Networking hardware giant Cisco Systems (NASDAQ:CSCO) expects sales to decline during the fourth quarter, results for which will be released on Wednesday after the market closes. The company's guidance calls for a 4% to 6% year-over-year revenue decline, driven by weak product orders from some large customers and emerging markets, uncertainty delaying orders from the U.S. federal government, and a continuing headwind from shifting its business toward subscriptions.
While the first two issues are likely temporary, the shift to subscription software and services will have longer-lasting effects. Cisco announced during its financial analyst conference in June that it now expects to produce revenue growth of just 1% to 3% annually over the next three to five years, down from a previous outlook of 3% to 6% annual growth. The software business is expected to grow by 12% to 15% annually, but Cisco's focus on subscription software will push revenue into the future, hurting near-term results.
Putting it into numbers, Cisco estimates that roughly $2 billion of revenue would have been recognized between fiscal 2015 and fiscal 2017 if not for the shift to subscriptions. Over the next few years, Cisco expects its subscription push to knock down annual revenue growth by 2% to 3%. With annual revenue of roughly $50 billion, that's a $1 billion to $1.5 billion negative impact each year.
Cisco's fourth-quarter results probably won't be much to look at, with a decline in revenue and earnings expected. Investors should focus on the company's progress growing its subscription business -- deferred revenue growth is one important measure. But don't forget about the hardware business. Switches and routers are still the core of Cisco's business, and competition, particularly in emerging markets from companies like Huawei, could turn what looks like temporary weakness into a more permanent situation.
What analysts are expecting
The average analyst estimate calls for fourth-quarter revenue of $12.06 billion, a 4.5% year-over-year decline, toward the more optimistic end of Cisco's guidance range. Analysts expect the first quarter of fiscal 2018 to be a bit better, with the average estimate calling for a 2.3% revenue drop.
Turning to the bottom line, analysts see non-GAAP EPS coming in at $0.61, down from $0.63 in the fourth quarter of 2016. That's right in the center of Cisco's guidance range of $0.60 to $0.62. On a GAAP basis, Cisco expects earnings between $0.46 and $0.51 per share, with the discrepancy mostly due to stock-based compensation and amortization of acquisition-related intangible assets.
The last major analyst action came on May 15, prior to both Cisco's third-quarter report and its financial analyst event. Morgan Stanley upgraded Cisco stock to overweight, raising its price target from $32 to $39 per share. The Morgan Stanley analyst sees sales of security products driving networking hardware upgrades among Cisco's customers, potentially driving revenue growth through a quickened replacement cycle. Cisco's security segment is one of its strongest, producing 12% growth through the first nine months of fiscal 2017.
Putting the numbers into perspective
While slumping revenue and earnings are disappointing, as is an outlook calling for sluggish growth over the next few years, the stock already prices in quite a bit of pessimism. Trading for around $32 per share, Cisco trades for about 13.5 times the average analyst estimate for fiscal 2017 non-GAAP earnings. Back out the $35.5 billion in net cash on the balance sheet, and this P/E ratio falls to just 10.5.
At that valuation, Cisco doesn't need to put up blockbuster numbers for the stock to be an attractive investment. If the company's shift toward subscription software and services pays off, eventually producing improved growth, today's valuation will look pessimistic in retrospect. If things go wrong, a low valuation gives investors at least some margin of safety.