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Cisco dollars pinched by cheap switches, vanishing cameras

Layoffs, product cuts

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Cisco Systems' third-quarter numbers for its current fiscal year reveal a company that has run its switching business aground and has become too dependent on the public sector for its revenues.

When discussing the results, the company's top brass said that Cisco would be lightening its load – in terms of products and people – to get off the rocks and back out to open commercial waters.

The numbers weren't vomitous, but they were far from delectable: overall product sales rose only 2.8 per cent, to $8.67bn, while services revenues increased 13.7 per cent, to $2.2bn. Overall sales were $10.9bn, up 5 per cent.

Cisco's product costs were more or less in line with last year, but sales and marketing costs were up, the company had $31m in restructuring charges relating to the closure of its Flip camera business and another $103m in amortization of acquired assets, plus higher taxes of $396m. Taken together, these pulled net income down by 17.2 per cent, to $1.81bn.

That's a bad quarter for Cisco – its fourth bad quarter in a row, in fact – and the company did a corporate reorganization last week to focus its engineering and sales efforts and simplify its command structure.

And now come the layoffs and product rationalizations and cancelations.

In a conference call with Wall Street analysts going over the numbers, Gary Moore – who was anointed chief operating officer at Cisco just this February – said that the company would eliminate $1bn in costs out of its annual run rate from a baseline that will be set in the fourth quarter of Cisco's fiscal 2011 year, which ends July 31.

Neither Moore nor Cisco chairman and CEO John Chambers would elaborate about how many people might be let go at Cisco or what products would be eliminated, but Moore said in the call that a comprehensive portfolio review was underway, and Chambers said that in any market segment where Cisco cannot eventually be number 1 or 2 it will make cuts.

"We want to do this surgically, as opposed to with a blunt instrument," explained Chambers, which is why Cisco did not talk about how many layoffs are planned or what products might get tossed into the woodchipper. Chambers did say that it would take about three months to do the review and come up with the plan, and that Cisco would elaborate during its Q4 financial call. The company will present an even more-detailed plan at its financial analysts meeting in September.

Cisco began offering early retirement to employees in the United States and Canada during the quarter, and the company expects to book charges of between $500m to $1.1bn in its fiscal Q4 relating to severance packages, depending on how many employees take Cisco up on its offer. The number of layoffs will also depend how many people leave voluntarily.

"We know what we have to do," said Chambers. "We have had to make big changes before," he added, alluding to a reorganization of the company in the wake of the dot-com bubble bursting in 2001, as well as earlier transitions, "and each time, we have emerged stronger."

Cisco's switching business would seem to be its biggest problem – not only because Cisco has tough rivals, but also because the company alienated its server partners when it entered the server racket two years ago.

In Q3, switch sales fell by 9 per cent to $3.3bn, with fixed-switch sales actually up 8 per cent but modular (and expensive) switches taking a big hit, falling 10 per cent. Chambers said that one of the problems was that the Nexus line of top-of-rack and end-of-row switches offered so many more ports and so much more performance than their predecessors that companies can downshift to cheaper boxes and still improve performance.

What's more, margins for the Nexus 7000, the biggest switch in the new lineup, are lower than for the Catalyst 6000 switches they replace, so Cisco's margins are under pressure. Chambers said that to make the same numbers, Cisco needs to sell two or three times as many Nexus switches as their equivalent Catalyst boxes.

Cisco's router business – where the company got its start, in fact – remains strong, and sales were up 7 per cent to $1.86bn for these products during fiscal Q3.

The New Products group at Cisco, which includes collaboration products as well as the Unified Computing System blade and rack servers, among other things, had $3.26bn in revenues, up 15 per cent. Chambers said in the call that the collaboration products were now at $4bn annualized run rate and grew at 39 per cent in the quarter.

The Data Center products in this group, which is mostly UCS systems and related software and services, are now at a $1.5bn annual run rate and were up 31 per cent in fiscal Q3. Orders for UCS systems rose by 61 per cent in the quarter, to $1.8bn, and Chambers said that Cisco could not fulfill all of its orders. It looks like Cisco has demand forecasting and manufacturing issues with its server lineup, but that's not surprising for an entirely new business unit.

The UCS hardware products alone have a run rate of $900m, Chambers said. During the quarter, Cisco added 1,570 new customers, and the base is now over 5,400 customers. If Cisco is going to cut back any business where it cannot be the number 1 or 2 player, will the UCS business survive the impending cuts?

Looking ahead, Cisco said that it expects continued weakness in its fiscal fourth quarter, with sales flat to up 2 per cent when compared to the prior year's Q4. Non-GAAP earnings per share are expected to be in the range of 37 to 39 cents, but the shuttering of its Flip camera business will knock off a penny and early retirement will shave off another 6 to 12 cents.

When you take into account stock compensation and other writedowns, Q4 GAAP earnings per share will be in the range of 14 to 25 cents. Cisco did 33 cents per share this time around, and you can expect Wall Street to not be happy about Q4. And investors and Cisco employees alike probably won't be happy until they know exactly what Cisco plans to do in terms of products and layoffs – and customers will probably be a little edgy, too.

All of this will only make it easier for Cisco's networking rivals, of course.

But, only a fool would think that Cisco cannot figure its way out of this, and with $6.6bn in cash and $36.7bn in marketable securities, Cisco has the resources to take its time, think this through, and do it right.

There's no putting the UCS genie back into the bottle, and perhaps the best answer, therefore, is to merge with Dell, become the number two server maker in the world, and get into some real serious trouble. ®

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