Some Cisco investors urge an exit from set-top box unit

Some Cisco investors urge an exit from set-top box unit

7:04am EST

By Sinead Carew

NEW YORK (Reuters) – Cisco Systems Inc Chief Executive John Chambers is facing growing pressure from investors to exit its television set-top box business, where revenue has been plummeting and profit margins trail the rest of the company. The problem is that there are few obvious buyers for the unit – the former Scientific Atlanta that Cisco bought for $6.9 billion in 2005 – so Chambers might have no choice but to close the business, analysts said.Cisco stunned the market on November 13 by warning that revenue would fall as much as 10 percent this quarter and keep declining for several quarters. It blamed everything from emerging economy weakness and political backlash in China to company-specific problems, such as market share losses in network equipment and declining sales in set-top boxes.

Investors are hoping Chambers gives a clear break-down of the individual impact of all these problems at Cisco’s Financial Analysts Conference on Thursday.

But for many, the ailing set-top box business has emerged as a particular sore spot. Raymond James analyst Simon Leopold said it could represent as much as a third of Cisco’s roughly $1 billion revenue miss for its current quarter.

The unit, which generates roughly 5 percent of total revenue, had a 20 percent decline in sales in Cisco’s first fiscal quarter ended in October. And Chambers has warned that the decline in this business would continue for “a number of quarters,” but did not say when it might improve.

With such a bleak outlook, it might be time for the company to move on from the “past its prime” set-top box business, said Peter Karazeris, an analyst at Thrivent Asset Management, which holds 4 million Cisco shares among its $82 billion in managed assets.

“I’d like to see more definitive action there,” said Karazeris, who sees a strategy change as a potential boost for the stock at a time when Cisco investors have little to look forward to. “I think this is diluting the attention.”

However, Karazeris said it is not clear how exactly Cisco should move on from the business, whether it could find a buyer or should just shut it down.

Since its November warning, Cisco shares have fallen more than 11 percent compared with a 2 percent increase in the Nasdaq composite index. The shares of smaller network equipment rival Juniper have risen almost 12 percent in the same period.

NASCENT STAGE

Cisco bought Scientific Atlanta to enter the business of set-top boxes, which are connected to TV sets to receive and unscramble digital signals, and can also support services such as video on demand.

But this past February, Cisco said it had started to forgo sales of less profitable set-top boxes and was instead seeking higher margin business from video service providers. At best, traditional set-top boxes offer roughly half the gross profit margins Cisco seeks to maintain company wide.

Cisco has said so far that it will keep offering set-top boxes to big customers who want a whole package of products and services, but it will focus primarily on supporting so-called cloud-based video services.

Cloud-based services, which can include mobile video access and digital video recording, rely on high-end equipment on the operator’s network rather than the set-top boxes inside consumer homes. But such services are nascent, so it is unclear when they will bear fruit.

In the meantime, Cisco has let sales dwindle at the set-top box business, which has $2.6 billion in annual revenue, as it instead favors products that can help achieve its target non-GAAP gross margins of 61 percent to 62 percent.

Since set-top boxes only generate profit margins in a range of 25 percent to 30 percent, according to Needham & Co analyst Richard Valera, there might be no way for Cisco to keep selling these products if it is to maintain its goals.

“The only way for them to fix it is to effectively walk away from that business,” said Valera, who sees no chance of an uptick in set-top box margins, which he says are “fundamentally incompatible with the business model they want.”

NOT A CORE BUSINESS

Valera said Cisco’s biggest rival Arris Group Inc would be unlikely to have the capacity to buy the business as it spent $2.35 billion buying Motorola’s set-top box business from Google Inc in April.

If Cisco’s unit were to command a valuation that was similar to the Motorola deal, it would fetch just $1.8 billion, well below the 2005 Scientific Atlanta purchase price.

Arris led the global market in 2012 followed closely by Cisco, then U.K.-based Pace Plc and Echostar Corp ahead of South Korea’s Samsung Electronics Co Ltd, according to data from market research firm IHS.

One person familiar with Cisco said set-top boxes are not a core business for the company, and noted that Cisco has shown a willingness to step away from businesses that did not fit in with its bigger strategy in the past. The person cited its 2011 shutdown of its Flip video camera business, acquired just two years earlier for $590 million.

Some investors still hope Cisco can turn around the set-top business, but they want answers sooner rather than later.

“They’ve been kicking the can down the road on that one,” said Scott Rodes, an analyst at investment firm Bahl & Gaynor Investment Counsel Inc.

He wants more details about Cisco’s prospects in cloud services and its intentions for the existing business. His firm holds about 4.79 million Cisco shares.

Peter Tuz, President at Chase Investment Counsel Corp, which has under 10,000 shares of Cisco in its $520 million assets under management, said “traditional set top boxes will be challenged going forward” as consumers switch to online video.

Tuz added that Cisco should put the unit, “on a fairly short leash, give it another year or so, then take action if it is determined it can’t grow or produce decent returns going forward.”