Cisco Will Rise Sharply On Transition In 2013

| About: Cisco Systems, (CSCO)

Cisco (NASDAQ:CSCO) often feels like a one trick pony. It trumpets networking and has done it well for many years now. However, being so invested in one market is problematic when you fail to see a major change or opportunity coming. This is exactly what happened to Cisco. It did not adapt to the rapid growth of data centers and is now playing catch up. This will bring mixed results.

Cisco, with its heavy reliance on mergers and acquisitions, is looking to acquire its way back to prominence in the market. It recently invested $100 million in a networking start-up called Insieme. Cisco is using a spin-in to acquire Insieme, meaning Cisco invests $100 million today, with the option of purchasing the company at a later date for up to $750 million. By doing this, Cisco eliminates the chance that Insieme with directly compete against it in a market it is already struggling in.

To be more specific, Insieme is a startup in software-defined networking (SDN), "which is expected to be a cheap and efficient way to deploy large cloud computing systems." Additionally, software-defined networking allows those operating data centers to separate the physical infrastructure from the management of it. This means that networking equipment will become less expensive as companies will not need to rely on networking experts to operate and deploy them.

Some believe that software-defined networking will cause routers to become commodities. If this does occur, Cisco will take a huge hit, as its value will erode. It's a scary prospect for Cisco, and so it must make sure to prepare accordingly.

Make no mistake, Cisco is scrambling to ensure it does not miss the mark this time. Its CTO, David Ward, signaled it is developing different interfaces and functionality for its networking equipment. I do not expect this to change very much or slow down the adaptation of software-defined networking. In the software industry, disruption is rarely stifled. Typically, if a new breakthrough is going to occur, adding functionality or other features merely buys a company time.

On the bright side, Cisco may not need these interfaces and functionality anyways. It turns out that some of the companies that foresaw the rapid growth of data centers might look back to Cisco. Notably, Google (NASDAQ:GOOG), one of the first companies to build its own data center, wants Cisco to be a major part of the software-defined networking market. For Google, and many other companies, leaving its networking to a start-up that it has not developed trust in, is not desirable. Hopefully for Cisco, more tech companies will agree. Perhaps Cisco's greatest strength moving forward, then, will be its name and past reputation.

Another major source of concern regarding software-defined networking is Cisco's certification programs. While they are not its main source of income, Cisco's networking certification programs provide a steady source of revenue. In fact, it recently launched a new program in configuring and troubleshooting its networks. If software-defined networking separates the infrastructure and the management of it, I anticipate the revenue from these certification programs will dry up.

In the light of these new developments, Cisco has done a good job of seeming cool-headed. There is no doubt that software-defined networking frightens Cisco very much. At this point, if Cisco were to fall behind, it would need to undertake extreme measures to catch up. Luckily, it has deep pockets. I expect it is watching developments surrounding software-defined networking extremely closely.

Cisco's typical competition is much further behind in these developments, as the recession eliminated a majority of demand for networking equipment. Take Juniper Networks (NYSE:JNPR) for example. Its long-term prospects are so stagnant that its stock has become popular among speculators. Juniper missed out on the rapid growth of data centers the same way Cisco did, but it has not been quick to react to other prospects. Combined with a macroeconomic environment not favorable to networking companies, Juniper's net income fell by 88% in the past year.

Similarly, Alcatel-Lucent (ALU) is also hurting due to a poor economic environment. This has led to an operating loss in the first fiscal quarter. Unfortunately for Alcatel-Lucent, as a French company, it will continually be squeezed harder than its competition as long as the euro crisis keeps popping up. This is just one reason its stock was recently downgraded to underperform.

There are two other companies that should be watched closely however. Both F5 Networks, (NASDAQ:FFIV) and Hewlett-Packard (NYSE:HPQ) are making big gains on the cloud-computing side of networking. Unlike Alcatel-Lucent and Juniper Networks, F5 Networks was recently upgraded by analysts, and is seeing substantial growth. Hewlett-Packard has also been experiencing modest growth due to cloud computing.

Both F5 Networks and Hewlett-Packard are players in the networking game. The addition of cloud computing has the potential to make a switch to software-defined networking very easy for these two companies. Unlike Cisco, which isn't a player in cloud computing, Hewlett-Packard and F5 Networks can absorb a loss in revenue from networking equipment due to the cloud computing revenue each will receive from the switch.

Cisco is certainly not a bad stock to own. Anemic growth of competitors Alcatel-Lucent and Juniper Networks puts Cisco in a great position competitively. The major question is whether Cisco will allow itself to fall behind on the next big transition in networking. Right now, I believe the jury is out. Cisco is trying very hard to ensure it does not miss out on the next transition, but it has very little innovation to suggest it will be a major player. My advice would be to watch Cisco very carefully. It is a networking juggernaut, and if it times the transition to software-defined networking well, it is in a good position to reap the rewards.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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