Better Buy: Cisco vs. Zscaler

Cisco Systems (CSCO -0.52%) and Zscaler (ZS -1.49%) are both providers of cloud security, though Cisco's roots are in networking platforms. Over the last few years, the shift toward cloud computing has affected these two tech companies differently, and their stocks have moved in opposite directions. Since 2018, Zscaler has surged over 1,200%, while shares of Cisco are down roughly 2%. But where should investors put their money today -- value or growth?

Cisco: The value investment

Cisco is perhaps best known for its core networking business, which includes hardware (switches, routers, and wireless access points) alongside embedded software solutions that help clients manage networks in data center and enterprise (campus) environments.

In recent years, cloud computing has reduced demand for on-premise hardware. As a result, Cisco has pivoted toward software and subscription-based products, and in the company's fourth quarter of fiscal 2020, management reported that subscriptions accounted for 78% of total software revenue. If this trend continues, it should help stabilize Cisco's top line, which tends to fluctuate due to the cyclical nature of networking hardware sales.

Image source: Getty Images.

Cisco also provides various software solutions that enhance its networking products. For instance, the company acquired AppDynamics in 2017, a market-leading  application monitoring platform that helps IT teams identify and resolve bugs (performance issues). And in 2020, Cisco released SecureX, a platform that integrates the company's security portfolio, from user and endpoint protection to cloud and network security solutions. Cisco's ability to combine its networking infrastructure with cybersecurity and monitoring software is an advantage that sets the company apart from its rivals. Put another way, Cisco is an end-to-end provider of networking essentials.

However, Cisco has also faced headwinds in recent years. For example, competition from Arista Networks has cut into Cisco's data center market share. Arista has also moved into the campus networking space with the acquisition of Mojo Networks, further intensifying the battle between these two giants. Additionally, according to The Wall Street Journal, Cisco recently decided to stop sales of Cisco Kinetic for Cities, a software product designed to integrate data from Internet of Things sensors and support smart cities. While this wasn't a major revenue driver, it's still a setback to Cisco's efforts at transitioning toward a more software-centric business.

All things considered, Cisco's financial performance has been disappointing. The company's push toward a subscription model has helped expand margins, but overall revenue has actually dropped since 2018 (fiscal year ended July 28, 2018), primarily due to weak networking infrastructure sales.

Data source: Cisco SEC. TTM = trailing-12-months.

Zscaler: An investment in growth

Zscaler, on the other hand, was built for the cloud, and the secular trends toward cloud computing and employee mobility have been  major growth drivers. Enterprises have migrated away from on-premise data centers, and more employees are working remotely (often on unprotected networks and devices). These changes have made traditional security measures like corporate firewalls ineffective and outdated.

Taking a modernized approach, both Cisco and Zscaler offer cloud-based security solutions, meaning all traffic is routed through the cloud, where it is inspected for threats and security policies are enforced. This allows users to securely connect to the internet and cloud applications regardless of location, network, or device.

Compared to Cisco's products, Zscaler's platform offers reduced complexity and greater geographic scale (better performance and reliability). In fact, Zscaler runs the largest cloud security platform in the world. And these advantages have earned Zscaler the leadership position in the Gartner Magic Quadrant for Secure Web Gateways for 10 consecutive years. What's more, Zscaler was the only leader in the most recent report. This gives Zscaler an edge over its rivals, and it has helped the company drive explosive revenue growth while maintaining a high gross margin.

Data source: Zscaler SEC filings.

Recently, Zscaler has also started competing with Cisco in another market. Like Cisco's AppDynamics, Zscaler Digital Experience (ZDX) is a monitoring platform that allows IT teams to measure user experience across business applications, which enables them to quickly isolate and resolve performance issues whether they are caused by the user's device, the network, or the application itself. Investors should watch this situation -- according to Gartner, fewer than 15% of enterprises have implemented holistic monitoring in the cloud, meaning this could be a growth driver for both companies in the coming years.

The verdict

Cisco is still a relevant, profitable business with an enormous customer base and plenty of cash on its balance sheet. And the company trades at just four times earnings and 18 times sales, a much cheaper valuation than Zscaler's 59 times sales and nonexistent price-to-earnings ratio (i.e., Zscaler is not currently profitable). But Cisco's dwindling top-line growth is a problem, and the company's fierce rivalry with Arista will likely result in further market share losses for Cisco's networking products. From that perspective, the company's future looks bleak.

By comparison, Zscaler is a smaller enterprise and it's expanding more quickly. Moreover, Zscaler has consistently been recognized as a leading provider of cloud security -- in other words, the company has much greater upside potential. That's why Zscaler tops Cisco and growth beats value in this contest.