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Market Update

Cisco Executes Well in 1Q

Cisco delivered solid fiscal first-quarter results and sound guidance, particularly given the tepid demand environment, says Morningstar's Grady Burkett.

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 Cisco Systems (CSCO) delivered solid fiscal first-quarter results and sound guidance, particularly given the tepid demand environment. First-quarter revenue grew 5.5% year over year to $11.9 billion, including approximately $200 million in acquired revenue attributable to NDS, while free cash flow grew to $2.2 billion, compared with $2.1 billion in the year-ago quarter. Management expects 3.5%-5.5% year-over-year revenue growth in the upcoming quarter, which implies total revenue of $12.0 billion at the midpoint. Cisco continues to execute well against fairly challenging macroeconomic and competitive backdrops while remaining focused on its core portfolio. We are maintaining our $24 fair value estimate.

Product revenue growth of 4% from the year-ago quarter was unsurprisingly tepid, as switches and routers, which accounted for 48% of total revenue in the quarter, collectively fell 2% from the previous year. We believe that the decline this quarter was the result of abnormally weak carrier and enterprise demand rather than material market share deterioration or significant technological shifts. Cisco continues to perform well relative to its key competitors in routers, and we have yet to see any deterioration in its port share of the strategically important 10 Gbps segment of the switch market. These facts, combined with relatively stable product gross margins over the past several quarters, lead us to believe that the firm's competitive advantages in core routers, edge routers, and data center switches remain intact.

The balance of Cisco's product portfolio grew 15% from the year-ago quarter to $3.6 billion, although roughly 7 percentage points of this growth was a result of the NDS acquisition. Similar to last quarter, Cisco generated very strong year-over-year growth from its strategically important data center business, and management noted that the firm has moved into second place in the U.S. x86 blade server market and third place worldwide. Wireless also posted strong results, growing 38% year over year to $486 million, and management highlighted service provider Wi-Fi as a future growth driver for this business. Cisco's security business grew 6% year over year to $339 million, while the service provider video segment grew approximately 8% excluding the effect of NDS and 30% including this acquired revenue.

Cisco's collaboration segment, however, continues to struggle, falling 8% from the previous year to $1.0 billion. As we noted in each of the past two quarters, we believe Cisco's collaboration business is at a competitive disadvantage to  Microsoft (MSFT) and low-cost alternatives to high-end video conferencing, and this view is reflected in our revenue forecast. We do, however, see opportunities for Cisco to leverage its collaboration offerings as a way to deepen its relationships with service providers and key partners and drive pull-through sales of other equipment and services. As such, we expect Cisco to remain fully committed to its collaboration business, despite the recent weakness.

Cisco's services business remains an area of strength, growing 12% from the year-ago quarter to $2.6 billion while generating a 65.5% gross margin, 450 basis points above the corporate average. As we've noted before, Cisco's services revenue is largely recurring in nature, generates high gross margins, and leads to stickier customer relationships. Service revenue has generated double-digit year-over-year growth in 24 of the past 29 quarters, with remarkably consistent gross margins over the same period. Management continues to focus on increasing service revenue faster than product revenue, and we model upper-single-digit annualized service revenue growth through 2017.

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Grady Burkett does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.