The tough year for computer and networking stocks such as Cisco Systems (CSCO) - Get Cisco Systems, Inc. Report, Hewlett Packard Enterprise (HPE) - Get Hewlett Packard Enterprise Co. (HPE) Report, and Pure Storage (PSTG) - Get Pure Storage, Inc. Class A Report won’t be quickly remedied in 2019 by anything the companies can do. The fact is, they are up against a broad change in the structure of their markets that is simply unstoppable.
Cloud computing operators Amazon (AMZN) - Get Amazon.com, Inc. Report, Microsoft (MSFT) - Get Microsoft Corporation (MSFT) Report, and Alphabet’s (GOOGL) - Get Alphabet Inc. Class A Report Google several years ago became among the biggest buyers of computer equipment in the world. And that’s a problem for Cisco and the rest.
Shares of HPE are actually one of the less-bad performers this year: at least they’re up 22.5%, though that significantly trails the 32% return of the Nasdaq this year. VMware (VMW) - Get VMware, Inc. Class A Report, a software vendor, is also one of the brighter lights, up 11.7%.
More muted, single-digit percentage gains can be seen at Cisco and at Dell Technologies (DELL) - Get Dell Technologies Inc Class C Report, and at storage networking vendor NetApp (NTAP) - Get NetApp, Inc. (NTAP) Report. Several, including Pure Storage, are basically flat for the year. But some newer companies, such as Nutanix (NTNX) - Get Nutanix, Inc. Class A Report, which is transitioning from being a hardware vendor to a software company, have had a harder time of it. Nutanix is down 20% this year.
What’s happening to all these companies is a crisis that has been a long time in the making. Their traditional sales to corporations of computers and software as the bedrock of IT systems is being replaced by the cloud.
As more and more companies run their operations inside of the cloud facilities of Amazon and its competitors, the cloud operators have become oligopsonists, meaning a handful of buyers who dominate purchasing (versus oligopolists, in which a handful of sellers dominate.)
Purchases by Amazon, Microsoft and Google replace some of the purchases that used to be made by smaller, individual companies. The shift to cloud is not entirely a zero-sum game: companies will still buy computing equipment, and there is a phenomenon called “hybrid cloud,” in which a company’s IT is split between its own data centers and what it runs in the cloud. That can help to balance things.
But the over-arching trend is for cloud to replace IT buying by companies, and it is playing havoc with the results of the vendors. The concentration of buying by cloud oligopsonists leads to pressure on prices, wild swings in order patterns and ultimately, some contraction in overall orders as cloud vendors either use machines more efficiently or displace some commercial systems with their own home-built computing equipment.
The impact can be seen in the results of Hewlett-Packard Enterprise, which reported fiscal Q4 results last month. Hewlett’s sales growth has collapsed from an increase of 4% in the fourth quarter of last year to a drop of 9% in the most recent quarter. Hewlett says it is adjusting its product portfolio to exit less valuable equipment sales and focus on higher-growth product lines -- what CEO Antonio Neri refers to as becoming a “a more streamlined and focused company.”
But despite growth of 21% in certain newer segments (what Hewlett calls “Composable Cloud” products) and even after backing out the sales of low-end server equipment, sales on an adjusted basis still fell 7% in the quarter.
The best that can be said is that Hewlett is treading water, keeping its head up and not drowning. And remember, Hewlett is actually one of the less-bad examples.
For almost all these companies, the revenue forecasts of analysts have been declining for the past year. Growth for the older companies such as Cisco, HPE, NetApp and Dell is in the low- to mid-single-digit percentage range. There’s simply no growth to speak of. While younger companies such as Pure and Nutanix have double-digit revenue growth to look forward to, estimates have been coming down for them, too.
If one wanted to pick a name that could show upside, it might be VMware, which has projected sales growth of 11.8% for fiscal 2021, is solidly profitable and whose estimates have been on the rise. But Dell is VMware's majority owner, holding 80.5% of the stock. Although VMware is not cheap, per se — it trades for 21 times projected earnings of $7 a share in 2021 — it probably would trade for a bit more if it weren’t getting the customary discount that happens with stocks that are majority-owned by a larger public company.
While VMware may be a special case, the trends at Hewlett and the rest show that what is happening is in the case of the older companies, a vast breakdown in sales, and for younger companies such as Pure and Nutanix, persistent uncertainty in forecast sales. This uncertainty is the effect of the cloud operators’ oligopsony on equipment purchases. It is a years’ long trend, perhaps a decades-long trend.
As such, it is an existential crisis for these equipment vendors. No one knows how they will puzzle their way out of it, and that means the shares will be trouble for investors for the foreseeable future.