Does Cisco Systems Inc Have a Growing Router Problem

Investors are buying Cisco's better-than-expected earnings report, but buried within is further proof of long-term trouble.

May 17, 2014 at 10:30AM

Cisco (NASDAQ:CSCO) shares soared nearly 7% after earnings when it beat analyst expectations. Essentially, Cisco had been beaten-down so badly in previous quarters that expectations had been drastically lowered, thus hiding a growing problem in its router and switch sales. Yet, while Cisco struggles in these areas, Alcatel-Lucent (NYSE:ALU) and Juniper Networks (NYSE:JNPR) thrive, which is a cause for Cisco's weakness.

Lower expectations hide poor router and switch sales
Prior to Cisco's third quarter report, it had been approximately one-year since the stock traded higher following earnings. In retrospect, its guidance and margins have been poor, and investors have become increasingly concerned at the rate of declines in switch and router sales.

For Cisco, switches account for the largest single segment of its business, which declined 6% in the quarter, as poor macro conditions deserve much of the blame. Yet, routers are also a significant piece, accounting for 20% of revenue, which saw sales decline 10% in the fiscal third quarter. Overall, Cisco's revenue fell 5.6% to $11.54 billion, and the company is guiding for a fourth quarter revenue decline of 1% to 3%.

Let's talk about routers
Typically, routers are discussed as either core or edge, which are crucial in delivering content and other services from one place to another. Due to a cyclical slowdown, and several of Cisco's top customers electing to use off-the-shelf equipment controlled by software, Cisco's specialized equipment has become increasingly replaceable. However, competition is also playing a large role in its decline.

Alcatel-Lucent is a well-diversified company, but a major player in the routing space. Specifically, 45% of its revenue comes from core networking, and routing is 40% of its core networking segment. In its last quarter, revenue for routing grew 16.4% over the year prior thanks to big contract wins and the growth of its mobile packet solutions.

If we look back further, Alcatel's routing business grew 10.3% in 2013, showing that it's seeing an acceleration of growth, while Cisco's declines are rather comparable to its 11% router decline last year. With that said, Alcatal-Lucent is not the only company that's stealing share from Cisco in this space, as Juniper is also becoming a real threat.

In the last 12 months, about half of Juniper's $4.78 billion in revenue came from routers. In the first quarter, its routing business grew 7%. So when Cisco's management says it can't slow its slump in router sales because of macro conditions: Why is it that servers have become a growth engine for Alcatel-Lucent and Juniper? I think the falling sales at Cisco are due more to rising competition than changes in the market.

Final thoughts
Cisco investors will naturally defend the company claiming that its business is more than just routers. While accurate, routers account for 20% of its business and is highly connected to its largest segment, switches, which is seeing similar fundamental declines.

Therefore, Cisco looks cheap at 16 times earnings, but is losing profits as its high-margin businesses dwindle. Conversely, Alcatel's servers business is driving growth in a large core networking segment that has operating margins of 7.1%, more than double the company's overall operating margin, thus implying higher profits long-term. Juniper may look pricey at 27 times earnings, but with improving margins and the most refreshed line of routers in the industry, it remains a good bet to steal more of Cisco's business.

Cisco may be up nearly 7% after earnings, but it might be a good opportunity to take profits, and invest in two competitors that could return larger stock gains over a long period of time.

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