Cisco’s Q3 Results Beat Estimates On Solid Growth In Key Businesses

Cisco (NASDAQ:CSCO) reported strong fiscal third quarter results on Wednesday, May 13, as operational revenue grew 5% year-over-year to $12.14 billion, non-GAAP net income grew 6% y-o-y to $2.8 billion and adjusted earnings per share (EPS) grew by about 6% to $0.54, narrowly beating expectations. The networking giant’s top line increase was driven by solid growth in its key businesses – Switching, Routing, Collaboration, Data Center, Wireless and Security. The only real challenges reported by the company were lower spending by telecom carriers, resulting in a 20% decline in Service Provider Video orders, and a 20% drop in sales in China, likely on the back of apprehension about foreign technology vendors in the country. ^{[1] [2]}

Although emerging market orders grew by just 1%, with China, Russia and Brazil 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., Latin America, Europe, Mexico and India. Cisco’s new high-end routers and switches continued their strong momentum from the previous quarter, as orders for the NCS and CRS-X continued to ramp up. The Nexus 9000 and Cisco’s SDN strategy also seem to have resonated well with customers, as the number of clients jumped from 970 at the end of Q1 FY2015 to 2,650 at the end of Q3 FY2015. ^[2]

The routing and switching transition seems to be going well, and these business divisions contributed meaningfully to the company’s top line and bottom line growth in the quarter. Cisco expects its overall revenue to grow by 1-3% this quarter, in line with market expectations. On the cost side, the company expects non-GAAP gross margins to be around 61-62% in fiscal Q4, slightly lower than those reported in the third quarter (62.5%). Gross margins are impacted by sales growth, product pricing, product mix as well as cost savings.

In the coming years, we expect Cisco to be able to defend its 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 cash to buy back shares at low valuations. It repurchased 35 million shares of common stock for an aggregate price of $1 billion in the three month period ending April 2015. In the first three quarters of fiscal year 2015, Cisco returned a total of $6.2 billion or 83% of its free cash flow to its shareholders, including $3 billion in the form of dividends. As per the company’s ongoing plans, there are still about $5.3 billion in authorized funds which are expected to be used to repurchase shares in the near future.

We have a $26 price estimate for Cisco, implying a slight discount to the current market price.

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Robust Switching, Routing Sales Drive Top Line

Cisco is facing a tough business environment in regions such as Japan, China and Russia, where customers are cutting their network spending in response to geopolitical factors, as well as intense currency fluctuations. 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 20% 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 the new equipment before deploying it. The slump has been more evident in the service provider market, where the lag in sales is typically greater than the enterprise market, and the company is shifting its video focus from traditional set-top boxes to the cloud. Last quarter, Cisco saw its service provider orders in the U.S. decline by 17% over the same period last year but its performance was better in the overall global market, where orders declined by 7%.

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 grew about 60% from the previous quarter. This helped the company register positive growth in switching division sales in all the three quarters this fiscal year (6% in Q3 FY15), after three quarters of continuous declines. Cisco seems well-positioned to reclaim some of its lost market share as the strong order flow translates into revenues in the near to medium term.

Collaboration Sales Growth Continues

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 functionality, 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. In the first fiscal quarter, overall sales in the Collaboration business declined by 10% y-o-y to $1.82 billion with Collaboration sales declining 8% and Service Provider Video sales declining 12%. Although demand for new video products DX70 and DX80 was strong, management stated that there were a lot of pricing pressures which impacted revenues. In the fiscal second quarter, Collaboration sales grew by 10% y-o-y on the back of strong growth in the Telepresence business, which reported a 60% rise in unit sales and 35% growth in revenue.

Cisco repeated this strong performance in the third quarter, with sales growing 7% y-o-y on the back of strong growth in the Telepresence business, which reported a 66% rise in unit orders and 19% growth in revenue. Going forward, Cisco remains optimistic on this business and expects it to sustain its strong sales growth in the near future as it develops more innovative, converged and secure collaboration products.

Service Sales Help Improve Gross Margins

The company has successfully defended 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 over 30% at the end of Q3 FY2015. We expect this trend to continue going forward, as the company leverages its recent acquisitions of NDS, Meraki, Intucell, Collaborate and Assemblage 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 4-5% 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 Q3 FY2015, adjusted service gross margins (65%) were 320 basis points higher than adjusted product gross margins (61.8%).

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1. Q3 2015 Presentation, Cisco, May 13 2015 [↩]
2. Q3 2015 Results Earnings Transcript, Seeking Alpha, May 13 2015 [↩] [↩]