What Happened to Cisco's Data Center Growth?

By Timothy GreenMarketsFool.com

Over the past few years, networking hardware giant Cisco Systems (NASDAQ: CSCO) has managed to become a major player in the global server market. Its data center segment, which includes its line of UCS servers as well as related software, was -- until recently -- growing at a double-digit rate. By the first quarter of 2016, Cisco had become the fourth-largest server vendor in the world, tied with Lenovo and behind IBM, Dell, and HP Enterprise, according to IDC.

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This once fast-growing business for Cisco has since slowed down. Double-digit growth quickly transformed into no growth at all, with the segment even suffering year-over-year declines in recent quarters.

Data source: Cisco quarterly earnings reports, presentations, and SEC filings. Graph by author.

What's behind the sudden slowdown? Here's what management has said on the issue.

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A downturn in spending

After producing 24% year-over-year revenue growth during the fiscal first quarter of 2016, a major slowdown occurred during the second quarter. The data center segment contracted by 3% year over year, bringing in just over $800 million of revenue. This marked a sudden end to a long streak of double-digit revenue increases.

During Cisco's second-quarter conference call, CFO Kelly Kramer blamed a slowdown in enterprise spending, but pointed to the company's line of servers as a key piece of its strategy:

CEO Chuck Robbins explained that macroeconomic uncertainty can cause the company's customers to delay purchases.

In the same quarter, Cisco's switching business, by far the largest contributor of revenue, slumped 4%, while the wireless business was flat. Security grew at a double-digit pace; Robbins attributed that growth to clients continuing to spend in mission-critical areas while pulling back in others:

A shifting market

These issues continued to negatively affect Cisco's data center business during the third quarter, with Robbins pointing to continued uncertainty in the conference call. But he also explained that shifting enterprise workloads were contributing to stagnating data center revenue:

HyperFlex is Cisco's entry into the hyperconverged infrastructure market, which Gartner expects to generate $2 billion of revenue this year and $5 billion in 2019. A hyperconverged integrated system combines compute, storage, networking, and software, allowing each resource to be scaled independently. Cisco is actively moving its business toward software, and its next-generation data center products demonstrate that shift.

When asked by an analyst during the fourth-quarter conference call when the company expects its data center segment to return to growth, Robbins sounded optimistic:

According to Robbins, HyperFlex is off to a good start, with over 500 customers by the end of the fourth quarter, with a quarter of those customers new to the company's line of servers.

Two factors -- macroeconomic uncertainty and a rapidly changing market for servers -- are keeping Cisco's data center segment from growing. The good news for investors is that the company is investing in next-generation products like HyperFlex, looking to capture what could be a multibillion-dollar opportunity. There's still plenty of growth potential for Cisco in the long run, but it may be a while before the data center segment turns the corner and returns to growth.

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Timothy Green owns shares of Cisco Systems and IBM. The Motley Fool owns shares of and recommends Gartner. The Motley Fool recommends Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.