Quick Thoughts: Well Done Cisco! But the Problem is Still Out There

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–          Cisco is out executing its competitors, taking share in most categories to deliver growth in tough conditions, while cutting costs and expenses to sustain strong margins.

–          However, the comprehensive paradigm shift underway in TMT does not play to Cisco’s favor – routing and switching will be increasingly commoditized as IT shifts to the cloud.

–          As global traffic and data processing migrates to highly sophisticated operators like Google, Amazon and Microsoft, proprietary software-based solutions and commodity hardware will predominate.

–          Still, services, wireless, and security should remain attractive businesses, with high performance networking a smaller, but potentially lucrative, niche market.

Cisco turned out a good quarter at a very difficult time, a testament to the company’s well-honed operations, financial controls and sales positioning.  Cost cuts, both in the bill of materials and on the expense lines, paved the way for a round of price cuts that beat rivals like HP, Huawei, and newcomer Arista Networks at their own game.  Investors were obviously pleased, taking the stock up more than 7% at the open, and analysts followed with dutiful upgrades and estimate revisions.

Cisco had been fighting a serious sentiment bugbear, as a combination of the weak global economy, slowing data center investment and the specter of open source software networking dominated the market’s imagination.  The first fiscal quarter results reminded us that Cisco’s scale and general excellence gives it the industry’s lowest costs, and when mixed with a talented and well positioned sales force, the company can still deliver upside surprises.  2QFY13 guidance promised more of the same, bringing a sigh of relief to IT investors growing accustomed to disappointments and downward guidance.

So, hurrah for that.  Nonetheless, the iceberg in the water remains, even if the estimated time of impact is pushed out a couple of quarters.  Several major trends are working against Cisco.  First, enterprise IT departments are poised to begin moving applications and data onto cloud-based distributed data centers, limiting investment in their own internal data centers in the process.  This is a bad trade for Cisco.  Corporate data centers are awash with high-end Cisco gear, as the push to virtualization required considerable networking investment to keep pace.  In contrast, Google is already building its own routers and other major cloud providers like Amazon and Microsoft are not far behind.  The exodus to the cloud has begun slowly and will take years to play out, but the profound cost and performance advantages for enterprises are compelling and the end game is clear.

The bad trade extends to the service provider space as well.  Internet traffic continues to concentrate onto a smaller and smaller number of larger and larger networks.  The biggest of these operate as distributed data centers, serving requests from servers located as close as possible to the user.  The error and latency of data transmissions increases geometrically with the number of routers that it must traverse along the way, so the distributed architecture works to minimize the number of router hops necessary, and thus, the amount of router capacity that must be deployed.  Behind that local server, the most sophisticated cloud operators interconnect their own data center locations with proprietary software based networking solutions that rely on commodity hardware.  The end result is that the service provider “Internet” is increasingly pushed further and further to the edge, eventually stemming demand for routing and switching capacity despite ongoing traffic growth.

The last trend working against Cisco is the commoditization of workgroup switching.  Switches remain Cisco’s largest sales category, but are generally rely on far less sophisticated technology than do routers or other Cisco products.  In particular, workgroup switches, used to connect various desktop PCs back into the enterprise data center, are under siege from cheapo competition, even as a shift to portable platforms threatens to eliminate them as an important future product category.  With more than 30% of sales still coming from switches, and another 19% from the increasingly competitive router space, Cisco remains vulnerable to being crowded out by software defined proprietary alternatives and eroded by low margin knock-offs, even if the change is slow and partially mitigated by cost reductions and share gains.

However, all is not lost.  Demand for the high performance turnkey networking products that remain Cisco’s core may be constrained by the shift to the cloud at the high end and commoditization at the low end, but the market for these products won’t go away quickly or entirely.  Second, Cisco is investing in new product categories that have promise in the new paradigm – security, video and WiFi – and will have in important roll providing services to enterprises that look to manage networks that will span to the public cloud.  Finally, service provider spending has been somewhat muted by carrier oligopolies that have held back on capital spending.  Deals in the US market consolidating T-Mobile with MetroPCs and adding Softbank’s resources to Sprint look likely to stimulate competition, and thus, spending.  AT&T’s recent announcement of $14B in incremental new spending is further evidence, and ought to benefit Cisco directly in both wireline broadband and wireless LTE deployments.

Taking the picture as a whole, Cisco is likely to be a rollercoaster ride as it navigates the sea change underway.  Short term results may well continue to offer hope, even as significant obstacles loom farther in the distance.  Those obstacles will surely test the mettle of management, and ultimately, Cisco’s core business will be smaller and less profitable than it is now, but that is probably well considered by most investors in the stock given the current valuation.  The key will be establishing video, security, wireless, services and other growth businesses as viable drivers for the future Cisco.  John Chambers seems to understand the task at hand, and given the company’s history that is at least half the battle.

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