Cisco’s Quarter: Are They Really Facing the Future at Last?

Cisco reported its quarterly numbers, which were still down in revenue terms, but they forecast the first growth in revenue the company has had in about 2 years of reports.  “Forecast” isn’t realization of course, but the big question is whether the gains represent what one story describes as “providing an early sign of success for the company’s transition toward services and software”, whether it’s mostly a systemic recovery in network spending, or just moving the categories of revenue around.  I think it’s a bit of everything.

Most hardware vendors have been moving to a subscription model for all their software elements, which creates a recurring revenue stream.  New software, of course, is almost always subscription-based, and Cisco is a bit unique among network vendors in having a fairly large software (like WebEx) and server/platform business.

Cisco’s current-quarter year-over-year data shows a company that’s still feeling the impact of dipping network equipment opportunity.  Total revenue was off 2%, infrastructure platforms off 4%, and “other products” off 16%.  Security was the big winner, up 8%, with applications up 6% and services up 1%.  If you look at absolute dollars (growth/loss times revenue), the big loser was infrastructure and the big winner was applications.

Here’s the key point, the point that I think at least invalidates the story that this is an “early sign of success” for the Cisco shift in emphasis.  Infrastructure platforms are over 57% of revenue as of the most recent quarter.  Applications are about 10%, Security about 5%, and Services about 25%.  Two categories of revenue—applications and security—that are showing significant growth combine to make up only 15% of revenue, and that 57% Infrastructure Products sector is showing a significant loss.  How can gains in categories that account for only 15% of revenue offset losses in a category that account for almost four times as much revenue?

Two percent of current revenues for Cisco, the reported q/q decline, is about $240 million.  To go from 2% loss to a 2% gain, which is where guidance is, would require $480 million more revenue from those two gainer categories, which now account for about $1.8 billion in total.  Organic growth in TAM of that magnitude is hardly likely in the near term, and change in market share in Cisco’s favor similarly so.  What’s left? [see note below]

The essential answer is M&A.  Cisco has a decent hoard of cash, which it can use to buy companies that will contribute a new revenue stream.  However, Cisco classifies the revenue, getting about half a billion more would create everything Cisco needs.  Cisco is being smart by using cash and M&A to diversify, to add products and revenue to offset what seems the inevitable diminution of Cisco’s legacy, core, products’ contribution.  So yes, Cisco is transforming, but less by a transition toward software and services than by the acquisition of revenues from outside.

It may seem this is an unimportant distinction, but it’s not.  The problem with “buying revenue” through M&A is that you easily run out of good options.  It would be better if Cisco could fund its own R&D to create innovative products in other areas, but there are two problems with that.  First, what would an innovator in another “area” want with a job with Cisco?  They probably have experts in their current focus areas, which doesn’t help if those areas are in perpetual decline.  Second, it might take too long; if current infrastructure spending (at 57% of revenue) is declining at a 4% rate, the Cisco’s total revenue will take a two-and-a-quarter-percent hit.  To offset that in sectors now representing 15% of revenue, Cisco would need gains there of about 12%, right now.  That means that at least for now, Cisco needs M&A.

Most of all, it needs a clear eye to the future.  You can’t simply run out to the market and look for people to buy when you need to add something to the bottom line.  The stuff you acquire might be in at least as steep a decline as the stuff whose decline you’re trying to offset.  If you know where things are going you can prevent that, and you can also look far enough out to plan some internal projects that will offer you better down-line revenue and reduce your dependence on M&A.

Obviously, it’s not easy to find acquisitions to make up that needed $350 billion.  Cisco would have to be looking at a lot of M&A, which makes it much harder to pick out winners.  And remember that the losses from legacy sectors, if they continue, will require an offset every year.  A better idea would be to look for acquisitions that Cisco could leverage through its own customer relationships, and that would represent not only that clear current symbiosis but also future growth opportunity.  That kind of M&A plan would require a whole lot of vision.

Cisco has spent $6.6 billion this year on the M&A whose prices have been disclosed, according to this article, of which more than half was for AppDynamics.  Did that generate the kind of revenue gains they need?  Hardly.  It’s hard to see how even symbiosis with Cisco’s marketing, products, and plans could wring that much from the M&A they did.  If it could, it surely would take time and wouldn’t help in the coming year to get revenues from 2% down to 2%up.

To be fair to Cisco, this is a tough time for vision for any network vendor, and a tough industry to predict.  We have in networking an industry that’s eating its heart to feed its head.  The Internet model under-motivates the providers of connectivity in order to incentivize things that consume connectivity.  Regulations limit how aggressively network operators could elect to pursue those higher-layer services, which leaves them to try to cut costs at the lower level, which inevitably means cutting spending on equipment.

That which regulation has taken away, it might give back in another form.  The FCC will shortly announce its “end of net neutrality”, a characterization that’s fair only if you define “net neutrality” much more broadly than I do, and also that the FCC was the right place to enforce real net neutrality in the first place.  Many, including Chairman Pai of the FCC, think that the basic mission of non-discrimination and blocking that forms the real heart of net neutrality belongs in the FTC.  What took it out of there was less about consumer protection than OTT and venture capital protection.

The courts said that the FCC could not regulate pricing and service policy on services that were “information services” and explicitly not subject to that kind of regulation.  The previous FCC then reclassified the Internet as a telecommunications service, and the current FCC is now going to end that.  Whether the FCC would end all prohibitions on non-neutral behavior is doubtful.  The most it would be likely to do is accept settlement and paid prioritization, which the OTT players hate but which IMHO would benefit the ISPs to the point of improving their willingness to capitalize infrastructure.

What would network operators do if the FCC let them sell priority Internet?  Probably sell it, because if one ISP didn’t and another did, the latter would have a competitive advantage with respect to service quality.  Might the decision to create Internet QoS hurt business VPN services?  No more than SD-WAN will, inevitably.

Operators could easily increase their capex enough to change Cisco’s revenue growth problems into opportunities.  Could Cisco be counting on the reversal of neutrality?  That would seem reckless, particularly since Cisco doesn’t favor the step.  What Cisco could be doing is reading tea leaves of increasing buyer confidence; they do report an uptick in order rates.  Some of that confidence might have regulatory roots, but most is probably economic.  Networking spending isn’t tightly coupled to GDP growth in the long term (as I’ve said in other blogs) but its growth path relative to GDP growth still takes it higher in good times.

The question is what tea leaves Cisco is reading.  Their positioning, which is as strident as always, is still lagging the market.  Remember that Cisco’s strategy has always been to be a “fast follower” and not a leader.  M&A is a better way to do that because an acquired solution can be readied faster than a developed one, and at lower cost.  But fast following still demands knowing where you’re going, and it also demands that you really want to be there.  There is nowhere network equipment can go in the very long term but down.  Value lies in experiences, which means software that creates them.  I think there are players out there that have a better shot at preparing for an experience-driven future than any Cisco has acquired.

What Cisco probably is doing is less preparing for “the future” than slapping a band-aid on the present.  They are going to leak revenue from their infrastructure stuff.  The market is going to create short-term wins for other companies as the networking market twists and turns, and I think Cisco is grabbing some of the wins to offset the losses.  Regulatory relief would give them a longer period in which to come to terms with the reality of networking, but it won’t fend off the need to do that.  The future doesn’t belong to networking at this point, and Cisco has yet to show it’s faced that reality.

[The paragraph in italics had errors in its original form and is corrected here!]