quarter, as Cisco transitioned its portfolio and introduced new products, namely the DX70 and DX80. This is a significant improvement over the 12% decline witnessed in the third quarter ending April 26 and 6% decline reported in the first nine-months of the 2014 fiscal. While telecom and fixed line products witnessed weak demand, sales of conference products including WebEx gained traction. We expect the new products and recent Assemblage and Collaborate.com buys to help Cisco further improve its WebEx offerings and help increase sales in the near to medium term.
Restructuring to Cut 6,000 Jobs
We are encouraged by the company's intent to defend 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 about 29% in 2013. We expect this trend to continue going forward, as the company leverages its recent acquisitions of NDS, Meraki, Intucell 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. We estimate that Cisco's non-product gross margins are about 6% 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 addition, the company is working hard to take fixed costs out and become more cost-efficient to navigate this tough macro environment. Cisco has reduced its workforce substantially in recent years, and announced another round of restructuring starting Q1 FY15. As part of this exercise, the company will let go of around 6,000 employees, which is about 8% of its total workforce. The company's management stated in its earnings call that investors should understand this workforce reduction as "reallocation of resources" wherein the company is trying to shift focus from struggling businesses to the growth areas such as cloud, software and security.
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