Cisco Continues To Face Top Line Challenges But Upbeat Order Growth Bodes Well

Cisco announced a mixed set of Q3 FY2014 results on May 14, as revenues continued to decline 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 by 5.5%, as sustained weakness in emerging markets and sluggish spending by service providers weighed on results. However, the revenue decline was better than the 6-8% slump that the company had forecast during the previous earnings call. Although emerging market orders fell by 7%, with the BRIC nations and Mexico 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 both commercial as well as enterprise orders grew by over 10% year over year. Cisco’s new high-end routers and switches gained strong momentum, as orders for the NCS and CRS-X grew above expectations to reverse a three-quarter negative trend. The Nexus 9000 and Cisco’s SDN strategy also seems to have resonated well with customers, as the company signed on over 150 clients and grew its pipeline to almost 1,000 customers during the quarter.
However, the routing and switching transition is still in its initial stages and will take a few quarters to ramp up and meaningfully contribute to top line growth. As a result, Cisco expects its revenue decline to continue in the fourth quarter, albeit at a slower pace. The company expects Q4 revenues to fall by 1-3% – a meaningful improvement from the decline seen in the last two quarters. With revenues declining, 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 slightly revised $26.50 price estimate for Cisco, which is about 10% ahead of the current market price.