Cisco Systems, Inc. (NASDAQ:CSCO) is a company that is caught deep in the throes of business cycle and product transitions. The company has over the past decade gradually transformed itself from a niche route vendor to the de facto standard in the networking industry.
And the networking leader could soon lose its tag as a company whose core business involves selling switches and routers that move data around the internet. Cisco is getting ready to disrupt its switching business, the company’s largest segment that brought in 36% of revenue in fiscal 2016. The company is planning to sell operating system software for its networking devices as a standalone package without requiring businesses to purchase its expensive hardware.
This effectively means that Cisco’s customers will now be able to use cheaper switches that run on non-CSCO chips from companies like Broadcom Ltd (NASDAQ:AVGO). Cisco has dubbed the new operating system Lindt, and hopes that it will keep its customers from moving to rivals such as Juniper Networks, Inc. (NYSE:JNPR) and Arista Networks Inc (NYSE:ANET).
CSCO Stock Is Taking On Networking Rivals
It’s crazy move by CSCO stock, since there’s a big risk that customers will simply buy the company’s new software and pair it up with cheaper boxes instead of buying Cisco’s high-margin switches. But, as they say, desperate times call for desperate measures.
Like most legacy technology providers, Cisco stock has come under pressure from software-based infrastructure companies and cloud providers who are giving businesses enhanced tools without forcing them to purchase expensive hardware. CSCO has little choice other than to bite the bullet.
Further, Cisco is increasingly finding itself under fire from networking upstarts such as Arista. ANET has managed to evolve into a fierce Cisco competitor, which is hardly surprising considering that the company was founded by former CSCO top brass. Arista has been punching above its weight by stealing many of Cisco’s moves, leading to never-ending patent infringement wars by the two companies.
With only about 3% of Cisco stock’s top line, Arista might still be a minnow in the networking universe, but certainly understands how to play hardball. The company manufactures networking software that’s capable of running on white box hardware, meaning companies don’t have to buy expensive networking gear from CSCO.
That might explain why Arista’s revenue climbed 33.6% during the most recent quarter whereas Cisco’s switching business shrunk 5% marking the sixth straight quarter the segment recorded a revenue contraction.
It’s little wonder then that Arista stock has racked up handsome gains of 38% in the year-to-date and 106% over the past 12 months, leaving CSCO stock in the dust with gains of 9.5% and 18.2% over those timeframes.
Cisco Stock Remains a Prime Holding
For all its troubles, Cisco remains the industry leader in the networking business and is busy building out a new-look recurring revenue subscription business model.
Meanwhile, the company’s high-margin businesses have made it an efficient cash machine. Cisco’s gross margin improved 400 basis points during the last quarter, a sign that its pricing power has not been affected by the competition. The company’s free cash flow yield of 7.1% is the best in the industry, and the company has been using that cash to generously reward shareholders. Cisco just declared a 29-cent-per-share quarterly dividend, an 11.5% year-over-year increase and good for a healthy 3.5% dividend yield.
This is not the first time that Cisco is facing a major upheaval in the industry. The company has weathered the software defined networking (SDN) scare pretty well, and will likely survive the disruption by companies such as Arista and Juniper Networks.
Despite the industry challenges facing it, CSCO stock remains a prime long-term holding.
As of this writing, Brian Wu did not hold a position in any of the aforementioned securities.
