Last week, The Information reported that Cisco (NASDAQ:CSCO) may be disaggregating the software from its hardware in its switching products. This is big news, and while not exactly worthy of panic, it is something for Cisco investors to keep an eye on. Cisco immediately shot down the rumors, calling them "unsubstantiated," though not necessarily saying they were untrue.
A brave new world of switching?
Why might Cisco be touchy about the subject? There are a number of reasons. First, the company's switching products are by far its biggest revenue driver, at roughly 30% of sales, despite efforts Cisco is making to transform itself into more of a software and services-oriented company. Its next generation network (NGN) routers -- which could also be affected by the same phenomenon -- represent another 15% of revenue.
Furthermore, if the company were thinking along these lines it would be due to competitive pressures. For years, Cisco's switching software was only available on its own high-margin hardware; however, the data center switching industry is changing, as competitors like Arista Networks (NYSE:ANET) are winning market share by offering low-cost switches with high functionality. In the past year or two, though, an even greater threat to the industry has emerged, as smaller networking companies started selling stand-alone software that could be run on low-end "whitebox" switches made by low-cost Asian vendors.
This pressure has caused Cisco competitors Juniper Networks (NYSE:JNPR) and Arista to start selling their operating systems separately from their custom hardware. Moreover, large cloud companies such as Microsoft (NASDAQ:MSFT) are writing their own switching software, putting even further pressure on the market. In fact, Arista recently let Microsoft run its own SONIC software on Arista hardware. Cisco, the largest player and, one could say, the "premium brand" in the business, has been the holdout in keeping its software and custom hardware 100% integrated.
Until now. Maybe. Though we're still not sure. The Information cited two people "familiar with the matter" saying that Cisco was working on a new operating system called Lindt. According to The Information, this new system is designed to run on third-party hardware.
A Cisco spokesman replied:
While we are not commenting on Lindt, I will say that the vast majority of our customers see huge value from the power and efficiency of our fully integrated networking platforms. This tight integration of hardware and software will continue to be the basis of the networking solutions we offer our customers.
Reading the tea leaves
I have no idea what Cisco's plans for Lindt are, but it appears Cisco may be preparing for the worst case, while also not conceding disaggregation just yet. I think that's prudent. Still, competitive pressures are competitive pressures, so even if Cisco makes all of the right moves, it may not be able to stem the secular decline in high-end switching. In the most recent quarter, its product revenue was down 10%, with switching down 5% and data center down 4%.
That doesn't necessarily make Cisco a bad investment. The company is investing in and acquiring companies in fields like security, the Internet of Things, software, and applications. Furthermore, Cisco's services segment grew 5% in the second quarter of 2017, partially offsetting the product decrease.
It is also possible that many customers would still prefer an integrated software and hardware switching platform. Having a single networking vendor is probably attractive to many companies, even if it costs a little bit more. I liken it to some consumers preferring Apple's (NASDAQ: AAPL) more expensive but integrated platform versus those who prefer the customizability and lower cost of Windows.
The problem is that the most likely customers to go "whiteboxing" are also the largest, with the sophistication and resources to do more things in-house. For instance, Cumulus Networks, which sells disaggregated software for whiteboxed hardware, has nabbed a bunch of customers from Cisco, including Verizon (NYSE: VZ) and many large banks.This, combined with the hyperscale cloud companies going to Arista or their own whitebox solutions, makes for a concerning setup.
Cisco is still an industry leader and is making the right transitional moves, but investors need to keep an eye on its existing switching and routing cash cows in case these segments show signs of rapid deterioration. I think Cisco can manage the transition, but since switching and routing make up such a large portion of current revenues, investors should be wary going forward.