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Why Cisco Systems, Inc. Shareholders Have Something to Worry About

By Leo Sun – May 4, 2017 at 8:00AM

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Will the networking giant be left behind as customers shift towards cloud-based solutions?

Cisco (CSCO 3.02%) is often considered a mature tech stock that delivers stable dividends instead of explosive price growth. Its position as one of the biggest networking equipment makers in the world ensures that it will benefit from the growth of connected devices worldwide. That's why its annual revenue rose from $28.5 billion to $49.2 billion between fiscal 2006 and 2016.

But as tech companies become bigger and older, they become more vulnerable to disruptive new technologies. Therefore, Cisco investors should recognize one looming threat that won't go away anytime soon -- software-defined networking (SDN).

A graphical representation of a computer network.

Image source: Getty Images.

What is software-defined networking?

Cisco's core business relies on the notion that customers should buy all their networking hardware from a single vendor for everything to run smoothly. Cisco sells large quantities of routers and switches to these customers, which are offered additional collaboration, security, or video features. That bundling strategy locks in customers, boosts Cisco's overall revenues, and fends off smaller competitors like Juniper Networks (JNPR 2.05%).

But in recent years, customers discovered that it's cheaper to buy generic "white box" routers and switches which are equipped with open source software. These white box devices generally sport less powerful hardware than Cisco's products, but the heavy lifting is accomplished with cloud-based software, which can be produced in-house or bought from a wide range of companies. This approach -- known as software-defined networking -- likely terrifies companies like Cisco and Juniper, since it shatters their single-brand control over large enterprise customers.

White box hardware has some big backers

Many big tech companies consider SDN to be the future of networking. Facebook (META 1.83%) has been using white box hardware in its massive data centers, and it even invented new switching hardware which directly challenges Cisco and Juniper's switches. Facebook is giving away those hardware designs for free via its Open Compute Project.

In early April, AT&T (T 4.12%) tested a high-speed network which used exclusively white box hardware, some open source software, and additional software from a small start-up. That test successfully delivered data between white box hardware from two different vendors with two different types of chips -- which basically proved that companies shouldn't buy all their networking hardware and software from a single vendor like Cisco.

Which companies could take Cisco down?

Arista Networks (ANET 2.30%) is often cited as the biggest long-term threat to Cisco, since it sells cheaper multilayer network switches which are specifically designed for SDN purposes. It also offers an open source Linux-based OS called EOS (Extensible Operating System) for that hardware. Arista claims that combining its switches with its FlexRoute software could eventually replace all routers with cheaper SDN solutions.

That could torpedo Cisco's top line, since 15% of its sales still came from router sales last year. Cisco is clearly concerned about Arista -- that's why it repeatedly (but ultimately unsuccessfully) tried to slow down its advance with multiple patent infringement lawsuits. But that litigation didn't stop Arista's growth -- the company posted 35% sales growth in 2016, and analysts anticipate another 26% growth this year.

Another disruptive player is fiber-optic components producer Acacia Communications (ACIA), which sells a smaller, denser, and more power-efficient 400G chipset for data transfers than rival companies. Acacia claims that these chipsets are better optimized for SDN solutions, which could greatly improve the quality of white box networks in the near future.

Should Cisco investors start worrying?

Cisco looks like it could be left behind a crucial tech curve, but investors shouldn't panic yet. Cisco has already been diversifying its business away from switches and routers with fresh acquisitions and expansions in higher-growth markets like cybersecurity and collaboration solutions.

Bundling these new services with its existing hardware should make it tough for bigger enterprise customers to abruptly switch to white box and SDN solutions. Cisco has also developed its own SDN solutions, with an emphasis on cheaper hardware, less complicated connections, and cloud-based networking -- which could all counter the imminent rise of white box networks.

Therefore, I believe that investors can still rely on Cisco as a stable income stock, with its reasonable P/E of 18 and its forward dividend yield of 3.4%. But they should also be aware that its top line growth will remain weak for the foreseeable future due to a market shift away from its pricier routers and switches.

Leo Sun owns shares of AT&T and Cisco Systems. The Motley Fool owns shares of and recommends Arista Networks and Facebook. The Motley Fool recommends Cisco Systems. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Cisco Systems, Inc. Stock Quote
Cisco Systems, Inc.
$41.21 (3.02%) $1.21
AT&T Inc. Stock Quote
AT&T Inc.
$15.97 (4.12%) $0.63
Meta Platforms, Inc. Stock Quote
Meta Platforms, Inc.
$138.16 (1.83%) $2.48
Juniper Networks, Inc. Stock Quote
Juniper Networks, Inc.
$26.66 (2.05%) $0.54
Arista Networks, Inc. Stock Quote
Arista Networks, Inc.
$115.49 (2.30%) $2.60
Acacia Communications, Inc. Stock Quote
Acacia Communications, Inc.

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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