On October 3, 2013, I published an article called The Existential Threat to Cisco in which I argued that Cisco (NASDAQ:CSCO) was heavily exposed in three areas. First, it faced a disruptive threat to its legacy IP networking equipment business from software defined networking (SDN) technology. Second, even if it embraced SDN completely, its medium term earnings were likely to take a hit. And third, international demand for its products would suffer in the aftermath of the Edward Snowden affair as foreign governments became more cautious about internet surveillance by US firms under the direction of the US National Security Agency.
Wednesday, Cisco warned its revenues could fall as much as 10% in the current quarter. Threats from new technologies and political issues were foremost in management's minds. Cisco shares were down 11% in after-market trading on Wednesday November 13, 2013 because Wall Street analysts couldn't see this coming. According to Bloomberg, 31 analysts rate Cisco a Buy with only 3 rating it Sell, and 13 on Hold.
Analysts at bulge bracket banks tend to miss big seismic events in the life cycle of great technology companies because momentum drives their valuation models. Most analysts forecast margins with an eye on historical trends. So many of them simply extrapolate Cisco's recent operating margins of about 23% way out into the distant future because that's what they had in the past. The bigger a company and the longer its been around, the more confident analysts are about extrapolating historical profit margins forward at current levels.
But Cisco's industry is undergoing a dramatic transition with a host of new technologies that will impact its business. Add to that the political risk that Cisco now faces with the Edward Snowden revelations and its all too obvious that analysts are going to have to change their future profitability estimates.
But guess what. As always, when the tide changes against a legendary technology company, analysts are reluctant to downgrade it too hard on the basis that "the company will ride through this storm".
Cisco's charismatic leader, John Chambers, once said that "history is littered with companies that bet against Cisco and lost." These kind of bravado-filled, awe-inspiring comments add to the notion that the champions of yesterday will remain invincible tomorrow.
The tide is turning for Cisco. Too many factors - both technological and political - are turning against it. That is why I re-iterate my Sell rating on Cisco. It is not a Sell rating forever. Just for now.
Below, I summarize the main arguments in my Sell note of 3 October 2013, which remain valid today, especially in light of Cisco's earnings call yesterday:
Cisco - Negative Outlook
For the first time in its history, Cisco is facing an existential threat. By value, Cisco supplies 59% of the world's switches, 53% of its routers and 52% of its data centre equipment. But the era of IP networking - which Cisco has comfortably dominated - is giving way to another technology cycle known as "software defined networking". SDN is a new architecture for telecom networks in which the emphasis shifts from hardware to software.
On traditional valuation metrics, Cisco looks cheap
Cisco current trades on a multiple of 11.5 times this year's earnings. Our valuation scorecard ranks it the fifth cheapest stock amongst 32 of its peers. However, Cisco is the market leader in a sector that is about to be heavily disrupted.
Cisco is a hardware company caught up in a software revolution
SDN technology will be hugely disruptive for Cisco because it fundamentally changes who controls the telecom network. Cisco's proprietary IP networking hardware will be threatened by open hardware standards. With networking hardware accounting for 78% of its revenues today, Cisco will have to transition into a software company to survive.
It faces a strategic dilemma
If Cisco ignores the open standards movement associated with SDN, it risks being side-lined. But if it embraces SDN technology too fast it could see revenues and earnings dip in the medium term. Officially, Cisco has chosen to engage with the SDN world. This is the right decision for its long term future. But in the medium term, its challenge is to adopt cutting edge SDN technology without cannibalizing its legacy hardware business. The problem is that virtually every market that Cisco operates in will be hit simultaneously by this disruptive threat, making its transition more difficult than for any of its rivals. Moreover, at 23.7%, Cisco's operating margins are the highest in its peer group and almost double the industry average. So it has further to fall.
The threat may not be imminent, but it will not go away
We are early in the SDN investment cycle. In 2012, the SDN equipment sector was worth less than $400m. So whilst Cisco's collapse is by no means imminent, if SDN technology gathers momentum, analysts could find themselves downgrading profit estimates for its core hardware business faster than they can upgrade estimates for its emerging SDN business.
Cisco may also get dragged into a dirty trade war over cyber-security
China and the US are in the midst of a trade war over telecom equipment. For years, the US has accused Huawei of being a national security threat, banning it from selling hardware to US telecom carriers. Now, with the Edward Snowden revelations, Cisco is suddenly in the firing line. The next two years could see weak sales in China, one of its most promising growth markets until the Snowden scandal broke.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.