Cisco Woes Spook IT Sector

Despite announcing “another record quarter,” Cisco Systems endured a dramatic drop in its stock price Thursday as investors reacted to news of declining sales to U.S. enterprise companies in what CEO John Chambers called “challenging economic times.”

Cisco shares plunged $3.12 a share, or 10 percent, to close at $29.55 in Thursday trading.

Although Cisco delivered better-than-expected sales and earnings in its first quarter and maintained its guidance for the rest of the fiscal year, Chambers’ cautionary comments could portend some rough times ahead for the networking industry and for technology companies as a whole.

While the company, like most in the technology industry, has diversified and expanded its business interests across the globe, the 3-percent drop in its U.S. private sector sales—which represents about 13 percent of Cisco’s total business—is a bit disconcerting.

This news, in the eyes of some analysts, suggests that even the most global technology companies aren’t necessarily recession-proof.

“For the bears to take full control, I think they must take down the tech leaders,” said Charles Kirk, of the Kirk Report. “Most of the market is hiding there and the bulls aren’t going to give up unless you bomb and completely destroy their safety shelter.”

In a conference late Wednesday, Chambers said the company’s growth in the last quarter was tempered by what he called a “dramatic” decline in sales to portions of its enterprise market in the U.S. Cisco reported $9.6 billion in sales for the first quarter of its 2008 fiscal year, an almost 17-percent increase over the same period last year, which Chambers said was “comfortably above our guidance.”

However, growth in the U.S. enterprise market slowed to single digits, with almost all of that growth centered in the federal government market, with 16 percent growth year over year. “The remainder of the U.S. enterprise market was lower,” said Chambers. “We expected the U.S. enterprise business to be lumpy, and continue to be lumpy.”

In response to a question from Goldman Sachs analyst Brent Thompson, Chambers said that while the overall global enterprise business was “very solid,” the market in the U.S. “excluding the public sector…did see some softness.” He called the drop-off in orders from financial services companies “pretty dramatic,” and characterized sales to the automotive sector in similar terms. “Retail was, candidly, mixed in results,” he added.

However, Chambers set guidance for Cisco’s growth in the next quarter at 16 percent, the high end of its guidance for the year—the same guidance that the company had given for its first quarter. Investors, used to seeing Cisco raise its forecasts quarter after quarter, reacted by selling off the stock in Thursday trading.

Mark Sue of RBC Capital Markets felt that a pullback in Cisco’s stock was in order because much of uptick in its stock price was based on expectations of higher guidance.

“Typically, North American enterprise (ex Fed.) is about 13 percent of sales and the delta in spending observed from our checks may amount to approximately $100 million per quarter spread between retail, financial services and manufacturing,” he wrote in a research note Wednesday. “It’s not a huge amount, considering Cisco’s revenue base but still something to ‘monitor’ going forward.”

“The first fiscal quarter was a record quarter for Cisco in terms of cash and operations,” said Jordan Zounis, an analyst with Morningstar. “So it’s kind of hard to argue that any material weakness in terms of their overall business is inherent in their numbers.”

However, Zounis said that the weakness in the financial sector was viewed by some as evidence that the fallout from the subprime lending crisis was spreading to other sectors.

“When a bellwether like Cisco makes a comment like this, however, it gives some people the fear that it’s now starting to bleed into other sectors like technology,” he said.

But the financial services market only makes up about 8 percent of Cisco’s enterprise sales—a small portion of an overall global segment that makes up more than 41 percent of Cisco’s total business, according to Zounis.

Cisco’s diversification has prevented the company’s declining sales in one sector from throwing it off the rails as a whole, something that cannot be said for other companies in the networking industry, particularly those catering to telecommunications service providers.

Tellabs, which sells networking equipment to the telecom industry, posted an 84-percent decline in net income and a 12-percent drop in sales in its latest quarter.

With sales to mobile phone network companies softening, the company announced today that its CEO, Krish Prabhu, will resign by March, and that the company will buy back $600 million in stock.

Other networking companies that have focused on the service provider industry, such as Alcatel-Lucent, have also seen declining sales for the same reason, Zounis said. “All of them in the past three months or so have highlighted the fact that their businesses have weakened considerably year over year, particularly due to the lack of spending by service providers around the world,” he said.

Ironically, Cisco’s growth in the U.S. has been focused around the service provider market. The company saw 13 percent overall growth in the U.S. in orders, according to Chambers, led by “sales to service providers, [with a percentage of growth] in the low 20s.”

“I think that’s a testament to how strong Cisco’s business model is. They can take the impact of any one business line and continue to grow,” Zounis said. “A company like Tellabs can’t do that because 90 percent of their business is in one market.”

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