The rivalry between Arista Networks (NYSE:ANET) and Cisco Systems (NASDAQ:CSCO) runs deep, and it's never been friendly. In 2004, Arista was founded by former Cisco engineer Ken Duda , and several other ex-Cisco employees joined the cause shortly thereafter, including Arista's CEO Jayshree Ullal. That set the stage for conflict, and in the years that followed, both companies filed lawsuits against the other, with the result that Arista paid Cisco $400 million in 2018.

Despite this intriguing backstory, both have been underperformers in recent years, with Arista's stock gaining 21% and shares of Cisco up just 10% since 2017. So -- which is the better buy today?

Cisco: Defender of the crown

Cisco has a broader portfolio than Arista, with products that range from networking infrastructure platforms (switches and routers), to software-as-a-service (SaaS) solutions for security, collaboration, and analytics. Cisco also operates on a much larger scale, generating $48 billion in revenue over the trailing 12 months -- 20 times more than Arista's $2.2 billion in sales. This breadth and scale gives Cisco an advantage, enabling the company to outspend Arista while providing more holistic solutions. For example, Cisco's security, analytics, Internet of Things, and networking software can be bundled with switches, routers, and wireless hardware, making Cisco a one-stop shop for networking needs.

Drawing of computers connected to cloud icon

Image source: Getty Images.

However, Cisco has also faced headwinds in recent years. The rise of cloud computing has reduced demand for on-premise hardware. And in an effort to remain relevant and boost recurring revenue, the company shifted its growth strategy away from hardware-centric solutions, focusing instead on services and subscription-based software. So far, these efforts have been moderately successful. Between fiscal 2017 and 2020, revenue from subscriptions and services increased from 43% to 51%. And in the first quarter of fiscal 2021, 78% of Cisco's software revenue was subscription-based, up from 54% in 2018. This has driven the company's margins upward, though revenue has remained flat.

Metric

2017

2018

2019

2020

Revenue growth

(2.5%)

2.8%

5.2%

(5%)

Gross margin

63%

62%

62.9%

64.3%

Operating margin

24.9%

25%

27.4%

27.6%

Source: Cisco SEC filings. Note: Cisco's fiscal 2020 ended July 25, 2020.

Arista: Contender for the throne

Arista first squared off with Cisco in the high-speed Ethernet switching market (data centers), an industry historically dominated by Cisco. And while Cisco is still the global leader, the company's market share has dropped from 78.1% in 2012 to 43.7% in the first half of 2020, while Arista's market share has climbed from 3.5% to 16.3%.

Arista's differentiated strategy has been key to its success. For example, Arista exclusively uses merchant silicon (third-party chips) in its switches, rather than designing custom chips like Cisco. This has allowed Arista to provide its clients with cheaper, more flexible solutions, while also enabling the company to focus its R&D budget on software development.

Not surprisingly, Arista's extensible operating system (EOS) is perhaps its greatest advantage. Unlike Cisco's switches, which require different operating systems in different settings, Arista's EOS runs on all its products. This makes the company's solution more reliable, more cost-efficient, and less complex. In fact, according to Gartner, Cisco's clients report trouble with product complexity and software quality more frequently than other vendors' clients.

This competitive edge has helped Arista grow revenue more quickly, while typically achieving higher margins than Cisco.

Metric

2016

2017

2018

2019

Revenue growth

34.8%

45.8%

30.7%

12.1%

Gross margin

64%

64.5%

63.8%

64.1%

Operating margin

21.6%

28.6%

12.7%*

33.4%

Source: Arista SEC filings. Note: 2018 operating margin reflects $405 million legal settlement with Cisco.

Arista has also moved into Cisco's other markets, like enterprise and campus networking , routing, and security. In the company's most recent earnings call, Ullal stated that Arista's campus portfolio would double in 2021, and that she expects the company to "disrupt the campus and router incumbency of the last few decades in the next few years" -- in other words, Arista's got Cisco in its crosshairs (again). Investors should pay attention to this situation; if Arista can extend its past success into the campus switching and routing markets, it would be a major blow to Cisco.

Valuation and risk

Shares of Cisco currently trade at four times sales and 18.5 times earnings, a steep discount to Arista's 11.4 times sales and 35.5 times earnings. However, Arista's faster growth more than justifies the difference.

CSCO PE Ratio Chart

CSCO PE Ratio data by YCharts

Finally, investors should be aware of the substantial risk created by Arista's revenue concentration. In 2019, Microsoft and Facebook accounted for a combined 40% of revenue. In other words, Arista's business depends heavily on just two customers.

The verdict

Despite Cisco's massive scale and the company's cheaper valuation, I think Arista has the better strategy. The company's software innovations and customer-centric business model are strong advantages, and they have led to faster growth and higher margins. From that perspective, Arista is well positioned to continue taking market share from Cisco.

However, investors shouldn't forget that Cisco is still the dominant player in the switching, routing, and wireless markets. If the company's efforts to evolve beyond hardware continue to gain traction, Cisco may be able to pull itself out of this rut.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.