Cisco's Third Quarter and Cloud Computing

Whereas the fiscal second quarter for Cisco wasn't a barn burner by any means, the fiscal third quarter ended April 2014 did have some encouraging signs.  The third quarter results evidenced that while the IT industry and its customers struggle to get their arms around cloud computing models, any company that wants to be around for the party needs to be able to manage its legacy businesses through a halting transition. Cisco seems to be very capable of doing this, despite its flat stock performance over the past twelve months. Its financial strength and balance sheet also give it a big advantage over some other aspirants.

Revenue of $11,545 million was down 5.5% from the prior-year period, and 46% of the revenue came from the core businesses of switching and routing, which declined 6% and 10% year-over-year, respectively. Service revenue of $2,725 million has been flattish quarter-to-quarter in the current fiscal year, but it increased 3% year-over-year in the third quarter.

The future core of Cisco will include Data Center revenue, which increased 29% year-over-year to $662 billion, and Security revenue of $361 million that increased 10% year-over-year.  So, these two businesses already account for almost 10 percent of consolidated revenue.  That is not to say that some portion of Wireless and Collaboration revenues won't move over into this future core offering, but Cisco seems to be making a successful marketing effort to help customers understand their commitment to a broad and deep product and service offering for cloud computing.

Revenue in the Americas increased 3% year-over-year, with Enterprise customers increasing their purchases by 6% and Commercial customers growing by 3%.

While investors are legitimately concerned about gross margin compression, the company continues to manage this transition well. GAAP consolidated gross margin rate in the third quarter was 60.7%, down 80 basis points compare to the prior-year period.  Product gross margin declined by 120 basis points on a GAAP basis; on a non-GAAP basis, the decline was 70 basis points.  Service gross margin rates were flat on both bases, at 65.4% on a GAAP basis.  On a year-to-date basis, the GAAP gross margin comparisons were distorted by a significant supplier component remediation charge.  All told, revenues in the legacy businesses declined, and gross margins are under some pressure.

However, in the quarter, there was a discernible improvement in the order trends.  Total US orders increased 7%, and Enterprise and Commercial orders both increased by 10% year-over-year.  Orders in developed Europe increased by 7% in the UK and by 4% in Germany. Orders in the global Security business were up 20%.  This is a change from the prior quarters of the current fiscal year.

Emerging markets continue to show weakness across the board, but we don't think that investors will perform their litmus tests for the company on these markets.  Sales and gross margins in Asia Pacific Japan and China are weak, with gross margin rates at 58%, which is a real problem.

Non-GAAP net income of $2.64 billion compared to prior-year period net of $2.5 billion, on the same basis. Diluted EPS of $0.42 compared unfavorably to last year's $0.46 per share, but the non-GAAP EPS of $0.51 exceeded analyst expectations.

Operating cash flow was $3,198 million in the third quarter.  Share repurchases were $2,005 million and dividends were $974 million, so nominal cash returned to shareholders was $2,979 million, virtually all of the OCF in the quarter.  While this is commendable, given the importance of the transition to a new business, it just feels like this mechanistic, formula-driven capital allocation may be overdone.

Worldwide cash balances were $50.5 billion, of which $4.6 billion is domiciled in the U.S. The ongoing issue with repatriation and potential taxes should be cleared up in order to take this economic distortion off the table.

The company issued $8 billion of debt in the quarter, of which $3.3 billion was devoted to refinancing maturing debt.  The company said that the dividends and share repurchases were funded by $3 billion out of the net new cash raised of $4.7 billion.  More tax and financial engineering, but that is what a strong balance sheet affords this company.

At a presentation given at a Cisco UCS (Unified Computing System) meeting, the speaker reported on a survey which said that top corporate IT departments allocated 75% of their resources--essentially skilled labor--to management of their applications, software layers and infrastructure.  A meaningful implementation of cloud computing would require this allocation to fall to 25%, with the rest of the resources devoted to strategic development of IT resources to achieve specific business goals.  Clearly, the institutional structure of corporate IT workflows and their own bureaucratic cultures offer both barriers to, and opportunities for blue chip cloud providers to expand their sales of software, services and management to their corporate customers.

The technologies themselves aren't the big problem, but the siloed, reactive setups in corporate America and Europe are.