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Cisco Systems (NASDAQ:CSCO) on its Analysts Day forecasted a compounded annual growth rate ("CAGR") of 3-5% for the next 3 to 5 years. The recent growth estimates by the company are 33% lower than the estimates that the company forecasted just twelve months ago.

Reasons:

The prime reasons behind this outlook are:

  • Macroeconomic uncertainty.
  • Tough service provider market dynamics.
  • Conservative budgets.

Macroeconomic Uncertainty:

The macroeconomic uncertainty in many parts of the world particularly in emerging markets is increasingly becoming a big worry for the company. The top five emerging markets for the company namely India, Russia, Brazil, China and Mexico have been showing a negative order-growth (collectively) since Q4, FY 2013 (see the table below).

(Source: The company's transcripts for Q4, FY 2013 and Q1, FY 2014)

Top 5

India

Russia

Brazil

China

Mexico

Q3 FY 2013

13%

29%

16%

14%

8%

4%

Q4 FY 2013

-1%

19%

-0%

-1%

-6%

12%

Q1 FY 2014

-21%

-18%

-30%

-25%

-18%

-18%

  • Outcome:

The new orders from the emerging markets showed a significant decline due to many reasons like increasing competition, economic uncertainty, and also due to the company's strategy to stay away from the low margin deals (in SP video product segment). The order-decline from the emerging markets is one of the prime reasons behind the overall decline in orders during the last two quarters. The decline in the orders will negatively affect the revenue-growth of the company in the near future.

  • Conservative budgets:

Emerging economies are considered as the growth markets by most of the global enterprises. The sluggishness in the emerging markets has been affecting enterprises all around the world, as these markets play an important role in the future growth-strategy of most of the global enterprises. The economic sluggishness in these supposed to be growth markets, to some extent, is hurting the investment sentiments all around the world which ultimately leads to the lack of orders and postponement of orders.

Tough service provider market dynamics:

The company's customers primarily operate in the following markets: enterprise, service provider, commercial, and public sector.

Service providers offer data, voice, video, and mobile/wireless services to businesses, governments, utilities, and consumers. Service providers contribute significantly to the company revenues.

Since the last few years, the service providers are gradually losing their financial strength due to the decline in ARPU (average revenue per user). Moreover, the operating cost as a percentage of the revenues is on rise, and the return on the capital employed is in decline (see the table below).

(click to enlarge) (Source: The company's documents)

  • Outcome:

This new financial reality of the service providers have caused them to take cautious approach towards the new investments, which leads to slower investment decisions and lesser budgets for upgrading and expansion particularly in the price-conscious emerging markets. The orders from the market (service providers) declined by 13%, during the last reported quarter (see the chart below). The decline in the orders from the market is the result of the said financial reality.

(click to enlarge) (Source: The company's documents)

Conclusion:

The company designs, manufactures, and sells products related to the communications and information technology industry worldwide. It is a leading provider of networking and communication infrastructure.

The company has reduced its long-term revenue growth estimates by 33% in just 12 months. This is due to a big let down by the emerging markets from where the company was expecting a huge growth.

Since the last few years, the company was focusing (for growth) more and more on the emerging markets, which contribute about 20% of the company's revenues. Just twelve months back, the company was expecting that the long-term growth from the emerging markets will be in the range of 7-13% as compared to 6-10% in the recent forecast.

The forecast once again showed the unpredictability of the company's business in the short-term, and also showed the competitive and inconsistent nature of the emerging economics.

Moreover, if the company decides to stay away from the low margin deals* then it may well have to miss lots of business opportunities, as the emerging markets are highly price sensitive and lots of high-class, cost effective manufactures compete for the business.

*As mentioned in the Q1 FY 2014 earning call transcript:

"as we evolved our business to the cloud and hold to our strategy to walk away from low profit deals."

In the last reported quarter, 2% decline in the order flows from the Americas region can be considered as an early signal that for the time being many consumer industries' capex cycle may have been touching their peak. The company's recent entry into the DaaS (desktop as a service) market shows that the company is well aware of the situation and is already focusing more on the other/new markets/segments.

With long-term fundamentals intact, and the company's significant presence in the growth oriented businesses, the company can sail through the difficult times without hurting shareholders returns. But, it's time for the company to rethink its strategy for the emerging markets, as most of the company's current worries are due to the emerging markets uncertainties.

The company may need some time to get its strategy right, but the good thing is that despite steep de-growth in some of the top emerging markets the company expects the revenue growth of 3-5%. Moreover, approximately 70% of the company's product revenues are dependent on new orders each quarter. So, the things can change in quick time if the macroeconomic environment improves but till then it's a tough going ahead, as the company in the near-term is heading towards the future that offers a limited growth. However, for the time being, the valuations look fair due to the recent fall in the share-price, and the current dividend yield of over 3%.

Disclaimer: Investments in stock markets carry significant risk, stock prices can rise or fall without any understandable or fundamental reasons. Enter only if one has the appetite to take risk and heart to withstand the volatile nature of the stock markets.

This article reflects the personal views of the author about the company and one must consult its financial adviser before making any decision.

Source: Cisco: It's Time To Rethink