I don’t often write publicly about the quarterly earnings of a technology vendor, because most IT buyers have only passing interest on whether a supplier has missed or beat its quarter. Obviously, if one is sliding quickly, indicating something is wrong or growing quickly, that’s a different story, because it’s a sign of a change in the business.
One of the vendors whose quarterly numbers I have been eagerly anticipating is Cisco Systems, because it’s one of the bellwethers of the tech industry. When things are good with Cisco, the market is generally solid. When things are weak with Cisco, the same can be said for the entire industry. In fact, there have been several times Cisco has put up quarters counter to the market, surprising people, only to be an indicator of what’s to come.
Cisco’s quarter showed surprising strength
On May 13 the San Jose, Calif.-based company announced its Q3 FY2020, which was its first full quarter mired in the uncertainty of COVID-19. As a global company, it's been tracking the impact of COVID-10 since it started, but the current environment is nothing short of chaotic for both its demand and supply chain. On top of that, Cisco has been giving away services such as Webex and Duo to help businesses communicate. On one of the TV news channels, CEO Chuck Robbins was asked how long Cisco could afford to give away services for free while incurring the cost, and he said something to the effect that the company has the resources to do it and would continue to support people and businesses in need for an indefinite period of time.
Also, despite the macro-uncertainty, Cisco is continuing to pay all its employees, including contractors, rather than furloughing them or moving to four-day work weeks or other drastic actions. Robbins said that as long as the world is in this pandemic situation, companies that can afford it should bear the financial burden--not individuals, small businesses, landlords and the like. He said that made no sense and called out his other large cash-rich company peers to take the same action.
This is all against an uncertain backdrop of IT purchases slowing, free services made available and a supply chain that has seen massive disruption. That would indicate a disastrous quarterly announcement and guidance, correct? Not so fast. I think this quarter should be Robbins’ strength, showing himself as an empathetic human but also as a leader, because the company fared better than expected--particularly when it came to margins. This is also a good indicator of the transition Cisco has gone through to become a leading software-and-services provider that also sells hardware--versus a hardware company that also happens to sell software and services.
Strong margins offset expected revenue declines
By all means, the quarter wasn’t perfect. Revenue declined 7.5% year over year, and it guided its Q4 to a double-digit YoY decline. Also, no one knows when things will return to normal--if there is a post COVID-19 normal--so there may be more shoes to drop in the future. The products that showed the most strength this quarter were security, particularly AnyConnect VPN and cloud-based Umbrella and Duo.
Also, Webex has continued its torrid run of growth from so many people working from home. Webex doesn’t get as many headlines as some of its peers, but it’s used in many large companies where security is paramount. Cisco has beat the security drum with Webex for years, only to have it fall on deaf ears; now people care. Other products that showed strength were its new Catalyst switches, Meraki and AppDynamics, the cloud-based management tool.
Unsurprisingly, weakness was felt in data center products such as HyperFlex. With so many people working from home, much of the IT spend has shifted away from data centers to remote access and collaboration.
Services continues to be a bigger part of Cisco’s business
Most impressive in the quarterly report were profit margins, signaling that the transformed Cisco Robbins has talked about quarter after quarter has indeed arrived. One of the most notable takeaways from the report is the growth of the services business. Cisco products, other than security, declined, whereas services saw 5% growth and a 160-basis points improvement in gross margins to a whopping 68.9%. In addition, despite a revenue decline, product margin improved to 210 basis-points to 65.8%. I remember a number of years ago, product margin dipped below 60% for the first time in history, and investors thought the business was crashing and burning. Since then it’s slowly recovered, and I expect to see continued upside in terms of gross margins.
Success with services is critical to Cisco and its customers. Despite all the innovation in technology, the IT environment has become more complex, particularly when it comes to the network. Cisco’s Intent-Based Networking solution has made running the network easier, but now IT pros need to think about connecting to the cloud, supporting mobile workers, handling gigabits of video traffic and other trends.
Cisco has rolled out a number of lifecycle (or CX in its vernacular) services that address many of these complexities. Every dollar Cisco customers invest in Cisco services, delivered by Cisco or its partners, typically results in a savings of several dollars as projects get up and running faster and with less risk. Cisco services used to be only maintenance and break fixes but now are predominantly high-value professional services.
The network has not been and will never be a commodity
The product margins have continued to see upside because Cisco has bucked the commoditization trend. Industry watchers have been pounding the table saying “The network is now a commodity” and predicting margins would slide. I fundamentally believe nothing in this world is really a commodity. The question is, can the vendor add enough value to make customers pay more? Cisco products are loaded with advanced features that enable the end-to-end Cisco network to do more than one built off point products. The network has never been more important, so why would any company buy networking products that are merely “good enough”?
Subscription revenue on the rise
Another interesting shift in the business is the move to subscription revenue. Last year at this time, 65% of software revenue was subscription-based, with perpetual buying accounting for the other 35%. Q3 FY20 saw the subscription number jump to 74% and perpetual account for only 26%. This is important to Cisco and its customers. For Cisco, if a customer signs a three-year software agreement, it takes a revenue hit, because it doesn’t get all the money up front--but it does help with product refresh and keeping customers current.
Consider when one buys a mobile phone: Paying a nominal amount for the hardware and then a monthly fee makes it easier to upgrade when the new phone comes out. Same principal; network spending used to be very lumpy. Spend a bunch of money year 0, then a small amount years 1, 2 and 3. Then go back to the well and spend a bunch of money.
Now the spend has been flattened. Also, the software subscriptions ensure customers always have access to the latest and greatest features. Instead of pondering: “Do I spend the money for the new features or wait?” customers have access to all the new capabilities as they come out. This is particularly important today because many of the new capabilities help protect the organization.
COVID-19 marches forward, as does the uncertainty that goes along with it. Cisco’s strength in the quarter shows the world isn’t collapsing, and that’s good news for everyone. We need to work differently, and it's technology that allows us to do that. As long as Cisco and its peers keep the innovation engine going, most of the world can continue to function.
Zeus Kerravala is an eWEEK regular contributor and the founder and principal analyst with ZK Research. He spent 10 years at Yankee Group and prior to that held a number of corporate IT positions.