Wall Street was shocked when Cisco (NASDAQ:CSCO) provided cautious guidance on its 1Q14 earnings call on November 13th for its upcoming 2Q14 quarter. The shocking guidance of sales declining between 8-10% year over year led to a decline of 11% on the stock the following day. While the investment community was well prepared for a challenging quarter given expectations of weak US government and China spending, the guidance was much worse than expected.
It was fair for Wall Street to be surprised by the guidance, as Cisco has never shown a year over year decline in sales on the order of 10% except during periods of economic recession. Since Cisco has significant market share in major categories within Enterprise Networking IT spending (e.g. switching, routing, WiFi, collaboration etc.), it is difficult for the company to grow during periods of economic contraction. Specifically, Cisco witnessed year over year sales decline ranging from 8% to 18% during the four quarters of the 2009 financial crisis recession and more significant declines of close to 30% year over year during the collapse of the technology bubble in 2001 given this downturn was more pronounced in the technology sector.
While GDP growth is not strong in the US and the world overall, the US and the world are not currently in a recession nor do economists generally expect the US and the global economy to enter a recession in the very short term. In fact US GDP growth has been improving with growth of 1.1%, 2.1% and 2.8% in 1Q, 2Q and 3Q of 2013, yet Cisco showed a declining trend in North America year over year order rate in the past three quarters at 7.0%, 5.0% and -2.0%. Cisco's weak order growth was not limited to North America as EMEA and Asia Pacific declined 4% and 10%, respectively, with an overall company decline of 4%. The declining order trends for Cisco in all regions of the world, and the US in particular is troubling.
Cisco's weak order growth and guidance is likely due to the following main points:
- Set Top Box: Cisco is losing share and managing its set-top box business for profit rather than growth. In addition, Cisco's sale of home networking division Linksys and the closing of consumer business a couple of years ago likely suggests the company is not focused on home products, thus, further putting pressure on the performance of the TV set-top box business
- Product Transitions: Cisco has major product transitions underway in Ethernet Switching and Routing. The transition in Ethernet Switching to the Nexus 9000 given the recent Insieme product launch, however, may reduce average price/port of high-end switches, which may lead to a multi quarter impact on year over year sales growth in the Cisco Switching unit. The core router product transition is also likely to take more than one quarter given the long evaluation and testing cycles that are typical for such products in service provider networks.
- Cloud Commoditization: Cloud operators like Amazon (NASDAQ:AMZN), Google (NASDAQ:GOOG), etc. are utilizing cheaper "white box" switches to build their data centers. While the use of "white box" switches is not yet mainstream in the classic enterprise or service provider markets, it is becoming mainstream in the large cloud provider segment. Industry research firm Dell'Oro group has estimated that Amazon Web Services has already deployed over 500,000 "white box" switch ports in its network. A recent Business Insider article discusses how Cisco lost up to $1 billion in networking sales to Amazon as it utilized more "white box" equipment in its network. Newly formed companies today often opt to not build their own networks, but rather outsource IT compute, networking and storage capacity to cloud providers like Amazon. Investors are concerned with this shift to the cloud for IT just like they are watching what teenagers are doing on Facebook (and other social media companies) as it shows where the future is heading. Cisco is trying to fight this use of "white box" networking by cloud providers through its launch of Insieme and its Application Centric Infrastructure (ACI) on November 6th and it did get endorsements from many technology companies. While investors can wait out the set top box business shrinking for Cisco and a product transition in the core router market, they will not be bullish on Cisco until they feel confident that Insieme and ACI will allow Cisco's enterprise networking business to better position the company against cloud commoditization.
In a prior article on Cisco, I mentioned that downside in the stock is likely in the $20-$24 range and upside is in the $26-$30 range and I think this analysis still is valid even after the recent stock drop. At a current valuation of about 5.75x EBITDA even when adjusting for repatriation of current international cash, Cisco will likely have valuation supporting the stock from going materially lower in the short term. Even though downside may be limited given valuation support, the stock is not likely to be a strong performer in the next few months as the set-top box declines, product transition issues and battle between "white box" networking and Insieme/ACI are not likely to be resolved for investors by the time the company reports the next quarter. Thus, I think Cisco's stock should be looked at for investors with at least a 6-month time horizon and you will need to be diligent in following how Cisco prevails in its battle with cloud commoditization and its ability to keep that from spreading to traditional enterprise and service provider accounts.
On its 1Q14 conference call, Cisco mentioned how order momentum decelerated in the last month of the quarter. On the other hand, total finished goods inventory increased slightly sequentially to $1.082 billion from $1.052 billion. The weakening of orders in the last month of the quarter, guidance of revenues to be down about 8%-10% sequentially and a slightly up sequential trend in inventories suggest that Cisco's supply chain may see slower than expected orders in the next 2-4 months than what they expected when it gave prior guidance. Cisco will be very focused on managing cash flow from operations in its current quarter, thus, inventory is likely to fall in a material way sequentially. Supply chain companies with material exposure to Cisco include Cavium (NASDAQ:CAVM) with Cisco at about 18% of sales, Finisar (NASDAQ:FNSR) with Cisco at about 17% of sales and EZchip (NASDAQ:EZCH) with Cisco at 44% of sales in its recent quarter. Contract manufacturer Jabil Circuit (NYSE:JBL) historically had Cisco representing at 10% of sales, but it fell to below 10% of sales in its most recent fiscal year, thus, it is less exposed than in the past. It is fair to say, however, that the supply chain stocks, especially those with exposure to Cisco, have all taken a hit since Cisco reported as the potential for declining orders from Cisco may be already discounted in the shares of some or all of these companies.
Additional disclosure: NT Advisors LLC is a consulting firm that may have in the past, present or in the future solicited or generated business with any company mentioned in this article.