Cisco (NASDAQ:CSCO) is set to announce its Q2 FY 2013 earnings on Feb. 13. Last quarter, the company saw a healthy growth in revenues as U.S. spending returned to strength amid sustained demand for networking gear in emerging markets. However, macroeconomic concerns surrounding the euro debt crisis weighed on network spending in Europe, which accounts for close to 20% of Cisco's revenues. While Europe will continue to be a worry going forward, we will be watching U.S. revenues closely to see if the recent strong performance was just a short-term spike, or the start of a broader long-term trend. With almost 60% of Cisco's revenues coming from the U.S., it is the single most important region for the company. At the same time, we will be looking at the company's routing and switching business results, to see if growing traction for Juniper's (NYSE:JNPR) new products has had an effect on Cisco's market share in these core areas.
Last quarter's strong numbers as well as optimism surrounding a potential revival in the U.S. business spending has helped Cisco's stock rise by more than 25% in the past three months. However, we see far more value in the stock coming from the company's renewed focus on its networking division.
The networking giant has of late tried to scale back its ambitions to diversify into 30 new businesses and instead focus on those areas that add value to its core routing and switching businesses. As a result, it has restructured its operations and cut jobs in areas that are not its core focus, making the organization leaner and more efficient. The restructuring has brought Cisco's focus back to its core networking products that contribute almost 40% to our estimated $26.50 fair value for Cisco, helping it perform better than rivals in an uncertain economic environment. As the long-term trends of data demand and cloud computing continue to strengthen, we expect Cisco to benefit even more in coming years. Our price estimate is about 25% ahead of the current market price.
The cost cutting and restructuring seems to be paying off for the company not only in terms of market share gains but also operating margins which are stabilizing at >20% levels after having fluctuated widely in recent quarters. This increases confidence in the management's guidance of achieving a long-term operating margins in the mid-20s and increasing profits at a faster pace than revenues. Cisco realized that almost all of the expected $1.1 billion in severance charges related to the workforce reduction program it had announced in July 2011, and the operating margins have remained fairly stable in recent quarters. With savings achieved on the operating side, Cisco will be able to make aggressive price cuts to compete better with low-cost rivals and gain even more market share.
Fundamentals Drive Cisco's Future Earnings
As for top line growth, we believe Cisco's fundamentals remain solid due to the ongoing transition from wired to wireless networks, the burgeoning usage of data on both mobile and wired networks as well as a strong demand for cloud-computing routing solutions on the enterprise side. The macro concerns have had little impact on data demand, which continues to be strong. Due to the proliferation of mobile devices such as smartphones, e-readers, and tablets, mobile data traffic has grown exponentially. According to a recent Cisco VNI report, mobile data traffic grew 70% in 2012 and is expected to grow at a CAGR of over 65% over the next five years.
Cisco will be counting on this growth to loosen the service providers' purse strings as macro concerns subside over time. With wireless carriers such as AT&T recently announcing almost $14 billion in network spending over three years, and smaller players such as Sprint and T-Mobile building out their LTE network aggressively, Cisco's revenues from the U.S. could see a boost in the coming years.
At the same time, Cisco is meeting the SDN threat head on with some recent acquisitions such as Intucell, which will also help it increase exposure to the service provider market (see "Cisco Buys Intucell With An Eye On The Service Provider Market And SDN Threat"). Its recent move to acquire NDS Corp. was made to drive device-agnostic video consumption and increase the demand for its routers and switches among service providers that are looking to monetize the booming data demand. As for the enterprise, the company debuted its virtual cloud-routing and WAN optimization platform under the Cisco Cloud Connected Solution brand, to enable businesses that are increasingly looking to move their applications to the cloud at a low cost.
Overall, we believe that Cisco has executed well on its turnaround plans so far and is well-positioned with its new-found focus to gain even higher ground going forward. The company's dominant market position as well as aggressive price cuts have helped it gain market share from rivals Juniper and Alcatel-Lucent in an uncertain economic environment so far, and could help it even further when the concerns subside. However, Alcatel Lucent's recent foray into core routers poses a downside risk for Cisco seeing as the former is No. 2 in edge router market share -- a position of strength that it can effectively leverage to provide an end-to-end solution to its customers.
Disclosure: No positions.