No matter how the coronavirus pandemic settles, the world will remain hungry for telecommunication services. Yet given underwhelming last-quarter results and following the tech market sell-off last week, the stocks of network telecommunication providers Cisco Systems (CSCO -1.86%) and Arista Networks (ANET -1.66%) have become cheaper by 13% and 19%, respectively, since Aug. 1.
That could represent an opportunity to invest in the network computing area at a reasonable price, but should you prefer the dominant vendor Cisco or its innovative rival Arista?
Cisco: Legacy dominant network vendor
With $49.3 billion of revenue over the last 12 months, down 5% year over year, Cisco remains the dominant network and telecom vendor, far ahead of rivals Juniper Networks and Arista. And thanks to its huge scale, it sustained a high operating margin of 27.6%, up from 27.4% the prior year.
Thus, despite a dividend that represents an annualized cash outflow of $6.1 billion, the company accumulated $14.8 billion of cash, cash equivalents, and investments in excess of total debt at the end of last quarter.
However, Cisco has failed to dominate the cloud networking area so far. Its share in the high-speed data center switching market (switches are network devices that connect servers together) dropped from 64.7% in 2015 to 45.9% in 2019, according to a study from Crehan Research. And that negative trend seems to continue. During the last quarter, the company's infrastructure platforms segment, which includes its core networking hardware and software solutions, dropped 16% year over year to $6.6 billion.
In addition, Cisco's other businesses are facing fierce competition from specialized vendors. For instance, the double-digit year-over-year revenue growth last quarter of Cisco's communications platform WebEx paled in comparison to Zoom Video Communications' stellar 355% growth.
Management isn't staying entrenched with the legacy products that drove Cisco's dominance over the last decades, though. Last year, the company launched a networking solution that separates its software from its hardware to become more relevant in cloud data centers. And during the last earnings call, CEO Chuck Robbins announced that the company will accelerate its transformation by offering more as-a-service capabilities to adapt to the new way of consuming computing technologies.
It remains to be seen whether these initiatives will succeed. And given these uncertainties, the stock trades at only 15.5 times trailing-12-months earnings.
Arista: Innovative cloud networking specialist
Arista filled the gap left by the legacy network vendors Cisco and Juniper in addressing the performance, scalability, and flexibility required by emerging cloud giants.
Thus, thanks to its innovative offerings, the cloud networking specialist grew its share in the high-speed data center switching market from 10% in 2015 to 18% in 2019. In 2019, its revenue increased by 12.1% to $2.4 billion.
Arista has been expanding its portfolio with Wi-Fi and campus (local enterprise data center) networking capabilities, but its revenue still depends on its cloud business. During the last quarter, cloud titans (web-scale cloud giants) represented approximately 40% of total revenue.
These few large customers lead to volatile results as their spending patterns vary over the short term. As an illustration, in contrast with Arista's strong revenue growth last year, revenue dropped 11.1% year over year during the last quarter, and management expects third-quarter revenue to drop by 11.4%, based on the midpoint of guidance.
Yet the company remains exposed to the secular growth of cloud computing. For instance, the high-growth edge computing specialist Fastly relies on Arista's products. More generally, management expects Arista's total addressable market to increase from $22 billion in 2020 to $30 billion in 2024.
Also, the company accumulated a large cash, cash equivalents, and investments position (with no debt) of $2.8 billion at the end of last quarter thanks to its high profitability driven by the low sales and marketing expenses of its large cloud customers.
Thus, given its greater exposure to cloud computing compared to Cisco, Arista's stock trades at a higher price-to-earnings (P/E) ratio of 22.5.
Verdict: It depends
Beyond their short-term challenges, both companies remain exposed to the long-term growth opportunities of new technologies such as 400G, 5G, Wi-Fi 6, and cloud computing. In addition, thanks to their high margins and rock-solid balance sheets, they shouldn't face financial difficulties should a prolonged recession materializes.
As a prudent investor, I prefer Cisco stock given the downside protection its low valuation offers. Growth investors may prefer Arista stock, though; The company only needs to sustain its strength in the cloud computing market to justify its reasonable valuation. Any strong performance from its expanding portfolio in the campus and Wi-Fi areas will provide investors with some extra upside potential.