Shares of Cisco (NASDAQ:CSCO) tumbled 4% on July 13 after The Information [sign-up required] reported that Amazon (NASDAQ:AMZN) was interested in selling its own network switches. Though Amazon later denied it was actively building a commercial network switch, if such a thing comes to be a reality, that could be dire news for Cisco, the world's top maker of network switches.
Amazon uses its own internally designed switches for AWS (Amazon Web Services), the largest cloud infrastructure platform in the world. Amazon recently started testing these cheaper "white box" switches (which use off-the-shelf components) with some enterprise customers, according to The Information, which cited anonymous sources as saying Amazon could launch them commercially within 18 months at 70%-80% discounts to Cisco's switches.
Cisco said in a response statement sent to media outlets that "Cisco and AWS have a longstanding customer and partner relationship, and during a recent call between Cisco CEO Chuck Robbins and AWS CEO Andy Jassy, Andy confirmed that AWS is not actively building a commercial network switch." An AWS spokeswoman reportedly confirmed that statement.
Despite the denial, there could be something to what The Information's sources relayed and an Amazon entry into this market sounds like a doomsday scenario for Cisco. But investors shouldn't panic. Here are four reasons why Amazon won't disrupt the networking hardware market in the same way that it disrupted brick-and-mortar retailers.
1. It could ruin AWS' operating margins
Cisco controlled 53% of the worldwide ethernet switching market in the first quarter, according to IDC. The rest of the market is fragmented among rivals including Huawei and Juniper Networks. Cisco generally posts industry-leading operating margins for two reasons -- it has superior scale, and it has a growing portfolio of higher-margin software and services.
AWS had an operating margin of 25.7% during the third quarter. Amazon relies on AWS' profitability to support the growth of its lower-margin marketplaces. If AWS sells its switches at much lower prices to win over Cisco's customers, it could ruin the unit's margins and fragment its focus as a public cloud services provider.
2. Cisco has an entrenched customer base
Several major data center operators and telcos switched over to white box switches in recent years since they're cheaper and run on open-source operating systems. But that setup doesn't really suit big enterprise customers, which lack in-house engineering teams and prefer one-stop bundles of networking hardware and software.
Cisco locks in these "campus" customers with competitively priced bundles, which include its expanding ecosystem of cybersecurity, collaboration, and wireless software. This strategy helps Cisco generate higher revenues per customer as demand for traditional routers and switches wanes.
These customers wouldn't switch over to Amazon's hardware unless Amazon offers very competitive bundles. Amazon could bundle its switches with AWS plans and other perks to challenge Cisco, but that would hurt its margins. Moreover, many of Cisco's enterprise customers already use AWS -- so it would actually be declaring war on a major hardware partner.
3. Cisco has a well-diversified business
Cisco's switching hardware and software revenue accounted for just over a third of its total product revenue last year. That revenue was split between data centers and campuses and while white box challenges from companies like Amazon could throttle its data center growth, they probably wouldn't impact its campus revenue.
Cisco generates the rest of its revenue from network routers, wireless products, security and collaboration software, Unified Computing Systems which bundle everything together, and various services. Amazon could struggle to disrupt all those businesses with white box switches.
4. Cisco's stock is cheap, and it has plenty of cash
Analysts expect Cisco's revenue and earnings to rise 3% and 8%, respectively, this year. Its stock pays a forward yield of 3.1%, and it trades at just 14 times forward earnings estimates. That stable growth rate, high yield, and low valuation should all set a floor under the stock -- regardless of what Amazon might do.
More importantly, Cisco recently recently repatriated $67 billion in overseas cash for buybacks, dividends, and domestic investments and acquisitions. Those moves will make its stock cheaper, attract more income investors, and widen its moat against challengers like Amazon with strategic acquisitions.
The key takeaways
White box hardware, open source networking software, and software-defined networking (which enables lower-end networking hardware to run) all represent long-term threats to Cisco's business. However, Cisco still has plenty of brand appeal, bundling power, and an entrenched position in the enterprise campus market.
Amazon might eventually challenge Cisco in the switching market, but it shouldn't be a major priority. Cisco's investors should keep an eye on these developments, but they shouldn't sell the stock on these rumors alone.
John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Leo Sun owns shares of Amazon. The Motley Fool owns shares of and recommends Amazon. The Motley Fool has a disclosure policy.