Network equipment maker Cisco Systems (CSCO - Free Cisco Stock Report) has reported some weak spots in its fiscal 2011 second quarter (ended January 31, 2011). While a 6% year-over-year revenue advance was better than guidance of 3%-5%, the product gross margin narrowed by 290 basis points, on a sequential basis. Earnings per share of $0.27 beat our estimate by a penny, but marked a 15% decline from the prior-year period. Around half of the margin compression was attributable to weak demand for home networking products that cater to consumers. The rest was the result of product transitions in Cisco’s switching business, where sales slipped 7% from the year earlier. In response, the stock was hit hard, eventually pulling the rest of the market lower.

The company’s new, high-end data center switches are growing faster than expected, but are less profitable than some legacy products and are suffering from increased pricing competition on the established Catalyst line. Too, Cisco appears to be providing customers with longer payment terms in an effort to maintain market share, which delays the recognition of revenue. At present, management expects these trends to keep the gross margin relatively weak over the next several quarters, but anticipates some improvement as the technology becomes more established and costs come down.

In addition, operating expenses are rising at a faster rate than revenues, further exacerbating the gross margin pressure. The primary culprit appears to be a 19% increase in R&D expense and 15% increase in marketing expenditures. We do not see this changing much in the near term, as the company invests to improve operating efficiencies in order to better compete in emerging technology markets, such as application delivery controllers and wide area network (WAN) optimization.

From a customer standpoint, management is seeing strong demand from U.S. enterprises, resulting in a 59% rise in sales of data center products. This, combined with healthy collaboration/videoconferencing volumes drove 15% sales growth at the New Products division, which now represents 39% of total product revenues. Although revenues from the public sector did advance 7%, management expects only low-single-digit percentage gains over the next several quarters, as budgetary challenges at the state, local, and eventually federal level worsen. Meanwhile, service provider sales ought to continue to be positive, as strong video demand pressures bandwidth. However, the routing segment’s 4% gain was below recent results from peers, and set-top box revenues will probably continue to experience double-digit declines as demand from consumers remain weak.

Management now anticipates full-year fiscal 2011 revenue growth in the 8%-11% range, versus its previous guidance of 9%-12%. In response to these trends and our expectation of continued gross margin pressure, we have lowered our fiscal 2011 earnings estimate by a nickel, to $1.25 a share.

About The Company: Cisco Systems Incorporated is the leading supplier of high performance internetworking products for linking local-area and wide-area networks of computer systems. Products include routers, LAN and ATM switches, dial-up access servers, and network management software. The Cisco IOS software platform ties these products together, delivers network services, and enables networked applications. Foreign business accounted for 49% of 2010 revenues. R&D was about 13% of revenues.


At the time of this article’s writing, the author did not have positions in any of the companies mentioned.