Cisco Delivers Strong 2Q, Sound Guidance

Cisco Systems CSCO delivered very solid fiscal second-quarter results, while management’s third-quarter guidance is in line with the firm’s three-year operating model. Management continues to execute well, and this quarter’s strong performance demonstrates the strength of Cisco’s inherent competitive advantages. We are maintaining our fair value estimate.
Product revenue and services revenue each grew 11{e1f18614b95d3cd6e4b3128e1cd15d99b042a60a5a19c19b7a8e07e7495efa10} year over year, bringing Cisco’s consolidated revenue to $11.5 billion in the quarter. Services gross margins improved sequentially to just over 66{e1f18614b95d3cd6e4b3128e1cd15d99b042a60a5a19c19b7a8e07e7495efa10}, well above our long-run forecast of 64{e1f18614b95d3cd6e4b3128e1cd15d99b042a60a5a19c19b7a8e07e7495efa10}. Services strength is not surprising. Cisco’s services business has delivered consistently strong results over the past three years, and management remains focused on expanding services faster than products. We believe that increasing network complexity and an ongoing convergence of previously disparate IT domains should provide a nice long-term tailwind for services.
Cisco’s ability to drive strong product revenue growth while maintaining product gross margins at 60{e1f18614b95d3cd6e4b3128e1cd15d99b042a60a5a19c19b7a8e07e7495efa10} was a pleasant surprise. Recent data points suggested to us a relatively weak demand environment in the fourth quarter, and we had expected management to allow product gross margins to fall below 60{e1f18614b95d3cd6e4b3128e1cd15d99b042a60a5a19c19b7a8e07e7495efa10} in order to drive top-line growth. Given the ongoing pricing pressures in China and some mix shift into lower-margin set-top boxes and servers, this quarter’s gross margin stability was particularly reassuring. We think product gross margins could temporarily tick up a little higher than management’s third-quarter guidance implies, as we expect a relatively benign pricing environment in switches over the next quarter. Still, we maintain our long-term view that product gross margins will trend moderately lower over time, as we expect Cisco to compete aggressively in China and India while offering price concessions to large cloud service providers over the next five years.
Cash generation was predictably healthy. The firm produced $2.8 billion in free cash flow, and its cash balance, net of debt, increased to just under $30 billion, or roughly $5.50 per share. The company bought back $466 million in stock at an average price of $17.84 and paid out $322 million in dividends. Importantly, Cisco announced its intent to raise its quarterly dividend from $0.06 to $0.08. Management continues to demonstrate shareholder-friendly capital allocation practices, and we expect the dividend to go higher over time.
Management expects year-over-year revenue growth of 5{e1f18614b95d3cd6e4b3128e1cd15d99b042a60a5a19c19b7a8e07e7495efa10}-7{e1f18614b95d3cd6e4b3128e1cd15d99b042a60a5a19c19b7a8e07e7495efa10} and moderately faster earnings growth in its third quarter, which is in line with its three-year financial targets. Although Cisco remains on track to outperform our 2012 earnings estimate, we believe our five-year forecast adequately captures the firm’s long-run opportunities, and we are maintaining our $26 fair value estimate.
Cisco still faces a number of long-run threats to its core franchises of switches and routers, and we believe increasing competition from Huawei and an ongoing shift toward cloud computing will pressure Cisco’s competitive advantage–and product gross margins–over time. Still, given Cisco’s balance sheet strength, improved execution, still-solid competitive position and attractive valuation, we continue to find the shares compelling at their current market price.