The 3 Biggest Challenges Facing Cisco Systems

By Markets

Networking giant Cisco (NASDAQ: CSCO) isn't a high growth stock, but it's generally considered a solid income play which delivers fairly predictable returns in volatile markets. Cisco's P/E of 14 is lower than the industry average of 25 for networking equipment companies, and its forward yield of 3.5% is higher than the S&P 500's average yield of 2.1%.

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While those numbers will likely set a floor under Cisco's stock, a few headwinds could also prevent it from moving much higher. Let's discuss three of those biggest challenges.

1. Competition in switches and routers

Cisco is the world's largest vendor of ethernet switches and routers. However, it's been losing market share in both markets to rivals like Huawei and HPE (NYSE: HPE). IDC reported that between the first andsecond quarters of 2016, Cisco's share of the switching market fell from 59% to 56.8%, and its share of the combined router and service provider market slipped from 48.8% to 44.8%.

That's a big problem, since Cisco's combined switches and routers revenue accounted for nearly halfof its top line last year. In the past, Cisco marginalized smaller rivals like Aruba Networks with aggressive hardware and software bundling tactics. But now that many of the smaller players have either been beaten or acquired, larger companies are striking back with their own bundling plays.

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Huawei, the largest wireless infrastructure company in the world, is leveraging that leading market position to sell switches and routers to telcos and large businesses. HPE, whichacquired Aruba last year to increase its scale in both switches and routers, is also bundling its networking hardware with various other IT services.

2. The rise of cloud networking

A newer challenge for Cisco is the rise of cloud networking solutions which rely more on software instead of hardware. These platforms, also known as SDN (software-defined networking) ones, are often more cost efficient and scalable than older hardware-based networks.

Last year, Credit Suisse analyst Kulbinder Garcha declared thatSDN platforms will simplify networking, hurt demand for Cisco's traditional networking equipment, and "shrink gross profit dollars for the networking stack." Guggenheim analyst Ryan Hutchinson also warned that Cisco's outlook was clouded by "uncertainty around future network architectures as more workloads migrate to the cloud."

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Cisco's biggest adversary in this space is Arista Networks (NYSE: ANET), which has posted double-digit sales growth for seven straight quarters. Cisco has tried to slow Arista downwith patent infringement lawsuits, which resulted in import bans on some of its products. The International Trade Commission and U.S. Trade Representative bothupheld that ban earlier this year in separate rulings. That ban throws a few hurdles in Arista's way, but it might not prevent Cisco from falling behind a crucial tech curve.

3. Inorganically growing its security business

Cisco's security revenue rose 13% last year, making it the company's fastest growing business. While the business merely accounted for 4% of its top line, Cisco has been aggressively growing it by acquiring cybersecurity firms like ThreatGRID, SourceFire, OpenDNS, and Lancope. That growth makes Cisco an oft-cited threat to smaller cybersecurity companies. However, many smaller players have "best in breed" reputations in certain markets which Cisco lacks.

For example, Palo Alto Networks' (NYSE: PANW) firewalls areapproved by a large number of agencies, including the U.S. Department of Defense. Threat prevention firm FireEye (NASDAQ: FEYE) was thefirst cybersecurity company to be certified by the U.S. Department of Homeland Security.

Therefore, instead of developing better security platforms than these leaders, Cisco might need to acquire them instead. That's why there are persistent rumors about Cisco buying smaller players like FireEye or Imperva. However, many of these companies aren't profitable and are trading at high valuations -- meaning that Cisco's cybersecurity expansion could be costly relative to the actual revenue and profits it generates.

Is Cisco still a worthy investment?

I believe that Cisco is still a solid long-term investment, thanks to its dominant position in the networking market, growth opportunities in the Internet of Things and across 5G networks, and expansion into higher growth markets like service provider video, collaboration, and security solutions. However, I also believe investors should carefully evaluate these headwinds, which could cause Cisco's top line growth to remain stagnant over the next few years.

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Leo Sun owns shares of Cisco Systems. The Motley Fool owns shares of and recommends Arista Networks and FireEye. The Motley Fool recommends Cisco Systems and Palo Alto Networks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.