Cisco (NASDAQ:CSCO) announced a mixed set of Q3 FY2014 results on May 14, as revenues continued to decline but the company beat guidance on stronger than expected demand for new products in developed markets. The networking giant saw its revenues drop year-over-year by 5.5%, as sustained weakness in emerging markets and sluggish spending by service providers weighed on results. However, the revenue decline was better than the 6-8% slump that the company had forecast during the previous earnings call. Although emerging market orders fell by 7%, with the BRIC nations and Mexico 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., where both commercial as well as enterprise orders grew by over 10% y-o-y. Cisco's new high-end routers and switches gained strong momentum, as orders for the NCS and CRS-X grew above expectations to reverse a three-quarter negative trend. The Nexus 9000 and Cisco's SDN strategy also seems to have resonated well with customers, as the company signed on more than 150 clients and grew its pipeline to almost 1,000 customers during the quarter.
However, the routing and switching transition is still in its initial stages and will take a few quarters to ramp up and meaningfully contribute to top line growth. As a result, Cisco expects its revenue decline to continue in the fourth quarter, albeit at a slower pace. The company expects Q4 revenues to fall by 1-3% - a meaningful improvement from the decline seen in the last two quarters. With revenues declining, gross margins are unlikely to recover in the near term given the long sales cycles associated with launches of new networking products. In coming years, we expect Cisco to be able to defend its overall operating margins better as 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 the cash to buy back shares at depressed valuations. We have a slightly revised $26.50 price estimate for Cisco, which is about 10% ahead of the current market price.
Strength In Product Transitions
Cisco is facing a tough business environment in regions such as China, India and Brazil, where customers are cutting their network spending in response to intense currency fluctuations and other factors. The company saw orders in BRIC and Mexico decline 13% over the same period last fiscal year. 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 8% 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 out the new equipment before deploying them. The slump has been more evident in the service provider market, where the lag in sales is typically more than the enterprise and the company is shifting its video focus from traditional set-top boxes to the cloud. Last quarter, Cisco saw its service provider orders decline by 5% over the same period last year.
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. The newly launched NCS and the CRS-X core routers helped high-end routers post growth in orders, which exceeded expectations and reversed the decline seen in the previous three quarters. On the switches front, Cisco's SDN strategy backed by the recently launched Nexus 9000 is gaining significant traction with customers. However, there is typically a lag of at least a quarter before the orders translate into revenues. In the near term, we therefore expect Cisco to continue to lose market share to rivals such as Juniper (NYSE:JNPR) which is further ahead in the sales cycle of its new products. However, Cisco seems well positioned to reclaim some of its lost market share as the strong order flow translates into revenues, possibly towards the back half of the year.
Margin Focus Important In An Uncertain Environment
We are also encouraged by the company's intent to defend 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 about 29% in 2013. We expect this trend to continue going forward, as the company leverages its recent acquisitions of NDS, Meraki, Intucell and Collaborate 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 6% 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 addition, the company is working hard to take fixed costs out and become more cost-efficient to navigate this tough macro environment. Cisco has reduced its workforce substantially in recent years, and is in the midst of another restructuring program that will cut around 4,000 jobs. Adjusted for restructuring costs and other expenses, Cisco's operating expenses declined by about 6% over the same period last year. We expect the declining trend to continue in the near term as Cisco manages its operating costs to protect margins in the face of declining revenues.
Disclosure: No positions.