Cisco (CSCO 0.06%), the largest manufacturer of network switches in the world, usually considers Huawei, Hewlett-Packard Enterprise, Arista Networks, and Juniper Networks to be its main competitors. Cisco controlled over half of the global ethernet switching market last year, according to IDC.

However, a recent report from The Information indicates that AT&T (T 0.29%), one of Cisco's major customers, is developing its own network switches. That move would reduce AT&T's costs and give it more flexibility and customization options across its networks. But it also could hurt Cisco by shattering a main pillar of its business model.

A graphical representation of network connectivity.

Image source: Getty Images.

Cisco shouldn't be surprised

One of the greatest threats to Cisco's business is the rise of generic "white-box" routers and switches. These unbranded devices generally have less powerful hardware than Cisco's products, but the heavy lifting is accomplished via cloud-based software. This disruptive approach is known as software-defined networking (SDN).

Cisco's core business relies on the notion that customers should buy all their networking hardware from a single vendor to ensure that everything runs smoothly. Cisco sells large quantities of routers and switches, which are often bundled with additional software to "lock in" these big customers. However, many companies now realize that white-box solutions usually work just as well as Cisco's hardware.

Last April, AT&T tested a high-speed network entirely comprised of white-box hardware. The test also successfully sent data between white-box hardware from two different vendors running on two different types of chips -- which proved that it wasn't necessary for companies to buy all their networking solutions from a single vendor like Cisco. AT&T's white-box network ran on its own open-source network-management software, ECOMP. AT&T gave ECOMP to the Linux Foundation, which allows anyone -- including rival telcos -- to use or modify the software.

That's why AT&T recently announced that it would deploy 60,000 white-box routers across its network, which would cut its costs and boost the capacity of its networks as it gears up for the 5G transition. Therefore, the revelation that AT&T is developing its own switches shouldn't surprise anyone -- least of all Cisco.

How badly could this hurt Cisco?

AT&T's white-box transition enabled it to reduce its spending on Cisco's networking solutions from $2 billion in 2013 to just $400 million in 2017. That figure could eventually fall to zero as AT&T rolls out its white-box routers and first-party switches.

Ethernet cables plugged into a switch.

Image source: Getty Images.

The good news for Cisco is that $400 million accounted for less than 1% of its revenues last year, so a total loss of AT&T's business wouldn't disrupt its long-term growth. However, AT&T isn't the only major company using white-box hardware.

Facebook (META 2.48%) uses white-box hardware in its massive data centers and also has invented new switches that can replace Cisco's hardware. Like AT&T, Facebook is giving away its designs for free through its Open Compute Project.

Other big service providers and enterprise customers likely will follow AT&T's and Facebook's lead in the near future. When they do, Cisco's routing and switching businesses -- which together generated 45% of its revenues last year -- could get crushed. Both businesses were already on shaky ground last year as switching revenues dropped 5% and routing revenues fell 4%.

Cisco also is losing market share in both routers and switches to challengers like Huawei. Between 2016 and 2017, Cisco's share of the routing market fell from 42% to 36.7% as its share of the switching market fell from 57% to 54.9%, according to IDC.

Should Cisco investors worry?

AT&T's embrace of white-box routers and first-party switches is worrisome for Cisco. However, investors shouldn't overlook Cisco's strengths. The company is investing heavily in its higher-growth security and software collaboration businesses, which could offset the declining sales of its routers and switches.

The company also is repatriating $67 billion in overseas cash -- and most of it is earmarked for buybacks, dividends, and domestic acquisitions. Those moves could attract value-seeking income investors and diversify Cisco's core business away from routers and switches.

Analysts still expect Cisco's revenue and earnings to rise 2% and 8%, respectively, this year as it focuses more on the growth of its software businesses. The stock isn't expensive at 17 times forward earnings and it pays a solid forward dividend yield of 3%. Therefore, AT&T's move signals a disruptive shift in the industry, but investors shouldn't assume that Cisco isn't preparing for the future.