Is Open Compute Project A Threat To Cisco?

  • Is Facebook's "Open Compute Project" going to adversely affect Cisco's sales and margins? Guidance will provide the clues
  • Can China keep growing like it did last quarter keeping in mind the turbulence we have seen in its equity markets so far this year?
  • Cisco has a strong balance sheet but can it buy itself out of trouble if hardware sales continue to languish?

Cisco (NASDAQ:CSCO) will announce its earnings for its fiscal 2nd quarter on the 10th of February and the average estimate is an EPS of $0.54 on revenues of $11.76 billion. Compared to the same quarter in 2015, estimates are light on the revenue side while earnings are slightly higher than Q2-2015 which illustrates that margins remain robust - a metric this company has long been renowned for. Even though earnings were strong in Q1 with revenues up 4% and earnings up 8%, the stock sold off after Q2 guidance was announced. Cisco has a very good opportunity of beating estimates in its second quarter due to 1) its lower guidance and 2) Cisco stock has beaten estimates in every quarter since 2011 illustrating the conservative stance in guidance of this company.

Therefore, since its almost a given that the company will beat estimates, Cisco has to provide the market with forward looking momentum. Although switching revenues grew by 5% in the last quarter, the underlying theme with Cisco is that its principal divisions (routing & switching which provide stellar margins) will come under pressure in the years to come due to elevated competition and an ongoing industry shift to white box manufacturers and cloud based solutions.

However, Cisco has been doing really well in other parts of its business such as Data Center and Collaboration both of which rose at double digit rates in the first quarter. Cisco will need more of this especially from its service division which only grew at 1% last quarter.

The reason why this earnings announcement is so important is because major telecommunication companies such as Verizon (NYSE:VZ) and AT&T (NYSE:T) have joined Facebook (NASDAQ:FB) non profit "Open Compute Project" which is a initiative that enables the collaboration of end user companies where they can design and source far cheaper industry standard hardware than from the likes of Cisco or Juniper Networks (NYSE:JNPR).

Verizon and AT&T, for example, will undoubtedly need more bandwidth in the future in order to keep rolling out their networks and Facebook's initiative is definitely going to involve far cheaper (likely from China) manufacturers of servers, storage gear and networks. What does this mean for Cisco? Well, the company has repeatedly played down any threat of the Open Compute Project stating that OCP equipment will take a long time to be standard practice in the industry especially when you consider the time-consuming stages such as design, installation and commissioning.

Nevertheless, one would think that Cisco's stellar margins will come under pressure if OCP gains traction as the US carriers for example (which don't have the strongest of balance sheets) will be open to exploring any avenues where they can save costs on required equipment. Guidance will be the key again when earnings are announced. Cisco needs switching to remain buoyant whilst routing growth needs to return to the green.

Another growth trigger that the market will be focusing on will be the Chinese market which was positive in Cisco's first quarter. Cisco reported 40% growth in Chinese orders which was the first positive growth in 2 and a half years. Investors shouldn't underestimate the value the market places on a market like China. It may be only providing 4% of Cisco's current revenues but it is a huge market dominated by the likes of Huawei so meaningful market share gains will have huge impact.

Cisco's way of getting around blocking attempts by the Chinese government (against US multinationals due to national security concerns) is to partner up with companies in China. Last September, Cisco formed a $100 million partnership with Inspur where Cisco's equipment would be sold under the Inspur umbrella and both companies would co-operate to develop new hardware.

This agreement came on the back of a $10 billion commitment by Cisco into China over the next few years to really boost its profile in the region and increase sales. Watch growth in this region when earnings are announced. If routing and switching continue to languish in developed markets, Wall Street will need to see outperforming growth in China to be convinced that over time other divisions and geographies can offset structural declines in its core business.

In terms of trading Cisco at earnings, Cisco stock currently has an implied volatility rank of 91 (implied volatility measured against itself) which is high meaning option premium is inflated. On the valuation front, Cisco stock currently has a p/e ratio of 12.6 and a price to sales ratio of 2.4 which are both below the company's 5 year average. Furthermore, dividend increase looks set to continue when you consider the company printed $11.33 billion in free cash flow last year but the dividend only costs $4.26 billion.

Long term debt only consumes about 30% of the company's equity which illustrates the strength of the company's balance sheet especially its cash position ($60.42 billion). With a balance sheet this strong, you have to back the recent acquisitions and partnerships it has done (Apple & Ericsson) as some of them no doubt are bound to do extremely well. Nevertheless, I'm cautious about weak guidance and a stronger dollar over the last 3 months so selling in the money puts or even waiting for Cisco stock to fall some more may be the prudent play here.

To sum up, I believe Cisco will again report an earnings beat but it will be guidance once more which will move the stock. Management has already stated that routing sales will return to normality this quarter which will definitely be a tailwind. Switching needs to keep its momentum going and data centers and collaboration need to at least match growth rates recorded in Q1.

Uncertainty surrounds Cisco stock because of Facebook's Open Compute Project especially by US carriers which are Cisco's big customers on the routing side. Again guidance and commentary here will be key. Finally, Cisco's service division growth needs to stay in the black as it provided over $2.8 billion in sales last quarter. This division also has stellar margins so meaningful growth here would definitely help the bottom line

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Comments on this article and CSCO stock

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Open Compute is major threat when tied to Amazon Web Services.

If more and more companies shut down their data centers and move to Amazon Web Services, less Cisco products will be purchased. One company, Amazon, will buy more but they are more likely to move to Open Compute.

Use NetFlix as an example. They moved all their data centers to AWS. I'm sure their usage of CISCO products is much lowers on AWS infrastructure than it was on their own infrastructure.

Amazon can use it's scale for AWS to really push Open Compute and push out CISCO.
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