Transition is real and underway at Cisco

Company facing realities of disruption to its core business from market adjacencies, migration to new platforms, bullish targets

Cisco's stock dropped 14% a day after announcing second quarter results that beat estimates, yet disappointed Wall Street with margin erosion, a challenging product transition and underwhelming Q3 guidance. Analysts say the company is in a period of transition and that earlier annual growth targets of 12% to 17% are being adjusted downward.

The product transitions are hitting Cisco's core routing and switching business. In switching, Catalyst 2000 and 3000 customers are migrating to newer generation platforms, while Catalyst 6000 customers are making their way to the Nexus 7000 line. Catalyst switching is a $10 billion-plus business for Cisco and any disruption will be felt widely throughout the company and the industry.

This transition is directly responsible for the decline in Cisco's second quarter gross margins, analysts note. But that's not the only product transition underway at the company.

Customers are flocking to new products, like data center, virtualization, video, collaboration and mobility. Cisco saw healthy revenue increases in new products and services in Q2, an indication that the company itself is transitioning away from routing and switching as its core business, according to Technology Business Research senior analyst Scott Dennehy:

...these two segments generated more combined revenue than routers and switches for the first time in Cisco's history, an indication that its business is moving away from the products that made the company what it is today... As customers continue to transition from traditional router and switch products to Cisco's next-generation products and services, the company will need to take a hard look at restructuring itself in order to meet the revenue growth and margin expectations it has set with the market.

Switching revenue was down 7% from last year and 11% from Q1. Routing revenue was up 4% from last year but down 7% from Q1. These trends suggest Cisco is also losing market share despite Cisco's claims that margin pressure is due to product transitions alone, according to investment firm UBS:

Cisco suggested (margin) decline from cannibalization rather than share loss...Switch/Router QoQ revs do not bode well for Cisco share.

But the pressure on gross margins may be from Cisco playing defense with its installed base and market share rather than losing business to competitors like HP and Juniper. Cisco may be offering deeper discounts in the face of such competition in order not to lose share. Says Oppenheimer & Co.:

We believe the GM pressure is a reflection of multiple concurrent switching product transitions as well as Cisco needing to aggressively protect its installed base. Although GM pressure is likely to linger for some time, we believe the silver lining is that Cisco is seeing quicker than expected uptake. This suggests the company is defending its switching position well... We're disappointed with GM and the slow pace by which it could recover, but we believe the strong uptake of Cisco's new switching portfolio suggests it's playing defense well.

Oppenheimer also notes that Cisco is "quietly backing away" from its 12% to 17% long-term growth target. It all adds up to Cisco being a bit too bullish on its prospects and not anticipating the timing or disruption of a) switching customers transitioning to newer platforms and product lines; and b) the upheaval new products borne of entry into market adjacencies would have on core routing and switching.

According to TBR's Dennehy:

Cisco believes its 2011 fiscal year revenue will grow in the mid to low somewhere in the 9%-10% range, which raises the question as to whether or not the company's future growth prospects are as bright as they were just a few quarters ago. While TBR believes that Cisco's overall strategy is solid, the company may simply be too large and dispersed to achieve growth rates comparable to smaller and more focused competitors... TBR believes this may be a sign of a larger issue that Cisco won't be able to address simply by becoming more operationally efficient.

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