Cisco Systems, Inc. (NASDAQ:CSCO) will present its quarterly earnings today after the bell, and analysts have low expectations. That’s because political and economic uncertainty may have reduced capital spending on IT this quarter. Yes, Cisco stock is near its 52-week high, but that position is in danger.
And one of the lesser-sung culprits might be open-source hardware.
A Threat to Cisco Stock
Facebook Inc (NASDAQ:FB) has been pioneering open-source hardware for a few years now. Other firms with big data centers, such as Alphabet Inc (NASDAQ:GOOGL), are doing likewise, designing their own hardware while Asian contract manufacturers build it. Low-cost, open-source hardware threatens to commoditize networking routers and switches, which firms such as CSCO rely on. Other forms of hardware, such as servers, have been commoditized, but networking remains the “last bastion of proprietary IT.”
The development of software-defined networking makes it easier for customers to use commodity hardware, known as “white boxes.” The appeal is twofold: this promises to reduce costs while giving IT departments greater control over the network, important for companies like LinkedIn Corp (NYSE:LNKD).
Both Facebook and LinkedIn’s hardware projects received media attention in the past weeks. LinkedIn is designing its own data hardware with Project Altair, and software under Project Falco.
With Cisco’s earnings due to be reported, now is time to re-examine the threat of open-source hardware to Cisco, downside risk to CSCO stock … and why Cisco should be able to navigate this transition without ending up on the rocks.
Cisco’s Willingness to Disrupt Itself
One problem Clayon Christensen writes about in The Innovator’s Dilemma is the failure of companies to disrupt themselves. Instead of reacting to the threat of a low-cost disruptor, they ignore it, and eventually go under.
Cisco isn’t burying its head in the sand and shying away from disruption. Last year, former CEO John Chambers warned that companies must disrupt themselves or face disruption.
Cisco has created “spin-ins” to deal with the threat of software defined networking. As Varun Bhatia writes:
“Cisco disrupts itself by creating spin-ins, separate companies that are fully owned by Cisco. Insieme networks disrupts Cisco’s hardware business by developing software that does the same thing, only cheaper and with a lot less hardware.”
Lower-cost options could perhaps reduce Cisco’s margins, but it’s better for CSCO to do this now rather than wait for someone else to. Steve Jobs was fond of saying, “If you don’t cannibalize yourself, someone else will.” And Cisco can make up for this with high-margin software and services.
Cisco stock has navigated many transitions in the market before, and with this proactive attitude, its chances of succeeding look good.
Indeed, Cisco might take a page out of the International Business Machines Corp. (NYSE:IBM) playbook, which transitioned from being a hardware producer to a software and services provider.
Low Valuation on CSCO Shares
Cisco stock trades at around 15 times earnings and 12 times forward earnings, below the Dow Jones Industrial Average and well below the S&P 500. CSCO also trades at 2.5 times book value, and only 2.4 times its cash position.
Mr. Market doesn’t expect Cisco to grow much, limiting the downside risk to CSCO stock. If the market were appraising Cisco at 35 or 40 times earnings, the downside risk would be greater.
Cisco’s valuation is on par with that of a market leader in a maturing industry.
Cash Position
Cisco last reported $7.631 billion in cash and $58.125 billion in short-term investments. When combined, these two equal 41% of Cisco’s $160 billion market capitalization.
This gives Cisco a lot of breathing room, and has allowed CSCO to go on a buying spree, announcing the purchase of IoT firm Jasper in February and security startup Cloudlock in June.
Buying upstarts is a strategy for incumbents like Cisco to deal with disruption.
White Boxes Hold Limited Appeal
While white-box technology does promise companies lower costs and greater control over their networks, their appeal is limited to mostly larger firms with major IT teams.
And the cost savings could be limited as well, since upfront capital costs on equipment are lower than operating expenses. As a spokesperson said in 2014:
“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.”
Cisco’s Margin Hasn’t Eroded
Cisco’s margins hold another sign that the IT behemoth has greater staying power than expected. Instead of dropping in the past few years, they’ve held steady. From SDX Central:
“When VMware acquired Nicira in 2012, many took it as a sign that the SDN and white box eras were imminent, and that Cisco’s gross margins could drop into the 50 percent range, writes analyst Simon Leopold of Raymond James. However, over the course of fiscal 2016, Cisco’s gross margins improved to almost 64 percent with an operating margin at or above 30 percent.”
Bottom Line
Cisco seems to be turning itself around, and it’s nearing its 52-week high. Yes, it’s possible that Cisco stock pulls back after earnings tonight, but if it does, consider it a dip worth buying.
As of writing, Lucas Hahn did not hold a position in any of the aforementioned securities.
