The battle for the Internet networking market features Cisco Systems
Which is the better place to invest your money: the established industry leader or the challenger that is about four years removed from its public listing?
The market likes to reward challengers with big market capitalizations. Just look at the multiples awarded to challengers like PMC-Sierra taking on chip giant Intel
Yet, for every company that topples an IBM or an AT&T, many others never even make it out of the trenches. Buying Dell Computer
So how do you choose? One way is to put the champ and the challenger in a head-to-head the same way sports analysts tally the strengths and weaknesses of two competing teams. Does the playing field favor one side? Can one overcome the other's strong points? Which has the most experience under pressure?
Let's apply this approach to the battle heating up in the data communications industry between Cisco Systems and Juniper Networks. We can score each side on positioning, offense, defense, management, and valuation and see which one is the better prospect.
Ten years ago, Cisco was the upstart, taking on 3Com
Now Juniper is the newcomer. Founded in 1996, Juniper focuses on the technology high road, developing and selling high-end, leading-edge routers to the biggest telecom and Internet service provider customers like AT&T, Sprint, Verizon, and SBC Communications. Juniper has built its business by marketing itself as the top alternative to Cisco in the carrier market.
In February, Juniper announced the acquisition of Netscreen, which builds firewalls that protect companies from viruses and hackers and constructs virtual private networks now common to corporate communications. The deal takes Juniper further into the business of selling to Fortune 500 corporate customers, throwing it into even more direct competition with Cisco. The purchase takes a leaf out of Cisco's playbook, echoing the string of takeovers in the 1990s that transformed Cisco from simply a router maker into a broad-based networking company.
Together, Cisco and Juniper dominate the market for routers -- the electronic devices sold to corporations and telecom carriers that direct Internet data traffic over networks. Both are well ahead of telecom network equipment vendors Lucent Technologies
Scoring the contenders
The market thinks Juniper's cutting-edge technology can take a big bite out of Cisco's dominance, especially as telecom companies start spending again for new Net-based routers to replace decades-old telecom voice network. At the same time, pundits argue that the Netscreen deal puts Juniper on a collision course with Cisco in the corporate networking market.
Here's my take on which competitor dominates.
Positioning: a toss-up. Cisco owns the big corporate networking market. About 95% of Fortune 500 companies are Cisco customers. Cisco, the industry's 900-pound gorilla, has a rock-solid base from which to expand its product offerings. On the other hand, Juniper does look sexy. With its advanced technology, Juniper is nicely positioned in the telecom carrier market, where it is chipping away at Cisco's market share. The Netscreen deal creates sales and distribution channels for penetrating the corporate market.
Offense: a toss-up. Juniper is making its name as an innovator, especially among customers that crave faster networks. When big service providers like AT&T, Verizon, and SBC Communications update the Internet infrastructure, they increasingly decide to buy from Juniper. At the same time, Cisco continues to be aggressive -- showing success in all new markets it enters, like voice over Internet, network security and wireless, optical, storage, and home networking.
Defense: a big plus to Cisco. Margins say a lot. While gross margins for both players are remarkably close at about 65% for Juniper and 68% for Cisco, there is a huge difference in net margins. Cisco squeezes out a healthy 24% bottom-line return compared to a fairly paltry 7% for Juniper. Cisco's bigger margins give it enormous advantage when it comes to fending off competition. Cisco almost never loses a customer; its attrition rate is less than 2% annually. Cisco also has deep pockets for R&D. Cisco recently unveiled the huge fast router (HFR), a hand-end product to stay competitive in the carrier market.
Management: a plus to Cisco. No disrespect to the folks running Juniper Networks, but Cisco's management team, led by CEO John Chambers, has proven that it can execute. Carving out and holding the industry's top spot takes business acumen, planning, and focus. Cisco not only survived through the technology market crash, but maintained profitability while rivals posted big losses. Return on equity offers a good gauge of management's ability. In 2003, Cisco's ROE exceeded 16%. By comparison, Juniper's ROE was just 4.5%.
Valuation: Cisco thumps Juniper. On a price-to-earnings basis, neither company looks cheap. But while Cisco trades at 26 times 2005 earnings, Juniper trades at a lofty 55 times. Considering its earnings growth potential, Juniper's P/E should trade higher than Cisco's, to be sure. Even so, Juniper's price tag looks rich. Juniper's P/E sells at 3.5 times its long-term growth rate. Cisco's PEG (admittedly, still high) is just under 2.
Cisco has by far the better balance sheet. Cisco has no long-term debt to speak of and a whopping $19.2 billion in the bank. Juniper, by contrast, has about $550 million in debt. Investors should remember that the Netscreen deal could be just the first of many more acquisitions for Juniper that could either gouge its cash balance or dilute earnings per share. (Acquisition candidates include Ethernet switch makers Foundry Networks and Extreme Networks.)
Enterprise value-to-free cash flow highlights the valuation gap. Fools know that EV/FCF is a tremendous measure of company value, especially for stocks that look pricey on the basis of P/E. Cisco is expected to throw off about $1.8 billion in cash per quarter in 2005, which translates into an EV/FCF of 17.5. By comparison, Juniper's EV/FCF multiple is 28.
The scorecard says it all
Bigger, stronger, and cheaper, Cisco is the better buy. Juniper makes an exciting growth story, but investors should take a pass. Juniper's price is too high, especially given the risks of broadening its business. Cisco is hardly cheap at its current price, but given the trends in its business, it's hard to envision the price getting much cheaper short of a retreat in the market as a whole. In this case, it's hard not side with the champion.