Today, our digital communications are more important than ever amid the coronavirus pandemic. While that should theoretically benefit switch-makers Cisco and Arista Networks, companies large and small are pulling back or hitting pause on their IT investments whenever possible. Throw in some supply disruption, and both Cisco and Arista saw declining sales and profits in the first quarter.

Still, both stocks remain well below their all-time highs and could benefit from the acceleration of digital trends over the longer term. Which of these two fierce competitors looks like a better bet at this juncture?

Looking down the hallway  between  two  walls  of servers in a data center.

Image source: Getty Images.

A dominant incumbent vs. an upstart challenger

In the enterprise switching world, Cisco has long been the dominant player, emerging in the 1990s. Meanwhile, Arista, founded in 2004, is the insurgent, having developed a lower-cost, more open-source switch specifically geared for data centers.

Cisco has long dominated campus switching for all kinds of enterprises, but Arista, by focusing on products specifically for the changing data center industry -- especially cloud data centers -- has been able to take market share away from industry giant Cisco in the data center segment over the past five years. In fact, since 2012, Arista's dollar-based market share of the data center switching market has grown from 3.5% to 18%, while Cisco's data center market share has declined from 78.1% to 45.9% over that time.

Moreover, the data center market has now passed the campus switching market in terms of size, and it's also projected to grow much more in the years ahead, while the campus switching market is projected to stay flat.

Thus, purely looking at the important data center switching market, Arista still seems better positioned.

Diversification

Of course, Cisco is much, much bigger than just the data center market, and it's benefiting from years of acquisitions in complementary technologies such as application monitoring and cybersecurity along with steadier service revenue for its installed base. Last quarter, Cisco's cybersecurity segment grew 5%, and services grew 5% as well. Though Cisco's main source of revenue is still its hardware switches, with cybersecurity at 6.5% of revenue and services at 28.3% of revenue, these segments helped limit Cisco's revenue declines to just 8% last quarter, even as core infrastructure hardware fell 15%.

Meanwhile, Arista is more purely dependent on hardware sales, and its revenue fell a greater 12.2% year over year. Arista has also begun to diversify its business as well, but it's much earlier doing so. Arista launched a new campus switching product last summer, but that line is only approaching $100 million in annual sales out of Arista's $2.34 billion over the last 12 months. Yet like Cisco, Arista has also found success in building up its services, which accounted for 21.4% of revenue last quarter -- not dissimilar to Cisco's 28.3% -- and that portion of revenue actually grew 24.6% last quarter, even as hardware sales fell 18.7%.

Thus, while the main hardware business can be volatile, Cisco's portfolio is more diversified, making its results somewhat steadier than Arista's in down markets like this one. 

Capital returns, balance sheet, and valuations

Cisco's more diversified, less-volatile earnings thus may appeal to the more conservative investor. However, even defensive qualities aren't cut and dried when picking between the two.

While both companies are highly profitable, have net cash on their balance sheets, and return cash to shareholders in the form of buybacks, Arista actually outdoes Cisco on margins and relative balance sheet strength -- surprising for the "smaller" company. On the other hand, Cisco also pays a big dividend, which yields 3.2% at today's prices, while Arista doesn't pay any dividend.

Company

Cisco (NASDAQ:CSCO)

Arista Networks (NYSE:ANET)

Net cash and investments (billions)

$12.5

$2.6

Net cash as % of market cap

6.7%

14.5%

Operating margin (TTM)

28.1%

33.05%

Dividend yield

3.2%

None

P/E ratio

17.3

21.8

Data sources: Company filings and Yahoo! Finance. Table by author. TTM = trailing 12 months

The conclusion

This is a tough time to sell switches to large enterprises, but in my eyes, Arista is the better buy today. Though its results are a bit more volatile than Cisco's, Arista is still maintaining high profit margins, it has significant cash on its balance sheet relative to the size of the business, and it appears to have an advantage and longer growth runway in the highest-growth part of the switching universe: the all-important data center. And if its campus platform ever catches on, that's just a bonus.

That being said, Cisco isn't a bad pick at all, especially for older and more conservative dividend investors. After all, with so many companies across a wide range of sectors cutting their dividends amid the pandemic, it's hard to find dependable dividend stocks with a decent yield. Despite recent revenue declines, Cisco's profits were down only 6%, and adjusted (non-GAAP) earnings were down only 2%, less than its 8% revenue decline last quarter, thanks to cost-cutting measures. While competition and disruption from Arista is a concern, Cisco appears to have the strength to maintain a decent position in both campus and data center and good profits for the foreseeable future, meaning the dividend should be safe.

Still, for overall gains, I like Arista's financial strength and long-term growth possibilities much more. That makes it the better buy today.