This past Friday, news spread about the possibility of Amazon’s (AMZN) AWS selling its own network switches for business customers, which sent shares of Cisco (CSCO), Juniper Networks (JNPR) and Arista Networks (ANET) down 2-4%. Today, I will go through why a pair trade between long CSCO and short JNPR is a great way to play this news and the potential of AMZN entering this market.
CSCO continues to innovate and grow at a faster pace than JNPR while offering a more diverse set of products. For example, CSCO grew revenue 4% and EPS by 10% y/y based on its FQ3 results (ending April 30) while JNPR saw revenue decline 11% and EPS decline nearly 40% y/y for its FQ1 results (ending March 31). CSCO has also placed more focus on entering the software market, which typically grows much faster than hardware and produce greater margins. JNPR seems to be stuck in its legacy operations and has struggled to adjust. The below chart shows how CSCO and JNPR shares have traded in near opposite directions over the past year.
CSCO data by YCharts
What The AWS News Means
On Friday, news spread that AWS was looking to get into the networking switching market. Headlines noted that AWS would sell its own networking switches for business customers, bringing AMZN into the competitive enterprise computing market. The main players in this market have been legacy players; CSCO, JNPR, and ANET. These three players create hardware systems that are typically integrated into their customers’ infrastructure. Though news about AWS noted it may not enter the market for another 18 months, this potential would provide a new entrant into this market and may bring in a more software-centric opportunity. A CNBC article states:
“The devices make it easier to shepherd traffic around networks. In developing its own, AWS could facilitate the shifting of traffic onto its services and away from customers’ on premises systems. However, networking vendors are well entrenched in large companies’ data centers, and Amazon could face significant sales challenges convincing customers to swap existing gear. It would also be a significant departure from Amazon’s expertise in providing hosted cloud services.”
These data center networks assist in moving data from the customer’s data center to cloud infrastructures. Over the years, CSCO and some other legacy networking/switching companies have integrated security functionality (such as firewall and network security) directly into their infrastructure. AMZN does not have its own security product to offer unlike CSCO. Though JNPR does offer its own security products, CSCO’s security products have gained significant traction in the marketplace and are considered to be one of the top four firewall offerings, along with Palo Alto (PANW), Fortinet (NASDAQ:FTNT) and Check Point (CHKP). This provides CSCO with a direct competitive advantage over JNPR because enterprises are constantly looking for ways to make sure their infrastructure is secured appropriately. Customers who place a high emphasis on security will typically select CSCO over JNPR, thus, enabling CSCO to grow its market share.
The switches AMZN would plan to sell are generally referred to as “white box” solutions and rumors noted it could be selling these at a 70-80% discount. Thought AMZN is known for selling products at a discounted rate, it is hard to imagine it is able to get that big of a discount when CSCO is overwhelmingly the largest player in the market and has some sort of economies of scale.
White box solutions are generic pieces of hardware with no brand name on it, though these are generally manufactured by Broadcom (AVGO). White box solutions would provide AMZN the ability to get cheap pieces of infrastructure to build off of from there, rather than attempting to reconstruct the entire piece of hardware. These solutions can be run by a variety of operating systems. However, CSCO and JNPR have hardware solutions that are run entirely on proprietary operating systems, sometimes referred to ASICs.
Even if AMZN were able to get a bigger discount and sell its white box solutions at a lower price, the company would not be able to provide the same level of service as legacy players. CSCO’s infrastructure offerings utilize ASICs which enable higher-quality products that run more efficiently. The unwillingness of AMZN to sell ASIC solutions immediately puts it at a competitive disadvantage for customers looking to uniquely set up and control their infrastructure hardware.
Cisco Is Safe, Caution Around Juniper
CSCO has more cushion and is a safer bet than other competitors in this space because it offers a wider suite of hardware and software products that are typically fully integrated into an enterprise’s infrastructure. CSCO has slowly transitioned into the software market over the past few years which provides it a great advantage over other competitors. Though JNPR also offers software components, CSCO’s products are typically seen as more integrated into one’s infrastructure. This gives CSCO a competitive advantage because an enterprise is likely to utilize CSCO-based hardware/software products for their entire infrastructure rather than a blend of hardware/software products from several providers.
Enterprises would be more reluctant to completely “rip and replace” CSCO hardware out of their infrastructure in favor of AMZN’s white box solution. It is a very expensive process to “rip and replace” hardware from the infrastructure because this would require not only purchasing all new pieces of hardware, but also making sure the current software and operating system are compatible.
JNPR, on the other hand, does not have as prominent of software offerings and does not offer the complete suite of infrastructure products as CSCO. This gives CSCO a leg up in a head-to-head competition between the two companies and can be further exhibited by their revenue and EPS growth rates over the past few years. JNPR continues to decline on both top- and bottom-line while CSCO is adapting to the ever demanding software world we currently live in.
AMZN’s potential planned white box offering would also provide a challenging place for it to enter the market. In a lot of cases, these networking switches are used to help connect the data from an enterprise’s infrastructure to cloud providers. If AMZN were to start selling white boxes, it would be challenging to believe other cloud providers, such as Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Microsoft (NASDAQ:MSFT) would buy into these products, as they directly compete with AMZN. So, even if AMZN decides to enter this market, it has already isolated itself from key customers who look to utilize the cloud infrastructure of either GOOGL or MSFT.
In this valuation, I will not even attempt to justify any metric between AMZN and CSCO or JNPR. AMZN is at a whole different level in terms of comparable valuation metrics. However, CSCO and JNPR compete in very similar markets and should be valued using the same methodology.
CSCO has been growing top and bottom line at a faster rate than JNPR and consistently generates better cash flows. Because of CSCO’s diversification and entry into more software-centric areas, it maintains better margins and is less susceptible to downward swings in profitability.
CSCO PE Ratio (Forward) data by YCharts
Over the past year, the P/E multiples of both CSCO and JNPR have been relatively close to each other. From August 2017 to February 2018, these two companies traded off which was valued at a greater premium based on an earnings multiple. However, over the past six months, CSCO clearly has been trading at a greater earnings premium, though the gap between the two has narrowed over the past few weeks. Now that the two companies are traded in near parity in terms of earnings multiple, it is time to become more constructive of the two.
As discussed above, the threat of AMZN entering the networking switching market is less of an issue for CSCO and is a greater threat to JNPR. CSCO is the better overall company in terms of growth potential, product diversification, and ability to withstand competitive forces. The pair trading of buying CSCO and shorting JNPR should provide significant upside potential, even if AMZN does not enter the market in the near term.
Over the next 18 months, it would not be surprising if more articles surrounding AMZN entering this market hit the press, which would likely send the shares of both CSCO and JNPR down. However, due to CSCO’s relative competitive advantages in this market, I would listen to one of Warren Buffett’s best investing advice, “buy the dip”.
Disclosure: I am/we are long AMZN, CSCO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.