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Cisco Beats Earnings Expectations Despite Falling Margins

Shares of the networking powerhouse declined despite reporting sales and profits that were stronger than forecasted.

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Cisco's fiscal second quarter earnings beat Wall Street's lowered expectations, with sales and profits ahead of forecasts. But other indicators showed that the IT networking equipment maker was still struggling in an increasingly competitive market.

Cisco reported Wednesday that net income for the quarter ended Jan. 29 fell nearly 18% to $1.5 billion, or 27 cents a share, from $1.9 billion, or 32 cents a share, for the same period a year ago. Revenue grew 6% to $10.4 billion, but that growth came at a price, as gross margins narrowed to 60.2% from 64.5%.

On a non-GAAP basis, Cisco's profits came in at 37 cents a share, slightly higher than Wall Street estimates of 35 cents a share, according to Thomson Reuters. Cisco's revenue for the quarter also beat analysts' estimates of $10.24 billion. Cisco had shaken Wall Street in November when it missed analyst estimates by projecting profits of 32 cents to 35 cents a share for the quarter and a revenue increase of 3% to 5%.

Cisco's performance failed to please investors, who dumped shares in after-hours trading and sent the stock down almost 9%. What left investors nervous was a product gross margin that fell to 61.1% from an average of 65% dating back to 2007, Gartner analyst Frank Marsala said in an interview.

"Product gross margins at 61% are a sign of price competition and a sign of increased competition," Marsala said. "Investors will be very concerned about a product gross margin at a 61% level."

During a conference call with financial analysts, Cisco chief executive John Chambers acknowledged competitive pricing in its consumer business and weaker margins on network switches, which the company had upgraded to deliver higher performance at a lower price. As a result, customers can buy fewer switches and get the same level of performance that they had in the past using more equipment. "There's a transition going on in switching to a lower-priced product line," Marsala said.

On top of that, sales of switches and routers, which account for about 46% of Cisco revenue, were down from the previous quarter, 11% and 7%, respectively.

Chambers told analysts that the company did not intend to get into a price war with competitors on switches or other products. "I want to say very specifically -- we are not fighting back on pricing," he said. "I want to be very specific. This is not a price game. This is a price-performance game with our new products coming out with dramatic price performance over our prior ones."

Nevertheless, Cisco does not have to have the cheapest switch or router in the market to take a hit on profits. "Maybe you're not the cheapest out there, but hey, you're lower than you were before," Marsala said.

Also affecting Cisco's margins is its transition to selling servers, switches, and storage as a single package called the Unified Computing System. Such data center bundles are what customers want, but also carry lower margins than selling products separately. Sales of Cisco's data center products were the strongest from the previous quarter, rising 17.5%.

Cisco's other major product categories did not do as well sequentially. The collaboration portfolio, which includes its videoconferencing technology, was down 4%, while its wireless technology was roughly flat.

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