Cisco’s disappointing third quarter outlook had analysts pondering whether the company can take an onslaught of pricing pressure from HP (NYSE:HPQ) and Juniper (NYSE:JNPR). A few observers were even pondering a break-up of the company or at least a strategic divestiture.
Sound dramatic? Perhaps, but that’s what happens when Cisco (NASDAQ:CSCO) reports three consecutive quarters that raise more questions than answers. Cisco’s outlook was lackluster relative to expectations as CEO John Chambers noted that there was pricing pressure for its switches. Meanwhile, Cisco’s lower end switches are cannibalizing high-end gear.
That reality had analysts wondering if Cisco’s premium pricing power would ever return. It also didn’t help that Cisco said gross margins for its Unified Computing System were about 36 percent, lower than some analysts estimated. However, those margins shouldn’t be that surprising. The server market has more than enough competition to keep pricing low.
Morgan Stanley analyst Ehud Gelblum was one of many questioning whether Cisco can keep its switch prices up in a maturing industry. Switches account for a third of Cisco’s revenue. “Premium products and new innovation no longer commands premium pricing and margins,” he said. Indeed, HP and Juniper are targeting Cisco’s 70 percent gross margins on Ethernet switches and forcing Cisco to price new gear the same as its older products.
Stifel Nicolaus analyst Sanjiv Wadhwani said:
Additionally, the switching business impacted gross margins by 1%. The reason given was a product transition from the Catalyst 6K to the Nexus 7000 and the Catalyst 2K/3K to a portfolio of newer switches with higher price-performance characteristics. We however believe that there is a more structural change occurring in the industry with pricing pressure being exerted by HP and Juniper among others. This is forcing Cisco to compete for the first time on pricing in its switching product line against well funded and capitalized vendors. Overall, the structural change we believe is likely to lead to a permanent change in gross margins.
Add it up and Cisco is in a commodity business and that’s a new environment for Chambers & Co. Cisco was one of the only networking companies to report sequential revenue declines (down 3.2% q/q) in what was a healthy IT spending environment,” said Piper Jaffray analyst Troy Jensen. What’s the fix?
Gelblum raised the possibility of splitting up Cisco. He has a point. For Cisco to deliver a great quarter, it needs everything from Flip, to enterprise security to switches to set-top boxes to WebEx to perform well. “Getting all the company’s ducks to line up at the same time appears to be getting increasingly more difficult,” said Gelblum.