Cisco Systems shares jumped eight percent this morning on the heels of a third-quarter earnings report that beat the expectations of analysts.
While Cisco’s sales declined overall by about five percent year on year, that was considered the first bit of good news. Last February, CEO John Chambers had braced shareholders for a bigger drop in the range of six percent to eight percent.
Cisco has been the world’s biggest supplier for networking gear sold to large companies and Internet service providers for years. But it has struggled in recent times to maintain its rate of growth and profitability at a moment when its traditional customers are contemplating a transition to less-expensive products that use software rather than the kind of specialized hardware that it manufactures to manage their data traffic. The shift is often referred to as software-defined networking, or SDN.
The shift, combined with the uneven global economy and the longer-term shift to cloud computing, where companies outsource their data centers to third parties, has led many Cisco customers to reconsider what they buy from the company or delay planned upgrades.
As analyst Brian Marshall of ISI said in a research note this morning, many of Cisco’s customers are as yet undecided how they’re going to proceed in the expected transition toward SDN, in part because the technology is still young, standards are still in flux and many vendors not named Cisco are promising, but young. “Our discussions with customers and vendors suggest uncertainty over future networking architectures has caused many enterprises to stretch out replacement cycles as they evaluate choices and wait for new solutions to mature,” Marshall wrote.
Even so, Cisco has managed to keep its business model intact. For proof of that, look no further than its gross margins, a key indicator of profitability. Investors and analysts have worried that as Cisco has weathered the transition, its gross margins would tip below 60 percent after years of hovering in the low 60s. Yesterday it reported a gross margin of 62.7 percent.
That plus word of an evening out of sales in some business segments and geographical regions has given Cisco shareholders their first opportunity for optimism in a while. As of midmorning, the shares were trading at $24.57 a share, up $1.75 from Wednesday’s close.
Last night, Chambers spoke with Re/code. We discussed the quarter, the state of the global IT market, the economy and the status of his plans to retire as Cisco’s CEO sometime in the near-ish future. Hard as it is to believe, he’ll be 65 in August.
The interview was edited for structure and brevity.
Re/code: Cisco always tends to be something of a leading indicator both for tech and for the economy generally. With that in mind, what are your tea leaves telling you?
Chambers: Based on what we’re seeing and what I’m hearing from other CEOs, the U.S. economy is going to grow about two percent for the last nine months of the year. I think the first quarter was an anomaly. We should be growing four to six percent, so I’m not giving us good grades. But I would say the economy is not going to be as bad as some people fear. Our U.S. enterprise business for deals worth a million dollars or more grew 25 percent. That is not something that indicates the economy is going flat. Europe is starting to recover but there are structural issues.
What do you think about the state of the tech economy? We’ve seen some flux in the valuations and some delays in IPO activity. People are talking about a tech bubble. What do you think?
I wouldn’t say we’re in a bubble. The difference is that there are a number of traditional players that have good profits and a good amount of cash on the balance sheet. But it’s almost like it was in 2000, and I’ve seen this movie before where something like 80 percent of the companies that are going to IPO don’t have any profits. I’ve also gone from a price-earnings ratio of 205 to eight, so I know what it’s like. If this market turns on them it’s going to be a long fall. I do think we’re going to see a shakeout here.
So where are you on the transition in leadership at Cisco? You started talking about the possibility of retiring about 18 months ago. Where are we in that process?
We said a year and a half ago it would not be another three to five years, but it would instead be more like two to four years. And the next time we comment on it will be when we actually announce the transition. I like what I see in the market, but you will hear me at some point in time in the future make this transition. We have an unbelievable bench of players here, maybe five or six who could do this job, or do the same job for someone else. My job is to hold on to them both before and after the transition.
Last quarter you set the tone for a quarter that might not be so good, but it turned out better than everyone expected. What happened?
I’d put it a little differently. We basically set a position last quarter for what we were going to do financially, but we exceeded in every category. It was a major step in the goal to return to growth. And in the quarter we actually moved sequentially four percent, and usually we move only one percent. When our peers like IBM and Hewlett-Packard are experiencing this ongoing decline of about 10 or 12 quarters, we outlined what we were going to do, and a number of things went well. We set some goals with emerging markets and high-end products, and we made progress on each of them, but we still have a ways to go.
In your largest market segment, which is switching, you reported another decline, but during the conference call you called it out at least twice, saying it would be two or more quarters before it starts growing again. What’s going on there?
I think it’s still several quarters out before switching turns up is the most likely scenario. In the data center we’ve passed the leveling out and we’re on our way back up. Our Nexus 9000 switch, we said, went from 20-plus customers one quarter ago to 175 this quarter with a thousand in the pipeline. … Campus switching is where we’re getting some tough competition pricewise, even from ourselves. We have some products that can deliver four times the throughput for one fourth the cost of the previous ones so you have to sell four times as many. But I would say we’re winning most of the architectural decisions in the data center market pretty well. In fact, if you watch our win rate at financial institutions it should be interesting. That startup Arista Networks had a lot of thought leadership in all of them and we’ve won almost all of them back.
Geographically, revenue in the Americas region was still down, Europe looks like it stabilized finally and Asia still looked weak. What’s happening around the world?
Actually, product orders in the Americas was up three percent and U.S. was up seven. Enterprises in the U.S. grew 10 percent, commercial customers grew 10 percent. Public sector was up a couple of points. … We are seeing northern Europe growing in the U.K. and Germany and southern Europe appears to be stabilizing. But the emerging countries are still very tough. They were down seven percent but the BRIC countries plus Mexico were down 13 percent. The good news is that it’s leveling out but at a bad number. Too early to call yet on Asia. If you were to ask CEOs in other unrelated industries, they’d be saying much the same thing.
So now it’s time for the song I pick for Cisco every quarter — it has been sort of a running joke between Chambers and me. This quarter the selection is Sly and the Family Stone’s “I Wanna Take You Higher,” because that’s exactly what Chambers and his team are trying to do in the quarters ahead. And of course I had to pick the most memorable performance of that song ever: Woodstock in 1969. Enjoy.