What Cisco's Q1 earnings report is really telling us

One might look at the quarterly results and see a company that's struggling to meet its own expectations, but numbers can often be misleading.

Cisco Systems announced its FY22 Q1 earnings this week. ZDNet posted this story covering the report, but as is often the case, the numbers don't tell the whole story. On the surface, Cisco reported what would be considered by most analysts to be in-line first-quarter numbers, because the company's revenues were at the midpoint of its guidance and a shade below consensus estimates. Revenue growth remained steady, up 8% year-over-year, which was certainly positive. Second-quarter guidance was also slightly below expectations as the company indicated revenue growth of 5% to 7%. 

One might look at the quarterly results and see a company that's struggling to meet its own targets, but as mentioned previously, the numbers can be misleading -- particularly in this current macro environment. 

Here are the most important points gleaned from Cisco's quarterly report:

  • Cisco's business has never been stronger. Despite the "meh" revenue numbers, Cisco's business is stronger than ever. It is being held back by ongoing component shortages. Although revenue was up only 8%, order growth hit a decade-high record of 33%, up from 31% last quarter, meaning growth is accelerating. Other indicators are that annual recurring revenue (ARR) was $21.6 billion, up 10% year-over-year, and remaining performance obligations are now $30.1 billion, also up 10%.

  • During the Q&A section of the call, CEO Chuck Robbins said: "With that RPO and the backlog that we have, the stuff (Cisco products) is going to ship. Short term, this doesn't feel great. What we are seeing is that the customers are making decisions right now to choose our technology across the board," indicating that Cisco's portfolio approach is working but the component shortage is holding the company up. One more note: Cisco, despite the lower guide, did reiterate full-year guidance, indicating the back half of the year should make up for the current slight miss. 

  • A margin rebound is coming. One of the metrics that investors watch is Cisco's margins. Gross margin this quarter was 64.5%, down 130 basis points from a year ago. It's important to note that a 64.5% gross margin is remarkable, particularly for a company that sells products that experts said would be commoditized by now. But the fact is margins are lower, which could indicate increased competitiveness or price pressure. The reality is that Cisco has been overpaying for components, delivery, shipping, and anything else it can do to get products into its customers' hands faster, and this has acted as a drag on margins. The company did announce it had raised prices to offset the higher costs, and customers seemed to be fine with this as they understand the current challenges. CFO Scott Herren explained that it takes a few quarters for the higher prices to make their way through the channel and procurement processes, and he indicated margins will return to normal in a couple of quarters.  

  • Cisco has revamped its webscale business. Cisco has long been known as the 800-pound gorilla and de facto standard in networking for companies of all sizes. The one exception was webscale. In that industry, Cisco was not just a laggard but for years, not even a serious contender for the business.  A few years ago, Cisco got closer to the cloud giants by working with them to develop products, rather than assuming it knew what they wanted and developing apps without them. In a relatively short time -- just a couple of years -- it has turned this business around; this quarter its webscale business grew by 200%. Cisco's differentiation in this space is in its Silicon One chips. The 11th processor in this family, the P100 chip, is capable of routing at 19.2 TB. Their custom-versus-merchant silicon debate has been an ongoing one, but Cisco has always obtained a performance advantage because it can customize a chip to a specific use case versus merchant silicon that's more general-purpose. Its product revenue in this area was up over $1 billion year-over-year, showing Cisco's strength in this area. 

  • Cisco is a massive software company. The company is best known for its market-leading hardware, but Cisco ranks among the biggest software companies in the world. This quarter, it delivered a whopping $3.7 billion, with 80% sold as subscriptionware. This annualizes to almost $15 billion in software revenue. At that number, Cisco is the fourth-largest software company in the world, ranking just ahead of Adobe. Software revenue comes from every part of Cisco's business, including networking, collaboration, security, application performance, and data center. Expect Cisco to continue to push more innovation into software in the future.  

  • Work to be done in security. Cisco's security business was up 4% year over year and given the size of this business, that's a healthy number. Looking back though, Cisco's security business had a growth number of 18% in 2019, which declined to 12%, then 7%, and now 4%, indicating a deceleration of the business. Meanwhile, the security pure-play companies have been seen growth in the teens -- and even 20% -- range. 

This is partially explained by the shift in the business, because the traditionally purchased perpetual products are in decline, acting as a headwind for growth. The subscription-based business from products such as zero-trust and unified threat management grew a healthy 15%, so there's a careful balancing act Cisco has been doing. Also, some of its security hardware products have been affected by the component shortage, which also has an impact. 

This partially explains the deceleration, but the reality is that the security industry is tending to a platform purchase model. In today's network-centric world, Cisco's dominant share in networking should enable it to dominate security -- perhaps not as it does in networking, but in that ballpark. The business is transitioning to software, which is certainly impacting the company, and Cisco does have some work to do here. Robbins will make sure the work gets done.