Cisco: No Respite In Sight

Feb.18.14 | About: Cisco Systems, (CSCO)

Executive summary:

  • One of the worst quarterly performances by the company in recent times.
  • Quarterly performance points towards a dismal future.
  • Service Provider market and emerging economies kept on hurting the performance.
  • The performance of the Americas region, the company's most established region, is more worrisome and could hurt the long-term outlook of the company if the trend continues.

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Recently, Cisco (NASDAQ:CSCO) reported its second quarter 2014 results. The following are the results, results insights, and my analysis of the results.

Results summary:

For the latest quarter, the company's revenues stood at $11.2 billion, down 7.8% from $12.1 billion, and net profit stood at $1.4 billion, down 54.5% from $3.1 billion a year earlier. On a per share basis, the earnings per share stood at $0.27, down from $0.59 per share during the same period last year.

The net income for the quarter includes the pre-tax charge of $655 million related to certain products sold in prior fiscal years, as against the total tax benefits of $926 million related to a tax settlement during the second quarter of FY 2013.

On a non-GAAP basis, which excludes the one-time items, the company's income declined 7.4% to $2.5 billion from $2.7 billion. The good thing about the results is that the revenue decline was lower than the earlier expectations (-8% to -10%), and the non-GAAP earnings stood at the higher end of the earlier expectations ($0.45 to $0.47 per share).

Segment insights:

The company reports its product revenue under seven product segments.

During the quarter, two product segments showed positive growth, while five showed negative growth. Security showed the maximum growth (17%), while Service Provider Video showed the maximum decline (21%), year-on-year.

  • Switching and NGN Routing:

Switching was the largest product segment for the company, as it generated 29% of the company's revenues for the quarter. The segment's revenue declined 12% to $3.3 billion from $3.7 billion a year earlier. Switching product orders declined 6% during the quarter.

NGN Routing was the second largest product segment for the company, as it generated 16% of the company's revenue for the quarter. The segment's revenue declined 11% to $1.7 billion from $1.9 billion a year earlier. Routing product orders declined 5% during the quarter. The decline in the segment's revenue was due to the product transitions as the company continued to manage the transition of its CRS platform to the CRS-X.

Switching and routing are the two core strengths of the company. The company introduced some key products and platforms in the recent past, including Nexus 9000 with ACR, CRS-X, and the NCS platform, including Telstra, KDDI, and BSkyB. In the long run, these products will further consolidate its position in the market as the most innovative provider of switching and routing solutions. The growth of both the segments to much extent depends on how quickly the demand for these products grows.

  • Collaboration:

Hurt by the decline (9%) in Unified Communications revenue, the segment's revenue declined 6.7% to $881 from $945 million a year earlier. On the positive side, Conferencing revenue grew 21%.

During the quarter, the company continued to move towards a different revenue model for Collaboration. It is now focusing more on the revenues that are recurring. This will increase the predictability of the revenues in the future.

  • Service Provider Video (SP video):

Service Provider Video was the worst-performing product segment. The segment's revenue stood at $957 million, down 21.5% from $1.2 billion a year earlier. SP video orders, including the set-top boxes, were down 20%, as the company continued to walk away from low-profit deals.

SP video is the key concern for the company in the near future, as not only the sales but also the order backlog is on decline at a rapid pace. The declining order backlog means more pain is about to come in the near future.

  • Data Center:

The segment once again delivered a phenomenal performance. The segment's revenue stood at $605 million, up nearly 10% from $548 million a year earlier. Data Center orders grew over 30%. The growth in the business was primarily attributed to the success of the company's Unified Computing Systems ("UCS"), which allow customers to consolidate both physical and virtualized workloads with unique application requirements onto a single unified, centrally-managed, scalable, and automated system.

Since the last few quarters, Data Center is the star performer for the company, and the rising popularity of UCS will further fuel the growth momentum.

  • Wireless:

The segment's revenue declined 1.8% to $511 million from $520 million a year earlier.

During the quarter, the key positive for the segment was the performance of the company's cloud networking platform, Meraki. With over 100% growth, Meraki continued to perform well. The growth of Meraki was fueled by the growth in the number of customers, which grew to 9,600 from 4,300 a year earlier. The success of Meraki means that the company is moving ahead successfully in the cloud market, which is a huge growth opportunity.

  • Security:

Security generated a revenue of $393 million, up 17% from $336 million a year earlier.

Security is considered as the key growth area for the company. The growth in the revenues was fueled by the strength in network security, up 21%, and content security, up 5%. The company's acquisition of Sourcefire (NASDAQ:FIRE) continued to perform well. The segment's orders grew 30%, which reflects a better future for the segment.

Services:

Services generated 24% of the company's revenues for the quarter. Services revenues grew 3% to touch $2.73 billion from $2.71 billion a year earlier. The Technical Services as well as Advanced Services both were up 3%.

The service revenues are tied closely to the company's product business. The slowdown in the product business will limit the growth of the service revenues in the near future.

Key Negatives:

The quarterly performance was one of the worst quarterly performances by the company in recent times. Listed below are key negatives that point towards a dismal future:

  • Continued order decline:

Not only the revenues but also the order booking, which is the key indicator for the company's future performance, showed dismal performance during the quarter. The orders from the Americas, APJC, and EMEA regions declined 5%, 5%, and 2% respectively.

Carrying on with its 4% decline in the Q1 FY 2014, the total product orders during the quarter declined 4%. The decline in the order booking for two continuous quarters reflects the depth of weakness in the business environment. The trend, if not averted in the next one or two quarters, can even hurt the long-term outlook of the company.

The economic sluggishness in EMEA and APJC regions to some extent can justify the decline in the orders from these regions. However, the continued decline in the orders from the Americas region is more worrisome. The company showed a decline in order booking from the Americas region during the last two quarters (2% in Q1 FY 2014, and 5% in Q2 FY 2014), despite the fact that the economy in the Americas region grew at a healthy pace during the same period.

  • Dismal guidance:

The company may carry on with its dismal performance in the ongoing quarter. The company forecasted that for the ongoing quarter, the revenue will decline to the extent of 6% to 8% on a year-over-year basis. Non-GAAP earnings per share is expected to be in the range of $0.47 to $0.49 per share for the quarter (Q3 FY 2014) and from $1.95 to $2.05 for the full year (FY 2014). The company's GAAP earnings are forecasted to be lower than non-GAAP EPS by about $0.10 to $0.13 per share in Q3'14 and $0.56 to $0.62 for the full year.

  • 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 the rise, and the return on the capital employed is on the decline (see the table below).

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

Due to this new financial reality of the service providers, the orders from the market declined by 13% (Q1 FY 2014) and 12% (Q2 FY 2014) during the last two reported quarters. The service provider market dynamics may continue to hurt the company's performance in the near future, as it is highly unlikely that the dynamics will improve in a hurry.

  • Geographic performance:

The company reports its revenues under three geographic regions, namely, the Americas, EMEA, and APJC. For the quarter, the Americas, EMEA, and APJC regions showed a revenue decline of 9.5%, 6.4%, and 3.75% respectively.

The gross margins by geographical regions were as follows:

Region

Q2 FY 2014

Q2 FY 2013

The Americas

61.6%.

61.8%

EMEA

64.6%

64.9%

APJC

55.2%

60%

Click to enlarge

Despite the fact that the U.S. economy grew at a healthy pace during the quarter, the Americas region showed a revenue decline of 9.5%. The trend, if continued, may well become the biggest concern for the company in the times to come.

The APJC region showed 480 bps decline in the margins, which reflects the market reality (high competition and low margins) of the emerging markets. It is highly unlikely that the margins from the APJC region will be able to match the margins from the other regions.

Outlook:

The results and the guidance once again showed the unpredictability of the company's business in the short term. The results also showed the inconsistent and competitive nature of the emerging economies, as the orders from BRICS countries and Mexico declined 10%.

In emerging economies, there are still a lot of growth opportunities, but if the company decides to stay away from low-margin deals, as it has done in the SP video product segment, then the company may well miss lots of opportunities, as the emerging markets are highly price-sensitive and lots of high-class, cost-effective manufacturers compete for the business.

The first six months of the year set the stage for a very tough year for the company. The company may well have to compromise the margins if it wants to get back the revenue growth, particularly in the emerging markets.

All in all, the company may well continue to deliver disappointing results in the foreseeable future, as the success of some new products under the switching and routing product categories is not good enough for the company to offset the decline of the emerging markets and service provider market. Moreover, the declining order flows from the Americas and EMEA regions may cause more worries for the company in the future. And if the position does not improve in the near future, the company may well have to rethink its business strategy, which till now concentrates on the profits rather than the revenues.

Valuations:

Currently, the company is trading with a PEx of 15, and offers a dividend yield of 3.4%.

With the long-term fundamentals intact and its significant presence in growth-oriented businesses, the company may sail through the difficult times without hurting shareholders' returns. However, for the time being, growth is out of the business. Considering the fact that the company is heading towards a future that offers no growth, the valuations demand a little caution.

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

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.