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Cisco Systems, Inc. (CSCO): Why Weakness In Cisco Shares Is A Buying Opportunity?

 March 07, 2014 12:52 PM

The recent weakness in Cisco Systems, Inc. (NASDAQ:CSCO) shares present investors a buying opportunity as the networking gear maker is set for long-term growth opportunities in wireless telecom networks. These opportunities will act as a fillip to Cisco as major carriers look to upgrade their networks to cope with the potential surge in data traffic.

The several architectural transitions that Cisco's new (and upcoming) platforms are targeting could be appealing for value and growth investors in fiscal 2015/16, especially on a near-term pullback.

A key architectural transition is the 10/40GE Leaf and Spine switching opportunity, based on the cost-reduced Broadcom Trident2 silicon based Nexus 9k switches. The blended 10/40GE switching market likely is growing in the 20 percent range.

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Deutsche Bank analyst Brian Modoff says the blended ASP/port for Cisco's Nexus switching business is likely to be accretive in the fiscal 2015 timeframe given 40GE seeing high double-digit growth rate trends and 10GE in the high teens.

Meanwhile, the 40GE port is currently pricing 2-3 times of the price of 10GE ports, 10GE Leaf switches and 40GE. Spine switches are a preferred architecture for Cloud-Scale Networks – i.e. for data-centers running several 1000s of servers and switch ports.

Further, the 10/40GE architectural transition is a long tail upgrade cycle, given that less than 25 percent of Top of Rack switch ports are currently 10GE and 40GE relatively early stage in its deployment cycle in Spine switches.

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Therefore, Modoff believes that Cisco could drive overall revenue growth in their datacenter switching business in fiscal 2015 and beyond, given the ASP accretive 40GE Modular switch refresh cycle and also from the 1GE to 10GE refresh cycle in the Top of Rack.

While the bear case for Cisco centers around accelerated ASP/port and market share erosion from the whitebox switching vendors, the risk factors to gross margins (a key metric for the stock) are overstated in the near-term.

The newer cost-reduced Nexus 9k switches are likely a mid 60s gross margin portfolio for Cisco at current ASP/port levels in the market – i.e. in the $200/port range for 10GE Rack Top switches; $900/port for 10GE Modular Spine switches; and with 40GE port pricing likely 2-3 times of 10GE price points.

As such, unlike prior multi quarter cost reduction episodes for the Nexus 7k and for the 5k, Cisco could be situationally competitive on pricing – especially in the Web 2.0 and Cloud segment – and run the Nexus switching business at slightly above corporate gross margin levels.

Modoff notes that the gross margin erosion thesis from competitive solutions is overstated in the near term, given the cost-reduced merchant silicon switching platforms (Nexus 9k, 3k, etc).

In addition, value propositions such as the cost reduced 40GE BiDi optics, the enterprise data-center feature sets, and software solutions such as the virtual overlay fabric, Cloud scale analytics are likely to be the drivers of architectural stickiness and share stability in enterprise data-centers over the next few years.

Meanwhile, Cisco is likely to introduce several new Cloud IT service offerings (likely at above corporate gross margin levels) in the July quarter and in fiscal 2015 and beyond. These IT service offerings are likely to be in the areas of Enterprise Network Security, Managed Campus Networking as Cisco is leveraging the Meraki acquisition.

Modoff views that management need to look to proactively transition several of their enterprise and service provider product assets into Cloud IT services.

Cisco's services business is a long tail growth opportunity for the company if management successfully executed on building a portfolio of high value Cloud IT service assets. This segment has a high barrier to competitive entry, especially at global scale.

While Cisco's service provider routing and video business are likely to see weak revenue growth trends over the next few quarters, an optimistic scenario for fiscal 2015/16 is the potential for Cisco to accelerate sales of virtual layer 2/7 appliances in Telecom Network Functions Virtualization (NFV) opportunities.

NFV – i.e. running various layer 2/7 network assets as virtualized features on off the shelf hardware and leveraging software tools such as service orchestration for dynamic service creation and delivery – is a game changer for the networking vendors (Cisco, Juniper, F5, etc) – especially from a share gains and margin accretion point of view.

Modoff believes that Cisco is likely to sell several of its hardware based platform assets such as LTE Evolved Packet Core, Access Edge Routing, Mobile Network Firewalls, etc as virtual appliances in the 2015/16+ timeframe.

Sales of virtual appliances and associated software tools are likely to be gross margin accretive for Cisco while the virtual layer 2/7 assets are likely to be sold at a slight price discount versus HW based systems. Moreover, the architectural stickiness of virtualized software based assets in service provider networks would act as another selling feature.



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