Cisco (CSCO) Q3 Earnings Beat, Shares Fall On Dim View

Cisco Systems Inc. (NASDAQ:CSCO) reported third-quarter fiscal 2017 earnings (including stock-based compensation) of 54 cents per share, beating the Zacks Consensus Estimate by a penny.

Excluding stock-based compensation, earnings increased 5.3% on a year-over-year basis to 60 cents, which was slightly better than management’s guided range of 57–59 cents. The growth reflected benefits from operational efficiencies that boost operating margin in the quarter.

Revenues declined 0.5% year over year to $11.94 billion but beat the Zacks Consensus Estimate of $11.89 billion. Management had anticipated revenues to decline in the range of 2% or remain flat on a year-over-year basis.

However, Cisco’s fourth-quarter outlook was disappointing. Revenues are anticipated to decline primarily due to lower order growth in the reported quarter, which affected backlog. Management anticipates order growth to remain weak in the fourth-quarter, similar to the third-quarter level.

Moreover, ongoing transition to subscription-based model will continue to hurt top-line. The company also expects macro-related headwinds in the public sector, particularly the U.S. federal government business to impact revenues.

Further, weakness in the service provider business segment in the Americas and intensifying competition from the likes of Huawei in the emerging markets are other concerns that will continue to hurt top-line growth.

Shares of the company fell more than 7% in after-hour trading. However, we note that Cisco has outperformed the S&P 500 on a year-to-date basis. While the stock gained 11.9%, the index witnessed an increase of 5.5%.

Segment Revenue Details

On a year-over-year basis, products (74.4% of total revenue) remained almost flat at $8.89 billion, while services (25.6%) decreased 2.2% to $3.06 billion. Product book-to-bill ratio was greater than 1.

Almost 31% of the revenues were recurring in nature, of which 90% came from the services business. Roughly 10% of the product revenues were recurring.

Under the Product category, Switching, Wireless, Security and Other increased 2%, 13%, 9%, and 57%, respectively, on a year-over-year basis. However, this increase was partially offset by weak performance from NGN Routing, Collaboration, Data Center and Service Provider Video segments which decreased 2%, 4%, 5% and 30%, respectively.

Geographically, on a year-over-year basis, revenues from the Americas and EMEA declined 4%, and 6%, respectively. Weak service provider business in the Americas, foreign currency exchange volatility in the U.K. and oil price related uncertainty in the Middle East hurt top-line growth.

APJC revenues increased 2% driven by solid growth in India and modest growth in Australia and Japan. Growth in China was affected by tough year-over-year comparisons (due to service provider video business in the year-ago quarter).

Total emerging markets declined 12% while the BRICs plus Mexico (down 49% year over year) went down 10%.

In terms of customer segments enterprise declined 2%, public sector declined 4% and service provider dipped 10%. However, commercial grew 3% (not as healthy as management anticipated) in the reported quarter. Weak European market impacted growth in both enterprise and commercial segments.

Operating Details

Non-GAAP gross margin (including stock-based compensation) contracted 200 basis points (bps) from the year-ago quarter to 62% in the reported quarter. The expansion can primarily be attributed to higher service gross margin (up 210 bps).

Operating expenses as percentage of revenues decreased 310 bps to 37.9% primarily owing to decrease in most of the expense line items. As percentage of revenues, Research and development (R&D), General and Administrative (G&A) and Sales and Marketing (S&M) expense declined 90 bps, 170 bps and 60 bps, respectively.

As a result, operating margin (including stock-based compensation) expanded 110 bps to 24.2%.

Acquisitions

Cisco completed the acquisition of AppDynamics during the quarter. Moreover, the company announced plans to acquire Viptela and MindMeld.

Viptela is a privately held software-defined wide area network company. Per Cisco, Viptela combined with its IWAN technology, will provide an industry-leading cloud-first software-defined (SD) WAN platform that addresses the Edge networking needs of the company’s most demanding customers. The acquisition is expected to close in the second half of calendar 2017.

MindMeld is a privately held artificial intelligence (AI) company. Cisco expects MindMeld to simplify and enhance the collaboration experience even further through the power of AI and machine learning.

MindMeld is expected to power new conversational interfaces for Cisco's collaboration products, simplifying user interaction with the company’s technology as well as increasing ease-of-use and enabling new capabilities simultaneously. The acquisition is anticipated to close in fourth-quarter fiscal 2017.

Cisco recently announced intent to acquire the Advanced Analytics team and associated advanced analytics intellectual property developed by Saggezza, a privately held technology services company. The acquisition is expected to close in fourth-quarter fiscal 2017.

Balance Sheet and Cash Flow

Cisco exited the third quarter with cash and investments balance of almost $68 billion compared with $71.8 billion in the prior quarter. Cash & cash equivalents and investments available in the U.S. at the end of quarter were $2.9 billion.

Cisco repurchased approximately 15 million shares of common stock for an aggregate purchase price of $0.5 billion. As of Apr 29, 2017, the remaining authorized amount under current share repurchase program is approximately $12.9 billion.

Guidance

For fourth-quarter fiscal 2017, revenues are expected to decline in the range of 6–4% on a year-over-year basis. Non-GAAP earnings are anticipated to be in the range 60–62 cents per share.

The Zacks Consensus Estimate was pegged at 58 cents on revenue estimates of $12.52 billion.

Gross margin is expected to be in the range of 63–64%, while operating margin is anticipated between 29.5% and 30.5% for the quarter.

Our Take

We believe that Cisco’s expanding footprint in the rapidly growing security and data center market are promising. The company’s security solutions continue to add customers, which is positive in our view.

Additionally, the company’s partnerships with the likes of salesforce.com (NYSE:CRM) and International Business Machines (NYSE:IBM) will help it to gain significant traction in the cloud and Internet of Things (IoT) market space in the long run.

Moreover, continued share buyback and dividend hikes are positive in our view.

However, the disappointing fourth-quarter guidance will weigh on the share price at least in the near term.

Zacks Rank & Key Pick

Cisco currently carries a Zacks Rank #4 (Sell). Extreme Networks (NASDAQ:EXTR) carrying a Zacks Rank #2 (Buy) is a stock worth looking in the sector. You can see the complete list of today’s Zacks #1 (Strong Buy) Rank stocks here.

Long-term earnings growth rate for Extreme is currently pegged at 17%.

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