Cisco Systems Inc.‘s fiscal second-quarter earnings report today was certainly a mix of good and bad.

The networking giant put up a solid quarter, with earnings per share of 87 cents, slightly ahead of its guide, and revenue of $12.8 billion, which was at the high end of its estimate from last quarter. Although these numbers were strong relative to the expectations set a quarter ago, it’s important to remember that Cisco issued a cautionary outlook, given a high degree of uncertainty from its customers.

Looking ahead to the third quarter, it appears the level of customer uncertainty has increased as Cisco applied a greater deal of conservatism to its numbers. The company guided to revenue of $12.1 billion to $12.3 billion, well behind the consensus estimate of $13.1 billion. The company predicts earnings of 84 to 86 cents, whereas the Street expected 92 cents.

To help manage costs, Cisco announced laying off about 5% of its workforce. Coming into the quarter, industry chatter was that Cisco might lay off as much as 15%, so the 5% was significantly smaller than I expected. This will create a pretax charge of approximately $800 million, enabling Cisco to rightsize its costs with the business.

On the earnings call, Cisco management explained (as they did last quarter) that customers had purchased products but not yet implemented them, creating the “air pocket” the company is experiencing. During the call, Chief Executive Chuck Robbins made this comment: “As we discussed last quarter and subsequently saw in other technology provider results, customers have been taking time since the start of our fiscal 2024 to deploy the elevated levels of products shipped to them in recent quarters, and this is taking longer than our initial expectations.”

This is consistent with the feedback I’ve heard from customers and channel partners. During the pandemic, the supply chain was very constrained, and it caused this effect where customers bought as much as they could when products became available. It’s like when you go to the grocery store hungry, you buy more food than you need, then you have a surplus of it at home, and then you buy much less in subsequent visits.

If one believes the commentary from Robbins, and again, it’s consistent with customer feedback I’ve heard, it’s just a matter of time before businesses spend with Cisco again. Is it one to two quarters, as the company predicts? I’m not sure of that, but Cisco has been using Meraki activations as a proxy for the broader company, and that business unit is tracking to the time frame the company guided to.

Regarding product categories, networking is the business unit that’s taken the biggest hit. Networking has been and continues to be Cisco’s largest product category, accounting for 55% of the company’s revenue. It came in at a shade over $7 billion, which was a 12% year-over-year decline. The company cited slowness in the enterprise, service provider, and cloud. This leads me to believe Cisco’s commercial business (SMB) stood strong with respect to networking, which makes sense as those smaller companies can digest technology much faster as their environments are simpler.

Regarding other products, security was up 3% YoY, with Cisco calling out zero trust as a key growth driver. Over the past year, Cisco has completely retooled security, and now it’s starting to bear some fruit. The RSA Conference is right around the corner, and I’m expecting to see more security innovation from Cisco. If it gets security right, this can move the needle for Cisco more than any other product category, given the highly fragmented nature of the business.

Collaboration was also up 3%, with Cisco highlighting devices and calling. This is another area Cisco has heavily invested in. At last year’s WebexOne event, the company rolled out its revamped cloud contact center solution, and it has had its foot on the gas getting customer trials going.

Also, Cisco has a “seeding” program to get more devices in customers’ hands, particularly Microsoft customers, as Cisco devices can run Teams natively. Last year, the program slowed down as device availability was limited, but channel partners have told me the program is now flourishing, so look for more device growth in future quarters.

Both security and collaboration have had generative AI-based agents introduced in the past six months. This should act as a driver for continued sales as the products get easier to use. One challenge for Cisco is trying to differentiate its AI from competitors.

For example, while every UC vendor has background noise removal, only Cisco can remove everything but voices or the active speaker’s voice. I’ve tried many products in Starbucks, airports, and other noisy places, and Cisco has an edge. However, many customers seem unaware of the differences.

Observability revenue rose 16%, driven by growth in ThousandEyes. In my Cisco Live EMEA post, I discussed how Cisco has been integrating ThousandEyes into more Cisco products. For those unfamiliar with ThousandEyes, it is the industry’s best Internet monitoring tool, and by integrating it into other Cisco products, Cisco is giving its customers better visibility across the “stack” than its competitors. With digital experience management becoming critical for hybrid work, Observability should be a key growth driver and eventually pull through other Cisco products.

Looking ahead, on the call, the company reiterated its recent partnership with Nvidia Corp. Robbins mentioned, “We continue to capitalize on the multibillion-dollar AI infrastructure opportunity. This quarter, we announced the next phase in our partnership with Nvidia to offer enterprises simplified, cloud-based, and on-prem AI infrastructure.” He added, “We are clear beneficiaries of AI adoption.” Cisco then quantified the opportunity when it stated that “The majority of that $1 billion in orders (mentioned previously) will turn into revenue in our FY25.”

Cisco also gave an update on Splunk Inc. The company stated, based on the positive progress to date made on regulatory approvals, that Cisco expects the deal to close in the first or early second quarter of calendar 2024. I believe the initial timeline was October of 2024, meaning Cisco is well ahead of the plan.

It will be interesting to see how investors view Cisco post-Splunk as the deal adds $4 billion in additional annual recurring revenue to Cisco. Right now, Cisco is viewed as a hardware company. Its EV/LTM multiple is just under three times, which is consistent with hardware vendors. Splunk, a software company is trading in the eights, which is the low end of software companies.

Given Cisco has transitioned much of its business to software and Splunk adds a much bigger chunk, one would think valuation would go up. However, it must get through this air pocket first. More to come, I’m sure.

Zeus Kerravala is a principal analyst at ZK Research, a division of Kerravala Consulting. He wrote this article for SiliconANGLE.

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