Cisco (CSCO) report: Government sales slump
The US economic recovery has not been smooth. Periodic setbacks have tempered a return to normal patterns of business. This is particularly prevalent in US government spending, which must be seen to be frugal as it faces a huge budget deficit in the years to come. That effect has impacted Cisco which depends on government spending for approximately one fifth of its business. Cisco recently shocked the market by revealing a large shortfall in orders and a lower rate of revenue growth for the coming quarter and year.
“Cisco maintains a long term target of 12-17% annual growth in revenue”
Chief Executive John Chambers described the recent weakness in orders as an “air pocket” as he revealed expectations for second quarter revenue growth of 3-5%, well below what the market had been anticipating. The cause, he reasoned, was uncertain demand from Europe and other markets and in particular, the US public sector. The latter provides up to 20% of Cisco’s revenue but has fallen on fiscal hard times and been forced to pare back spending on IT infrastructure.
This situation is something of a repeat exercise from what the market had seen a year before when private companies and corporations delayed spending on upgrades and new equipment. As conditions improved, so too did Cisco’s orders leading to a solid few quarters of earnings growth.
Now, the frugality of spending on IT equipment has caught up with the public sector leading Mr Chambers to deliver the bad news about order shortfalls. “The challenges we experienced in Q1 resulted in orders being below our initial Q1 sales order forecast by over $500 million” he said.
The company’s quarterly sales growth profile had been improving steadily since 2009 when the GFC affected sales and orders. This is shown in the chart below:
The difference between the second quarter revenue growth rate can be gauged by hypothetically adding back the $500 million order shortfall. Including those sales, the second quarter might have grown by 20% over the previous corresponding period. Without it, the growth rate plummets to 3-5% indicated by Mr Chambers.
The lower revenue forecast also translates into a lower annual forecast. Mr Chambers guided the market to expect sales growth for the 2011 financial year to be 9-12% ahead of the prior year. Again, the market had been anticipating growth of 13.1% on average.
Cisco maintains a long term target of 12-17% annual growth in revenue.
Mr Chambers is noted for his transparency and honest assessment of where he thinks the market for IT spending is headed. Given Cisco’s leading position in the basic equipment needed for internet infrastructure, he is also in an ideal position to make such predictions, so when he speaks, the market duly takes notice. A summary of his more recent comments is shown in the following chart:
However, this time the market has scrutinised the comments more closely and is suggesting at least some of the blame should be placed squarely in Cisco’s own camp.
Cisco’s vision for the demand for internet infrastructure suggests a massive increase due to the increased use of data, especially video, as the use of tablet devices and smartphones proliferates.
As a consequence, Cisco has spent heavily in acquiring technology and companies that can take advantage of this trend. In particular, Cisco sees teleconferencing as a commonplace service in the future that will demand high quality but affordable technology. Cisco already has its own sophisticated products being sold in the market today to top end corporate users, but expanded its market reach by acquiring Norwegian teleconferencing business, Tandberg earlier this year.
Cisco believes teleconferencing could help companies lower their travel costs as well as enabling industries such as retail, banking and healthcare to launch services from remote locations.
Supporting this strategy, Cisco’s annual Visual Networking Index forecast for 2009-2014 projects that global internet traffic will increase more than fourfold to 767 exabytes by 2014 (one exabyte equals one billion gigabytes). Over 90% of the growth will be driven by video data.
We concur with Cisco’s teleconferencing strategy and see it as a major earnings source for the business into the future.
Related to that strategy and vision, Cisco has also diversified its product suite into manufacturing consumer video products such as video cameras.
Notwithstanding the undoubted growth of data across the world’s telecommunications infrastructure, the market is concerned that Cisco has been distracted by these new sources of earnings and not paid enough attention to its bread and butter products of routers and switches.
Acknowledging the competition in basic equipment from Chinese communications equipment maker Huawei, Mr Chambers said it was unlikely Cisco would lose market share.
After being sold off sharply since reaching a high of US$24.58 on November 8, Cisco Systems found support at the psychological US$19.00. The rapid decline saw the RSI dip into oversold territory as highlighted by the yellow ellipse. This is an indication of an exhaustion of the decline. We would expect buying pressure to emerge in the near term. Overhead resistance lies at the US$20.00 region, followed by the 50 period moving average (green line) at US$21.45.
With reference to the weekly chart, the bearish moving average cross suggests broader term momentum to favour the downside. A break above the 200 week moving average (red line) at US$23.42 would signal a change of trend to the upside.
The likelihood is that the lower revenue growth outlook for 2011 will prove to be a short term aberration. Nonetheless, we think it is prudent to reduce our recommendation on Cisco to a hold until more clarity is obtained on company earnings.
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