Big Trends Are Underway as Cisco Reports Earnings

Big Trends Are Underway as Cisco Reports Earnings

Expectations are low going into networking giant Cisco's earnings report after market close. Last quarter, the company posted solid revenue and earnings growth, but a combination of weak guidance and planned layoffs spooked investors. The stock sunk on the news, and today it still sits well below the pre-earnings level.

The biggest threat
Cisco has a dominant share in its core switching market, and its proprietary hardware allows the company to achieve impressive margins. Network switches form the backbone of the Internet, receiving data and sending it to the correct destination. But a shift toward software-defined networking, or SDN, threatens Cisco's outsized profits.

SDN essentially allows software to manage the flow of data, and this means that commodity hardware can be used instead of proprietary hardware. This is bad news for Cisco, since its profitability depends on selling its specialized hardware. Shifting to an SDN solution would, according to this report, cut Cisco's revenue in half.

Competitors keen on taking some of Cisco's market share are launching SDN products of their own. Juniper Networks recently launched OpenContrail, an open-source SDN controller. A commercial version is also available, with Juniper charging a subscription fee for support.

With Juniper having a tiny switch market share compared to Cisco, the open-source strategy may make sense. After being unable to effectively compete with Cisco in hardware, jumping on the SDN bandwagon is likely the best move for the company.

Instead of pushing SDN and eschewing hardware, Cisco has adopted a hybrid approach. On Nov. 6, Cisco launched its Insieme line of products, a set of switches, software, and APIs which offer an alternative to other SDN products. These switches can dynamically adapt to an application's needs, and the APIs provide a high level of programmability.

Cisco is betting that its huge install base will stick with the company's products instead of switching to a different platform, and that its margins will be protected in the process.

While Insieme won't show up on the upcoming earnings report, next quarter's report should provide details on how the new product is performing. The company may discuss Insieme in its conference call, and investors should definitely tune in to get a sense of Cisco's strategy going forward.

New markets
Cisco has been trying to diversify beyond its core markets, and recent acquisitions and investments are driving that effort forward. Cisco recently invested in an unnamed start-up with the aim of pushing into the mobile base station market, and in September Cisco bought solid-state memory company Whiptail. These come a few months after Cisco announced the acquisition of Sourcefire, a leader in cybersecurity solutions.

Non-core businesses have been growing quickly at Cisco, but they still make up a minority of revenue and profits. The push into cybersecurity is particularly notable, as recent cases of large-scale hacking of governments and corporations have made clear the need for more security. Cisco is positioning itself to take advantage of this trend, and its size and resources should give it an edge against competitors like Palo Alto Networks .

Palo Alto is tiny compared to Cisco, with annual revenue of about $400 million. With estimates that the IT security industry will grow tenfold in the next decade, revenue should continue to grow at an impressive pace. Palo Alto still hasn't found consistent profitability, though, with the company losing $29 million in the fiscal year that ended in July.

It's difficult to tell which company will become the leader in the cybersecurity industry, but Cisco has the benefit of highly profitable businesses which can fund growth, both organically and through more acquisitions.

Analysts are expecting EPS of $0.51 for the quarter, slightly above the $0.48 reported in the same quarter last year. Revenue is expected to grow by 4% year over year, the midpoint of the company's prior guidance.

Cisco is a slow-growing company, and any kind of beat or miss will likely be small. Quarter-to-quarter results don't matter very much for a company of Cisco's size, with the long-term trends proving to be far more important. The conference call is what investors will be watching, as CEO John Chambers talks about the state of the company and the world economy as a whole.

The bottom line
The numbers aren't as important as the commentary from management when Cisco reports earnings on Wednesday. Guidance for next quarter -- as well as trends in the industry -- should provide more meaningful information for investors than the financial results themselves. I encourage all investors to listen to the conference call, or read a transcript, and look beyond the numbers.

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Timothy Green owns shares of Cisco Systems. The Motley Fool recommends Cisco Systems. 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.

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Originally published