Cisco’s Key Risks
Volatility in IT spending trends can impact demand for Cisco’s products and services any given quarter and cause the company to miss near-term earnings estimates. However, this risk doesn’t have any bearing on Cisco’s long-term earnings potential.
The bigger concerns in most technology markets are changing trends that make a company’s products irrelevant and increased competition that commoditizes previously profitable technologies.
There’s a reason why Warren Buffett tends to shy away from technology companies – change can happen fast. For this reason, technology is not one of the best stock sectors for dividend income.
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In the company’s shareholder letter, Cisco’s CEO notes that much of the company’s “success has come from [its] ability to lead market transitions.”
Technology shifts constantly threaten Cisco and require the company to continuously innovate to remain dominant in its markets.
Perhaps the most discussed technological risk facing Cisco is the rise of software defined networking (SDN). Essentially, SDN is part of the market’s transition to more programmable, flexible, and virtual networks.
SDN essentially moves some networking functions away from hardware to software, potentially reducing demand for networking equipment (or at least reshaping it) and enabling the substitution of lower-priced, unbranded gear. Unbranded systems can also provide opportunity for customers to customize their systems based on their unique computing needs.
Cisco has historically been strongest in branded networking hardware, which is why SDN gets so much attention.
Cisco is responding to this risk by building and acquiring new software and services and is actually a leading player in SDN today with its own solution.
The shift to more software and services is also improving the company’s mix of recurring revenues, which adds stability to Cisco’s business model.
It’s also important to realize that most companies implementing SDN still require a lot of networking hardware.
While Facebook Inc (NASDAQ:FB) introduced its own networking-equipment system a year ago for use in its data centers, non-branded, ”white box” equipment seems unlikely to ever dominate the market.
The following comments are from Cisco in a Barron’s article and highlight the downsides of using non-branded equipment:
“It is our belief that the open source switch market, sometimes called the “white box” market, is largely only attractive to a small, highly-resourced subset of the overall I.T. market. That’s because the approach is loaded with hidden hard and operational costs. For example, networking capital equipment outlays typically constitute only 30% of the cost of running networks. Labor costs constitute 50%, and will increase with the white box approach as IT departments are required to install, integrate and update separate network operating systems and network virtualization software. The largest hidden cost comes from network virtualization software licenses. VMware NSX, for example, charges a per-virtual-machine licensing fee ranging from $10-$50 per month. The combined cost of increased labor, network operating systems licenses, and per port “VM tax” leads white box networking costs to be 75% higher than for Cisco networks.”
Source: Barrons
It’s also important to keep in mind that the majority of businesses considering a move to SDN likely have Cisco hardware already installed (remember Cisco’s 50%+ market share in routers and switches?). These customers will likely find it more cost-effective to continue using Cisco’s hardware.
Beyond the SDN trend, competition in Cisco’s markets is fierce. Whenever the company misses earnings or sees growth slow, fears crop up that its dominant market share could finally be eroding – either due to SDN or competitive pressures.
The rise of cloud, mobile, and big data are certainly forcing IT architectures and computing to evolve and become more flexible. However, we have yet to see evidence that Cisco is losing market share or seeing its margins erode.
To sum it all up, Cisco’s technologies will continue facing functional and pricing pressures as its markets continue evolving. The company seems to have the strength (financially, technologically, and strategically) to remain relevant, but its sheer size also causes it to move slowly.
Cisco can’t be as cutting edge as some of its smaller rivals, but its entrenchment with customers should also not be underappreciated.
