In 1986, British coal miners ended a long tradition of bringing canaries underground to detect carbon monoxide and other toxic gases before they could harm human beings.
I thought of the canary’s history while covering this week’s earnings report from
Systems (ticker: CSCO). For years, Cisco has been Silicon Valley’s early-warning signal. And last week, the canary was clearly ailing. For the most part, investors covered their eyes.
While Cisco shares tumbled 11% on Thursday on the company’s weak outlook—their worst one-day drop in more than nine years—the Nasdaq Composite still rose on the day.
Investors knew that Cisco’s July-quarter results wouldn’t be great. The networking giant had previously projected a year-over-year sales decline of 8.5% to 11.5%, citing Covid-19 and the global slowdown. Cisco’s sales of $12.2 billion, down 9% from a year ago, and its quarterly profit number were actually a little better than the guidance and Wall Street’s estimate. But orders in the quarter were down a disappointing 10%.
In a postearnings interview, Cisco Chief Financial Officer Kelly Kramer told me that demand was OK at the very largest enterprises, and public sector demand held up. But there was softness almost everywhere else across product lines and customers of every size and in every geography. Product revenue was down 13%, while service revenue was flat. Security revenue was up 10%, but infrastructure-related revenue was down 16% and applications revenue was down 9%.
Perhaps the most worrisome line came from commercial orders—basically business from smaller customers; they were down 23%.
Investors had assumed that the July quarter would be the bottom for Cisco, but that clearly isn’t the case.
“The environment hasn’t really gotten better,” Kramer said. Indeed, for the October quarter, Cisco is projecting revenue to be down 9% to 11%. At the middle of the range, that would be a 10% drop, slightly worse than the July quarter; the Street had been looking for a decline in the 7% range.
“Cisco is facing a crossroads moment in its business that was not caused by the pandemic but is being exacerbated by it,” wrote William Blair analyst Jason Ader after earnings.
Ader said that the pandemic is spotlighting the fact that while Cisco has made some progress in shifting to higher-growth software and cloud revenue, it remains heavily dependent on hardware and on-premises revenue, with almost 60% of product revenue still tied to traditional switching and routing, down only modestly from 80% 15 years ago. “With the pandemic accelerating underlying digital-transformation trends, the warts in Cisco’s product portfolio are becoming more visible,” he wrote.
On the earnings call, CEO Chuck Robbins vowed to accelerate the company’s shift to software-based networking solutions and away from its traditional hardware base. Cisco is shifting its research-and-development spending to focus more on faster-growing businesses like cloud-based security and collaboration, enterprise automation, 5G, and WiFi6.
Kramer said revamping the portfolio will include some acquisitions. Cisco also unveiled plans for a $1 billion cost-cutting program, most of that to take place by the end of the current quarter—job cuts will be part of the equation.
William Blair’s Ader remains cautious. “Put simply, we believe Cisco missed a golden opportunity to fundamentally reshape its business post tax reform/repatriation, instead opting to repurchase nearly $37 billion in stock in 2018 and 2019,” he wrote. “Now, with sky-high valuations for growth assets, we worry that it is too late.” Ouch.
But this goes beyond Cisco’s strategic missteps. We’re in the middle of an ugly recession. Many companies are cutting back and shifting spending to cloud-based applications and away from internal data centers. In normal times, they would be buying Cisco’s routers, switches, and servers. After Cisco’s report, investors also sold off
Hewlett Packard Enterprise
(HPQ). In the era of accelerating “digital transformation,” the legacy tech players are falling behind, and investors are losing interest.
But the market seems blithely convinced that cloud-based software providers—companies like
(CRM)—are insulated from Covid-19 pain. Investors assume that these companies’ subscription-based models and high gross margins protect them as every business rushes to digitize operations. That seems shortsighted.
Cloud companies, after all, don’t just serve other tech companies. Like Cisco, they serve industrial manufacturers, financial institutions, retailers, hoteliers, and other businesses struggling to stay afloat.
Many cloud-based companies have revenue-per-seat business models—and their customers are trimming staff in the face of sagging demand. A cloud-based strategy is helpful, but it isn’t a vaccine for recession ills. As it happens, many of the cloud businesses have quarters that ended in July, and they’ll be reporting earnings in the weeks ahead.
Remember the canary.
Write to Eric J. Savitz at email@example.com