Cisco’s Narrow Moat Provides Competitive Firewall
#Cisco ‘s dominance in data networking is clear. Its Ethernet switches and routers, which move data along local computer networks, are considered the gold standard by network managers. The firm enjoys a 15%-plus market share advantage in the number of port shipments over #HP, its most significant competitor. Cisco is viewed as a premium provider, and as such, it extracts 50% more revenue per port than HP. Cisco’s carrier routers, used by telecom and cable service providers to move data across long distances, are also the market favorite. While #Huawei and ￼ #Nokia (NOK) have made recent inroads, Cisco still maintains a healthy global market share. Switches and routers account for nearly two thirds of Cisco’s product revenue. The remaining portion comes from a collection of faster-growing adjacent market segments such as wireless, security, collaboration, unified communications, and data center products. A string of recent acquisitions made by the company points to further investments in these areas. Given Cisco’s extensive product portfolio and broad reach into enterprises’ and service providers’ IT environments, we like management’s strategy of increasing its service capabilities, product integration, and software revenue. Services have been an area of strength for the company in recent years, as service revenue has grown faster than product sales and with less volatility. Also, service gross margins have recently pushed into the mid- to upper 60s, above the corporate average. Narrow Moat Protects Competitive Position We think Cisco’s competitive position will remain sound over the next 10 years, and this view is reflected in our narrow economic moat rating. The company’s massive installed base of switches, routers, firewalls, and UCS hardware deployed across businesses of all sizes provides a huge switching cost advantage based on a vast amount of knowledge and expertise amassed by network engineers. This advantage is supported by intangibles based on brand equity, the large scale of R&D investments, and expertise of support and services organization. Cisco’s mid-60s share of the enterprise LAN/WAN equipment revenue has been fairly stable. We anticipate a gradual decline to the mid-50s over the next 10 years as low-cost competitors present an increasingly compelling alternative, especially at the lower end of the market. For instance, today some enterprises may be compelled to deploy the commodity fixed 100Base/T switches from HP or Dell at the access layer while budget-minded SMB may opt for D-Link, Netgear, and Linksys options. Looking a few years further into the future, we will find generic so-called “white box” network switches underpinning the software-defined networking overlay as a growing alternative for many businesses. The existing ecosystem of channel partners, value-added resellers, and a skilled workforce provides Cisco with a revenue safe haven for numerous reasons. First, we believe IT managers are often more concerned about minimizing network disruptions than cutting costs and are reluctant to trial switches from less-proven vendors, particularly in mission-critical applications. Second, Cisco certification is still the de facto standard in network-related credentials. IT managers seek Cisco-certified employees to minimize training costs and risk, which in turn drives network engineers to seek these credentials. Third, the channel partners and VARs have accumulated the substantial expertise and talent needed to deploy Cisco networking gear and will be challenged to find the matching skills, expertise, and consequently, a revenue stream from the much-hyped white box/SDN approach. Finally, we think most enterprise IT departments are reluctant to support multivendor environments in Layer 2-3 switches because of increased complexity and compatibility concerns. New competitors would probably need to convince an IT manager to rip and replace multiple switches, a daunting task, rather than try to gain incremental adoption.