Monday, August 6, 2012

Is it Cisco or is it the Tech Market in General?


Whenever a technology bellwether like Cisco Systems $CSCO reports results, the market takes immediate notice. With the dust now settling over a disappointing outlook statement, it's time to look in greater depth at Cisco and formulate some conclusions for the wider technology market.
The broad-based sell-off was understandable and no self-respecting investor would ignore CEO John Chambers’ commentary, however, I think there is more to this than just the macroeconomic weakness that he emphasized in his statements.


Cisco Gives Weak Guidance

The actual results were ok, but what spooked the market was the guidance. Cisco guided Q4 revenue toward 2-5% growth when the analyst consensus was for 7%. Moreover, when this comes after a less-than-stellar comparable Q4 in 2011, it indicates that things are not firing on all cylinders.
A breakdown of sequential revenues shows that the mid-point of guidance indicates revenues sequentially flat.



Note the gradual weakening in 2012.

Chambers spent a significant amount of time on the conference call highlighting the macroeconomic headwinds. Frankly, I see no reason to doubt him on this. Cisco has always told it how it is. The CEOs in Cisco's customer base are not automatons devoid of influence from sentiment over the global economy, and ever since the events of 2008, there has been a heightened sense of risk perception. It wouldn't be surprising if the Euro Zone debt crisis led CEOs to be more cautious in their purchasing decisions. As Chambers noted, this usually shows up in lengthening sales cycles and increasing sign-off tightness.

However, all of this is well known to the market. Having followed a lot of company results in this earnings season, I think the typical company has reported stronger trends in the US but weakness in Europe and signs of slowing growth in Asia. It does point to weakness, but as Cisco underlined, it is not being caused by a lack of financial firepower but rather by cautious sentiment. Arguably, when the sentiment rescinds in the face of gradually growing employment and end demand, this will cause a snapback in growth.

Furthermore, with the huge injection of liquidity by the ECB, the risk of a failure in the European banking system has been hugely reduced. To demonstrate this here is a chart of the EUR/USD 3-month Swap basis. It measures the price that European banks will pay to get US dollars. In general, the lower the number the more stress there is.



It’s not hard to see that the ECB’s LTRO operation has shored things up. Unfortunately, should Greece try and do something silly and engage in a disorderly default, that number will go lower in a hurry. But, for now, things look ok.

So what is going on with Cisco?


The Underlying Picture for Cisco

Having briefly touched upon the macro outlook -- which Cisco claimed was the main cause for the weakness in the enterprise market -- it’s time to go into more detail. Here is a chart of Cisco’s product and service revenues.  I’ve excluded Data Centers, which has grown at 107%, 88% and 67%, respectively, in the last three quarters.



Indeed, Chambers did stress how well revenues in Cisco’s Data Centers were doing. Alas, it only represents 2.5% of revenues!

I think that Cisco’s problem is that its high-revenue businesses are exhibiting weak growth and facing structural challenges, whilst its smaller revenue businesses are not. The key point being that this is not so much about broad-based weakness and more about Cisco’s product mix and offerings.

Take a look at how strong Wireless, Security, and Service Provider Video have been.

I want to demonstrate this point further. I’ve split Cisco’s product revenues into the big three core divisions of Switching (31.4% of revenues), Routers (18.5%) and Collaboration (8.7%) and then the rest.



Note how weak the core numbers went in the middle of 2011 and how well "the rest" held up during the soft patch. As noted in the previous chart, Collaboration and Router annual growth rates were zero in the last quarter. In addition, Q3 Switching revenues were lower than in 2010.  In fact, Cisco only had one quarter in the last six whereby these three divisions reported, in aggregate, more than 2.5% annual growth. And that quarter (Q2 2012) came against a very weak comparable in the previous year.

With regards to Collaboration, this includes things like video conferencing and telepresence. It strikes me that this division is being challenged by cloud-based solutions and cheaper alternatives for corporate messaging. As for Switching and Routers, this looks like a mature industry and Chinese company Huawei is understood to be aggressively pursuing the enterprise market. In fact, Cisco spent a good part of the conference call discussing plans to fend off Huawei. We shall see.


In Conclusion

My point is that it is Cisco’s core revenues that are weak and, not the parts of the business that compete with other leading tech companies. For example, application delivery company F5 Networks $FFIV reported 20%+ revenue growth in the last quarter. Wireless testing company Ixia $XXIAreported 9%+ revenue growth, and network security company Fortinet $FTNT reported 26% growth. As for Data Centers, we only need to look at the aggressive expansion plans of companies like Equinix $EQIX to see that data center spending is rising in response to strong demand.

Cisco reported strong growth in Security, Wireless, Data Centers, and Virtualization. In other words, all the comparable parts of its business were in line with what these companies reported. The difference is that they all gave positive guidance. Cisco did not. My suspicion is that Cisco gave weak guidance because of weakness in the Switching, Routers and Collaboration segments. After all, these areas make up 59% of Cisco's revenues.

However, markets don’t care about such things in the short term. The whole tech sector was sold off in the wake of Cisco’s guidance. Only an idiot would ignore John Chambers’ commentary over weaker enterprise spending but I think we need to temper our reaction to it by understanding he is only responsible for what is happening to his company.

As I’ve tried to demonstrate above, the majority of Cisco’s revenues come from the largest three product divisions, which are all experiencing slow or no growth. Cisco is obliged to comment on its prospects, but investors can look in more detail to see currents of strength within the broader technology market.