Ahead of Cisco's (NASDAQ:CSCO) fiscal third-quarter report, there were concerns that the networking giant was abandoning growth. Recall, back in December, while citing lack of visibility in the economic environment, CEO John Chambers cut the low end of the company's revenue growth estimates for the next three to five years from 5% to 3%.
The Street was shocked, especially since Cisco had not cut its long-term outlook since 2011. Making matters worse, again in February, not only did Cisco report a 7.8% drop in revenue, the company also delivered its lowest product gross margin (58.8%) in more than a decade. So it's not as if the company had not done its part to create an environment of doubt. At the same time, though, I didn't believe things were as bad as some analysts suggested.
Cisco is suffering from the same issues affecting once high flyers like Intel (NASDAQ:INTC) and Microsoft (NASDAQ:MSFT), which has struggled to preserve market share amid consumer shifts to new and cheaper technologies. On Wednesday, all this was forgotten after the company delivered earnings that beat on both revenue and profits - albeit not in robust fashion.
Fiscal third-quarter revenue arrived at $11.5 billion, down 5.5% year over year. But this was still $200 million above Street estimates of $11.3 billion. From a segmental perspective, Cisco's product revenue, which accounts for 75% of total sales, decline almost 8% year-over-year to $8.8 billion. Services, which makes up the remain 25% of sales, advanced by 2.6% year over year to $2.7 billion. Product book-to-bill ratio was greater than 1 in the reported quarter.
With concerns about a slowing global economy, it was impressive to see sequential growth from most of Cisco's geographic reach. The Americas, Europe, Middle East and Africa all increased by low-to-mid single digit percentage points. I'm not ready to say that growth has fully returned to these markets. But I'm feeling more confident that Cisco has seen the worst of this dry spell.
Other IT vendors such as Rackspace (NYSE:RAX) is also feeling the effects of improved business conditions. Recall, Rackspace reported first-quarter revenue of $421 million. Aside from representing a 16% year-over-year jump, this was also enough to be Street estimates of $419 million. Net income for the quarter came in at $25 million, resulting in earnings of 18 cents per share, a penny below earnings from the year-ago. Equally impressive what that this was six cents above the 12-cent per-share analyst estimate.
So despite recent competitive threats, that both Cisco and Rackspace are posting strong numbers is encouraging. For Cisco, management has (in the past), countered recent weakness by aggressively discounting some of hardware, didn't appear to do that this quarter. Net income came in at $2.2 billion, or 42 cents per share. Although this was down 12% year over year, it still beat average estimates by 3 cents.
What's more, investors have to realize that the entire sector, including Juniper and Riverbed (NASDAQ:RVBD), has underperformed due to shrinking enterprise budgets. Cisco, which has always had a dominant market share in routers and switches, the company has struggled amid the arrival of cheaper software alternatives. These router and switches, which directs Internet traffic, accounts for almost half of Cisco's revenue.
No one is going to mistake Cisco for the same company that was posting the short of numbers achieved at the height of the dotcom era, but management has not forgotten how to lead. Including this quarter, Cisco has now strung together eleven consecutive earnings beats. For this performance, John Chambers, Cisco chairman and CEO said:
"I'm pleased with our performance in the third quarter. Our financial results exceeded the guidance we provided last quarter as we demonstrated clear progress on returning to growth. The entire team is focused on moving Cisco forward aggressively and we remain confident in our long-term goal to be the #1 IT company."
Cisco's challenge, of late, has been to reinstate investors' confidence. Corporations no longer need to build their own data centers, which was once the driving source of Cisco's growth. But if Cisco can offset the enterprises shift towards the cloud and outsourcing, Cisco's stock should do well in the long term. But that's a big "if."
For now, investors should be pleased with Cisco's results, including its plans to emerge as a leader in the "Internet of Things." With the stock trading at around $24, I am raising my target from $30 to $32 on the basis of long-term free cash flow growth and the quicker pace of the global economic recovery.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by Wall Street Playbook's tech sector analyst. Wall Street Playbook is not receiving compensation for it (other than from Seeking Alpha). Wall Street Playbook has no business relationship with any company whose stock is mentioned in this article.