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YE GADS, JOHN CHAMBERS went and did it again.
Back in November 2007, the Cisco Systems CEO made some disturbing comments on the networking company's conference call following its earnings report for the fiscal first quarter, ended in October of that year. In particular, Chambers noted that Cisco had begun to see signs of weakness in its U.S. enterprise business, and especially with trouble in the financial and retail vertical markets. Until that point, the Nasdaq Composite had been having a decent year, with a gain of around 13%. While there were plenty of troubles in the financial sector, tech demand until that point had been growing nicely–and then comments from Chambers rocked the stock market.
What followed, of course, was calamity: The Nasdaq Composite over the subsequent 17 months lost more than half of its value, and the U.S. economy sank into the Great Recession. Millions of people lost their houses and/or their jobs, and retirement portfolios were shredded. You can't exactly blame Chambers for all that, but you can look back to that day as one which, in retrospect, would have been the perfect time to get out of the market.
Ergo, you shouldn't be surprised the Street was none too happy with what transpired last Wednesday afternoon when Cisco (ticker: CSCO) disclosed financial results for its fiscal fourth quarter ended July. The report was about in line with Wall Street expectations. Revenue totaled $10.84 billion, a hair below the Street consensus at $10.88 billion, but was up 27% from a year ago, and toward the high end of the company's forecast for growth in the 25% to 28% range. And non-GAAP profits were a penny ahead of expectations, at 43 cents a share. But the report was in various ways troubling. For one thing, estimates had been ratcheting higher headed into the call, so an in-line print wasn't going to cut it with already-jittery investors.
The Nasdaq Composite Index fell 5%, bogged down by Cisco's cautious revenue outlook and an analyst's downgrade of Intel.
More substantively, Cisco posted a modest decline in gross margins, due to higher costs related to component shortages, among other factors. To make matters worse, the company projected October quarter revenue will grow 18% to 20%, which implies $10.6 billion to $10.8 billion. That is slower growth than in the July quarter, suggesting a sequential drop in revenue, and falls short of the prior Street consensus of $10.95 billion. Meanwhile, the company noted it is continuing to bulk up staffing. Cisco over the last two quarters has boosted its payroll by a net 3,000 positions, and it announced last week that it will add another 3,000 over the next few weeks. While there is nothing inherently wrong with hiring to expand the business, adding costs at a time when the company is disappointing at the gross-margin line is not a move that wins friends on the Street.
BUT THE BIGGEST ISSUE with Cisco's report came in the form of cautionary comments from John Chambers himself on what he is hearing from the company's IT customers. Chambers says corporate IT buyers are being unusually conservative, and highly uncertain about the near-term prospects for the economy. Keep in mind that his comments came on a day when the Nasdaq took a 3% hit, a drop due at least in part to growing concerns about a slowdown in notebook-PC sales.
The upshot: the Street suffered ugly flashbacks to November 2007, and the 54% Nasdaq plunge that followed. Investors on Thusday sold off any tech stocks with even the remotest connection to Cisco and the corporate IT sector. Networking-hardware companies, like Juniper (JNPR) and NetApp (NTAP), fell hard. So did chip makers with big exposure to networking hardware, like Cavium Networks (CAVM), NetLogic Microsystems (NETL), Xilinx (XLNX) and Altera (ALTR). The Street dumped shares of contract electronics manufacturers with Cisco exposure, like Flextronics (FLEX), and sold off corporate IT-dependent vendors like EMC (EMC), Oracle (ORCL) and IBM (IBM).
Let me point out here that there have been some other sore spots in the tech sector over the last few weeks. One problem has been the PC supply chain. In short, there are growing signs of softening demand for notebook computers. In particular, the Taiwan-based notebook makers known as ODMs, or original design manufacturers–they build the hardware sold by branded PC companies like Dell and Hewlett-Packard—reported a big drop in sales in July from June, and there were reports of similar weakness among the Taiwan-based manufacturers of PC motherboards. A variety of analysts responded to the disappointing news from Taiwan by reducing estimates, target prices and stock ratings for Intel (INTC), Advanced Micro Devices (AMD) and other companies in the PC food chain. The development left investors wondering whether the great PC refresh cycle that has emerged this year suddenly has come flying off the tracks.
So, what to do? Well, for Cisco, the good news is that the valuation isn't especially demanding at this point; the company's cash position of about $40 billion is about a third of the stock's $120 billion market cap. Back that out, and the stock is trading for around eight times expected July 2011 profits. But I can't see the stock gaining much ground until there's some sign that corporate IT buyers are still shopping. As for the PC stocks, a group I have been consistently recommending all year (to little avail, admittedly), I see no reason to panic. Both Intel and Microsoft (MSFT) still look cheap, although here, again, the stocks aren't likely to take flight without some better data points on PC demand.
Finally, let me note one surprising anomaly in last week's otherwise ugly data. Avnet (AVT), one of the world's largest electronics distributors, posted absolutely blowout results for its fiscal fourth quarter, ended June, and provided much-better-than-expected guidance for the September quarter. CEO Roy Valleenoted the company had 30%-plus year-over-year growth in sales of servers, storage and networking products. Vallee, always a straight shooter, thinks corporations have been underinvesting in IT hardware since the Internet bubble burst a decade ago—and he contends the hardware refresh cycle could have another six to 10 quarters to go.
In an interview, he offered two explanations for why Avnet's results are so bullish at a time when the Street is so worried about the fragility of the recovery. One possibility is that the Street is extrapolating from a small data set and reaching inaccurate conclusions. Or, Vallee says, Avnet could be so far down the food chain that it simply hasn't been hit yet by a slowdown that started in the end markets, and is still rippling through the system. I'm hoping for the former explanation…but I fear the latter.
You can reach Eric Savitz at eric.savitz@barrons.com, b
logs.barrons.com/techtraderdaily or www.twitter.com/savitz
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