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Here's Why Cisco's Guidance Was So Bad

By Timothy Green – May 18, 2017 at 10:37AM

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The company's continued shift toward subscriptions, combined with various temporary issues, led to the weak outlook.

Shares of Cisco Systems (CSCO -0.15%) were down around 8% at market open Thursda,y following a third-quarter report that featured surprisingly downbeat guidance. The company beat analyst estimates across the board for the third quarter, with the switching business returning to growth, and cost-cutting efforts boosting the bottom line. But the company's outlook for the fourth quarter, calling for a revenue decline between 4% and 6%, caught investors off guard.

What's going on with Cisco's guidance? Here's what management had to say.

The Cisco logo.

Image source: Cisco Systems.

A confluence of factors

Not surprisingly, the first set of questions asked by analysts during Cisco's earnings conference call, the transcript for which was provided by Thomson Reuters, were focused on the guidance. Cisco CFO Kelly Kramer laid out the three main factors that drove the company's guidance:

  • Weak product orders from service providers and in emerging markets.
  • Weakness among public sector customers, particularly the U.S. Federal Government.
  • The shift to subscription software and recurring revenue.

Product orders during the third quarter from service providers were down 10% year over year, while product orders from emerging markets were down 12%. In Brazil, Russia, India, China, and Mexico, total product orders fell 10%, with Mexico suffering a 49% decline on its own.

On the service provider business, Cisco CEO Chuck Robbins laid out the issue:

Our entire SP business around the world is driven by very large customers. And so when some number of them have an off quarter, it can affect the business. And I think the Americas would be probably an example of that this quarter as well. And the Mexico business that I discussed is heavily influenced by service providers.

In emerging markets, Robbins emphasized that competition wasn't the main driver of the company's problems:

We've had competition from several vendors. And clearly, Huawei is a very strong competitor. I don't feel like it has increased significantly in the emerging countries. It's been pretty consistent there, and our teams know how to compete, and we continue to evolve our strategy and bring different tools to help them compete. So I don't -- I wouldn't say that had much to do with it.

Certain markets suffered from specific issues. Cisco felt some pressure in the Middle East due to the uncertainty around oil prices, and currency was a major problem in the U.K. In Mexico, the Trump administration's tough talk on trade likely fueled uncertainty.

Robbins attributed about 1 percentage point of the revenue decline expected during the fourth quarter to the U.S. federal business: "It's a pretty significant stall right now with the lack of budget visibility." Robbins pointed to an elevated level of uncertainty around the budgets of government agencies, not surprising given that the budget proposal released by the Trump administration called for drastic spending cuts.

Another 1.5 to 2 percentage points of the revenue decline was attributed to Cisco's ongoing subscription software and recurring revenue push. Deferred revenue related to those businesses soared 57% year over year, with that revenue set to be recognized over time instead of up front. Recurring revenue accounted for 31% of Cisco's total revenue during the third quarter, and this will likely remain a headwind going forward.

Robbins commented on the progress of the transition to recurring revenue:

We set out 18 months ago to transition the business to one of more software and subscription. At the time, 8 quarters ago, it was $2 billion on our balance sheet. Today, we've more than doubled that, up 57% this quarter to $4.4 billion and accelerating. So I believe that is working, and we'll continue to shift more and more of our offers into that space.

No reason to panic

As a Cisco investor, I'm certainly disappointed in the company's guidance. But anywhere from one-third to one-half of the revenue decline is expected to be driven by the recurring revenue push, with the rest of the decline due to issues that appear temporary. These problems may persist for multiple quarters, particularly the weak performance of the U.S. Federal Government business, but they won't last forever.

Cisco's business is negatively affected by uncertainty, and there's quite a bit of that to go around these days. The drive to increase software subscriptions and other recurring revenue should help smooth things out in the future, but it's acting as a headwind in the present. The pain may last for a while, but there's little to suggest that investors should be worried about the long-term picture.

Timothy Green owns shares of Cisco Systems. The Motley Fool recommends Cisco Systems. The Motley Fool has a disclosure policy.

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