Why Investors Should Be Buying Alcatel-Lucent, Not Cisco

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Wedbush may have correctly identified future growth in IP switching, but has the wrong beneficiary.

ALU has beaten CSCO handily in IP routing the last several years.

With a deeper portfolio of products, ALU's growth may not slow; CSCO is showing no signs of growth.

On Tuesday Wedbush initiated coverage on Cisco (NASDAQ:CSCO) with an Outperform rating and a $31.50 price target. The driving force for the call was Cisco's leading share in the SDN market and expectations for IP switching to grow 7% in 2015. Cisco is the leader in IP switching, meaning it could have a lot to gain if Wedbush's estimates are accurate. However, the business solutions leader might encounter a problem - Alcatel-Lucent (ALU).

Specifically, Cisco's operating goal is to provide its many customers with a complete network experience that is entirely owned by Cisco itself. Cisco's goal to provide end-to-end business solutions was a driving force in the $5 billion Micros buy earlier this year. However, when Cisco discusses end-to-end solutions, it is often referring to IP routing and IP switching, businesses that relate to the connectivity and function of the business and the delivery of the internet. These businesses account for nearly 46% of Cisco's annual revenue and 70% of its operating profit.

That said, Cisco's IP routing and switching businesses have seen consistent declines throughout the last year. In fiscal 2014, Cisco's IP switching sales declined 5% to $14 billion while its IP routing revenue fell 7% to $7.6 billion. One reason for these losses is the two businesses are highly connected. Another is that Cisco is losing its edge as an end-to-end business service provider, especially in data centers as Alcatel-Lucent emerges as a major threat in IP routing, therefore putting pressure on Cisco's switching business.

Specifically, Alcatel-Lucent's IP routing business has quickly grown into a major piece of its annual revenue, nearly 20%. According to research firm Delloro, Alcatel-Lucent's IP routing business has grown at a compound annualized rate of 12.5% over the last decade. This includes a 10.3% increase in 2013. Even during a weak Q3, Alcatel's routing revenue grew 2.2% year-over-year.

While Alcatel-Lucent's Q3 routing revenue of $735 million hardly compares to the size of Cisco's similar business, it is clear that Alcatel-Lucent is causing havoc for the juggernaut, and has established itself as a threat in both core and edge routing. Notably, these are two markets where Cisco holds a comfortable lead in market share.

Albeit, Wedbush is initiating bullish coverage on Cisco in large part to its high expectations for IP switching, which also implies that IP routing is expected to perform well in 2015. The problem is that Cisco is yet to prove in recent quarters that it is the company to gain from this growth. Instead, Alcatel-Lucent may be the company with the most to gain, if in fact these estimates are an accurate reflection of future growth.

After all, Alcatel-Lucent has managed to grow rapidly in routing despite lacking the diversity of a company like Cisco. Therefore, three reasons suggest that it has a good chance to outperform Cisco and better capitalize on future demand. First, Alcatel-Lucent had been primarily relevant in the edge router space, which handles smaller quantities of traffic between networks. However, it has now entered the edge core routing space.

Second, Alcatel-Lucent just recently entered the virtual routing industry, which puts it two years behind Cisco, but also gives Alcatel-Lucent a fight in the fast-growing management of cloud networks. Alcatel might even have success in this market and grow its routing business even faster given its claim that the new product can handle twice as much data and has eight times the control plane performance (involved in communication between networks) as competing offerings (like Cisco).

Lastly, Alcatel's 7950 XRS core router is becoming a hot commodity in the IP routing space. In Alcatel-Lucent's last quarter alone, CenturyLink (NYSE:CTL) chose its 7950 XRS router to upgrade its broadband speeds to 1 gigabit per second in 16 seconds. Elsewhere, China Telecom (NYSE:CHA), China Unicom (NYSE:CHU) and China Mobile (NYSE:CHL) all chose Alcatel-Lucent's 7950 XRS core routers to meet growing fixed and mobile broadband demand. This helped Alcatel-Lucent's Asia-Pacific revenue soar 22.5% to $915 million, and implies that future growth in the region should be expected.

The bottom line is that Alcatel-Lucent has grown its routing business very fast over the last decade with a limited portfolio of products. But in recent memory, Alcatel-Lucent is investing more of its focus in routing, and expanding its portfolio with edge routers, virtual routers and the increasingly popular 7950 XRS. The reason for Alcatel-Lucent's historical success and current demand is anyone's guess. Clearly, some of its products are superior, like in virtual routing. However, the success might also have to do with better negotiating skills.

Notably, Alcatel-Lucent's operating margin from IP routing is about 10%, well above its company average, while Cisco and Juniper (NYSE:JNPR) top 20%. Thus, it is likely that Alcatel-Lucent is sacrificing margins to gain business, something Cisco investors would unlikely accept. All things considered, when you put all of these things together, the end result is that Alcatel-Lucent has more to gain in an improved IP environment than Cisco. If Wedbush's outlook is accurate, 2015 could be a big year for Alcatel-Lucent.

Disclosure: The author is long ALU.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.