Cisco’s Q4: Downturn 2.0

Cisco might be good at predicting market transitions; but the company admittedly can’t forecast the global economy. Cisco’s fourth quarter results may be an indicator that “Downturn 2.0” is upon us.

Cisco came up short on revenue in Q4, even though earnings beat estimates by a penny a share. But the revenue miss, combined with Q1 guidance flat to down 2% from Q4, and way off Wall Street expectations, helped drive the markets markedly lower today.

Several factors dampened Cisco’s Q4 and expectations for Q1:

• Continued supply chain constraints – component lead times have improved, and even stabilized, but are still too long for Cisco’s liking. The company expects them to continue for the rest of the calendar year;
• Economic uncertainty – slow GDP growth in many countries, including the U.S., and hazy GDP forecasting makes charting a course for quarterly growth equally uncertain. Indeed, both CEO John Chambers and CFO Frank Calderoni used the term “unusual uncertainty” in their remarks to Wall Street analysts yesterday;
• A slower recovery from the recession than anticipated – Cisco customers are conservative to the point of cautious about the economic recovery, with most expecting a more gradual return to normal economic conditions. Cisco noted that GDP growth in the U.S. slowed from 5% to 3.7% to 2.4% over the last three quarters and as a result, many of its customers are anticipating growth of only 2% in the second half of the calendar year. Consistent with that, they are re-evaluating their own capital spending, investments, business projections and job creation intentions;
• An unfavorable product mix – always a danger when introducing several new products is the pause in buying that occurs when customers size-up the new offerings. Indeed, sales of Cisco core products, routers and switches, were up 1% and down 1.4%, respectively, from Q3;
• Lower product gross margins – a 1% dip from last year and a 1.7% drop from Q3 due to supply constraints raising costs, combined with the unfavorable product mix, pricing and high discounts.

Chambers said Cisco is concerned about what its customers are concerned about. And those customers saw business softening in the second half of June and early July. Cisco saw the same trend in order growth from mid-June to mid-July, he said.

“Normally I would not have paid much attention to this, except this is the exact time period were we saw the challenges in Europe and the corresponding challenges in global stock markets,” Chambers told analysts yesterday during the Q4 conference call.

One analyst said Cisco is a victim of “Downturn 2.0.” In a report on Cisco’s Q4, Brian White of Ticonderoga Securities wrote:

The negative tech trends we highlighted during the Computex Show in June revolved around the notebook, PC, LCD TV and consumer electronics markets, however, the networking world has now fallen victim to the beginning of downturn 2.0. Cisco’s tone clearly reflected the deteriorating economic environment and the company specifically called out weakness that began in mid-June through mid-July (we believe more in the U.S.) that is driving the company’s conservative outlook.

Short-term, things are looking down. Cisco’s guidance for Q1 does not inspire immediate confidence, and may even be a harbinger of a protracted Downturn 2.0. But the company remains undaunted and, as usual, looks for opportunity in these challenging times:

“While there are many factors that we cannot control or influence such as the economy, compensation, some of the supply chain challenges, impact of government regulations etc., (the) majority of the future is under our own control and we’ve an unusually strong balance in our business and customer deliverables, which becomes even stronger in times of uncertainty,” Chambers told the analysts. “I believe this is one of the Cisco’s core strength and we have always used these periods of uncertainty to move into new markets and to expand our share of existing markets.”

But the optimism and confidence should be tempered with a little bit of reality. CFO Calderoni noted that Cisco will always be affected by major economic changes, capital spending patterns, new and existing competitors, potential issues affecting suppliers and its ability to execute.  

“It is important that expectations do not get ahead of where the market is today,” he cautioned analysts.

Setting expectations by predicting where the market will be is not as easy as predicting market transitions.

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