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Cisco’s latest quarterly earnings report alarmed investors, erasing billions of dollars in the valuations of many companies in related markets. Revenues for the quarter ended in October 2013 were slightly below expectations, but it is the significantly lower guidance for the next quarter and potentially the entire next year, that are worrisome.

Cisco attributed the lower guidance to a combination of several cyclical factors, which resulted in a perfect storm:

The last factor has not been confirmed in reports from other vendors yet, but it may be the most critical one for the long-term business outlook. The damaged credibility of the U.S. government and U.S. businesses is particularly embarrassing in the context of recent restrictions on sales of Huawei and ZTE networking products, imposed by the U.S. government and related to security concerns. In the near term, both Huawei and ZTE are likely to benefit from the shaken credibility of U.S. -based suppliers abroad. However, the long-term consequences could be result in a negative effect for all businesses. If national trade barriers on networking equipment are imposed around the world, this would limit business opportunities for the leading suppliers, creating a much more fragmented market.

National security concerns related to purchases of foreign networking equipment were raised in the past by several countries, including: Australia, Brazil, India, and Russia. However, none of these countries have domestic suppliers of comparable networking systems, at least not yet. The latest development may increase investments from such governments to nurture their local producers of communication equipment.

A potentially more fragmented landscape in the networking equipment market may not be bad news for manufacturers of communication components and modules. Dealing with just a few large and powerful customers is a huge burden for these suppliers, severely limiting the opportunity for profitability. Having more customers to negotiate with would be a welcome change, but the overall impact of potentially retreating globalization is a very high price to pay for a more favorable market landscape for just a few suppliers.

Many suppliers of optical components and modules are already benefiting from having a new set of customers, such as Google, Facebook and other operators of mega data centers who choose to buy directly from them. These companies tend to use “white box” servers, networking equipment and open source software bypassing the large datacom equipment manufacturers. None of this was mentioned on Cisco’s earnings call, but it is a major industry shift and the rapidly growing popularity of new approaches to data center design such as Software Defined Networking (SDN) is another confirmation of this change.

While SDN open hardware sales are still embryonic, these sales potentially threaten to commoditize hardware and hence could greatly impact Cisco’s revenue and high margins over the long term.  Simply embracing SDN would accelerate the impact and with 78% of its revenue in hardware, Cisco is not in position to make it up in software and services like IBM, who earns just 14% of its revenue from hardware.

Responding to these changes, Cisco recently announced their new Nexus 9000 line of switches along with their Application Centric Infrastructure:   These new offerings are based on policy-driven services and automation in the data center.  In this manner, Cisco appears to be embracing the promise of SDN while offering a proprietary ecosystem with added value.  

Meanwhile, the build out of cloud data centers and Big Data clusters continues to grow as an independent phenomenon, not nearly as dependent on service provider investment.  And as we noted in a recent newsletter, 10GigE has been on a roll replacing Gigabit Ethernet whether in rack to rack or across campus applications. 

So despite the volatile sales results of datacom equipment vendors, the datacom transceiver market held steady from early 2012 then posted a significant jump in Q2 2013 and it is likely to hold steady for the rest of this year. With the increasing importance of 40GigE and then 100GigE, datacom transceiver vendors have reason for optimism in 2014 as well, even if Cisco’ guidance is not encouraging.

We will have to wait and see if other major U.S.-based companies attribute declining international business to a rise in anti-American sentiment around the globe. It is very unlikely that the wave of economic globalization, which swept across the world over the last two decades, will be completely turned back, but newly erected national economic barriers could moderate the rate of economic growth. As long as these barriers help emerging economies to develop in a more balanced way, slower growth is not such a bad thing.

In summary, the answer to the question in the title is: Yes, the global economic climate is changing. These changes are often too slow to notice, but companies have to pay attention to them. Cisco has adopted a strategy for embracing change years ago and the company has an excellent record in navigating the turbulent waters of the global marketplace. Cisco has often been one of the first companies to see and acknowledge the changes. Their latest guidance may be yet another example of this strategy.

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