Cisco Takes 3 Steps Forward, 1 Step Back

 Cisco Systems (CSCO) once again turned in results that were slightly ahead of management's forecast, with third-quarter revenue coming in at $11.6 billion and non-GAAP earnings of $0.48 per share. However, management's fourth-quarter revenue and earnings outlooks are below what our current model reflects, and we plan to lower our near-term forecasts. 

We're also trimming our five-year growth assumption for Cisco's collaboration business to reflect our growing concerns over this segment's long-run competitive position. These adjustments will result in about a 10% reduction to our fair value estimate. Although Cisco's fourth-quarter outlook represents a moderate setback from a recent series of improving results, we think the firm's overall health is fine, and we maintain our view that Cisco's shares are attractively valued. 

Management's fourth-quarter forecast of 2%-5% year-over-year revenue growth implies no sequential growth at the midpoint, and we now expect full-year revenue will increase 6.3%, to $46 billion. Although this result is in line with management's three-year revenue growth target of 5%-7% per year through fiscal 2014, we had expected improved execution, a largely refreshed product portfolio, and fairly easy first-half comparisons to drive growth faster. Management cited the challenging spending environment as the primary culprit for next quarter's deceleration, highlighting the fact that issues in Southern Europe have expanded, while enterprise orders fell 1% from the year-ago quarter. Although weak demand in Europe is not surprising, the decline in enterprise orders is troubling from a broader IT spending perspective.

Cisco's switches and router segments collectively accounted for $5.8 billion, or 50% of total sales this quarter, and posted combined year-over-year growth of just less than 3%. Sales of switches increased by 5%, to $3.6 billion, which we believe was largely driven by an ongoing refresh to 10 Gbps port speeds in the data center market segment. The maturation of Cisco's Nexus 7000 platform, combined with what we believe to be poor execution from the firm's primary switch competitors, has temporarily squelched competitive threats within the data center segment, and we expect Cisco's share to remain stable through 2012 within this segment. Although investors seem to be increasingly concerned that software-defined networking presents an immediate risk to Cisco's data center switch business, we do not believe that SDN poses a meaningful intermediate-term threat. SDN is still in its infancy, and Cisco's market dominance should allow it to shape the SDN adoption curve while management fully develops its strategy around this emerging set of technologies.

We do, however, think that the campus, access, and aggregation switch segments will come under greater pressure during the next few years, as we expect growing competition from integrated vendors, server virtualization, and a push toward network layer consolidation to accelerate price declines and limit volume growth in these segments. We maintain our view that the overall switch market has matured, and our current forecast of low-single-digit revenue growth through 2016 reflects this belief. Although switch growth will likely remain sluggish, we believe Cisco's competitive position in the switch industry is stronger now than it was 18 months ago.

Like its peers, Cisco experienced weak demand from service providers in the third quarter, and the firm's router segment revenue was flat at $2.1 billion, or 19% of sales. North American carrier capital spending is widely expected to improve throughout 2012, and management noted that service provider orders grew 5% year-over-year this quarter. Cisco should benefit during the next few quarters from an ongoing transition to its CRS-3 core router platform, while Cisco's ASR 5000 mobile packet core router system appears to be gaining increasing adoption. Given service providers' ongoing transition to 4G wireless networks, the success of Cisco's mobile packet core platform bodes well for the firm's long-run competitive position in the service provider market segment. Although Cisco's router segment has recently underperformed our long-term forecast of mid-single-digit revenue growth, we are not lowering our five-year forecast just yet, as we believe that the demand environment has been unusually weak during the past three quarters. 

The remainder of Cisco's product segments generated solid results overall in the third quarter, growing 9% percent to $3.3 billion, as strong year-over-year growth in data center, wireless, and service provider video masked weak results from collaboration. We believe that Cisco's collaboration business is at a competitive disadvantage to that of  Microsoft (MSFT) and will face long-run pressure from other low-cost alternatives to video conferencing. We plan to significantly lower our growth forecasts for this segment to reflect this view. 

Security posted relatively solid results, with 9% year-over-year growth. However, we have become increasingly concerned that focused vendors such as  Check Point Software Technologies (CHKP) and Palo Alto will gain share of customers' network security spend at Cisco's expense, and  F5 Networks (FFIV) is just beginning to aggressively push into the market. While Cisco's recently announced CX security module is designed to be competitive with other vendors' application-aware firewalls, the product is relatively new, and Cisco's historical track record in layer 4-7 is mixed, at best. Network security is a strategically important market for Cisco, and we believe the firm may need to make another acquisition in this area in the near future to maintain its long-term leadership.

Services posted another solid quarter, growing 13%, to $2.5 billion, while generating 65.5% gross margins, 360 basis points above the corporate average. As we've noted before, Cisco's services revenue is recurring in nature, generates high gross margins, and leads to stickier customer relationships. We note that service revenue has generated double-digit year-over-year growth in 22 of the past 27 quarters, with remarkably consistent gross margins over the same time period. Management continues to focus on growing service revenue faster than product revenue, and we model upper-single-digit annualized service revenue growth through 2016. 

Cash generation was predictably healthy. The firm produced $2.7 billion in free cash flow, and its cash balance, net of debt, increased to $32 billion, or $5.87 per diluted share. Cisco is expected to close on its acquisition of NDS in the second half of calendar 2012, which will consume $5 billion in cash, or just under $1 per share. The company bought back $550 million in stock at an average price of $20.28 per share, and paid out $432 million in dividends. Cisco's shares continue to trade below our fair value estimate, and we would like to see management accelerate share buybacks while its stock is undervalued.

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