Cisco Systems Earnings Show a Company in Transition

By Markets Fool.com

Cisco Systems (NASDAQ: CSCO) is best-known for providing the IT hardware (switches and routers) that drive the internet, but investors may need to rethink that view in the future. The company's fourth-quarter results, which were reported Aug. 17, reveal a company generating growth from its non-core product offerings while continuing its transition toward more software and subscription revenue. Let's take a look at trends investors should watch.

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Image source: Cisco Systems.

Cisco Systems' fourth-quarter results: The raw numbers

The headline figures:

  • Revenue growth of 2% came in at the high end of the guidance range of 0% to 3%.
  • Non-GAAP total gross margin of 64.6% was above the guidance range of 63% to 64%.
  • Non-GAAP EPS of $0.63 came in above the guidance range of $0.59 to $0.61.

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Clearly, Cisco reported a good quarter, but the guidance for the first quarter of FY 2017 predicts a slowing of revenue growth and decline in gross margin:

  • Revenue growth guidance of negative 1% to 1%.
  • Non-GAAP gross margin guidance of 63% to 64%.
  • Non-GAAP EPS expected to range from $0.58 to $0.60.

When pushed on why guidance looks weak, CEO Chuck Robbins discussed two issues in the conference call. He talked about uncertainty about how emerging-market and service provider demand -- both negative in the fourth quarter -- would play out in the first quarter. Service providers typically generate around half of routing revenue, so it was no surprise to see routing revenue down 5.8% in the quarter compared to the same period last year.

More positively, Robbins said the guidance decline was part of the company's transition to a software and subscription business as revenue is recognized over time rather than initially, as with product sales.

Restructuring and core vs. non-core growth

Cisco's business is changing. Its core switching and routing products are growing slower than its non-core revenue. For example, a look at revenue growth for switching and routing (the combined figure is also included) shows lackluster growth in recent quarters.

Data source: Cisco Systems presentations.

Meanwhile, a breakout of revenue growth in the most recent quarter shows how non-core areas like wireless, collaboration, and security generated good growth. In addition, Cisco continued its good run with services growth. It came in at 5% following a normalized growth rate of 4% in the third quarter, and 3% and 1% in the previous quarters.

Data source: Cisco Systems presentations.

The principle of slowing core growth relative to non-core growth was further highlighted by substantive restructuring measures announced in the earnings release and conference call. Robbins said on the call:"Today we announced a restructuring, enabling us to optimize our cost base in lower growth areas of our portfolio, and further invest in key priority areas, such as security, IoT, collaboration, next-generation data center, and cloud."

The restructuring will eliminate up to 5,500 positions, representing 7% of the company's global workforce, and CFO Kelly Kramer said the restructuring would create up to $700 million in pre-tax charges with $325 million to $400 million expected in the first quarter.

Deferred revenue

Another important part of the transition to a software and subscription business model is something called deferred revenue. It's an important metric to follow because as a company shifts from hardware sales toward subscription-based sales, it typical suffers a loss of upfront revenue in favor of longer-term subscription revenue. The latter is recognized over time; meanwhile it sits on the balance sheet as deferred revenue.

As you can see below, Cisco's deferred revenue increased in the fourth quarter after sequentially flat-lining in previous quarters -- a good sign.

Data source: Cisco Systems presentations.

The strength in services and deferred revenue growth is a sign that Cisco's transition is working. In addition, non-core revenue growth looks solid. Cisco was affected by weakness in emerging markets and service provider demand in the quarter, but its core revenue growth has been tepid for a while now. There were a lot of moving parts in the quarter, but the key takeaway is that Cisco's business is in transition.

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Lee Samaha has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.