Sector Overview: Networking

The economic downturn has slowed down sales in the networking world: a recent report, “Service Provider Routers and Switches”, from Infonetics Research shows that sales of service provider switches and IP core and edge routers have declined 4% sequentially to $3.3 billion in Q308. Networking giant Cisco, which was the first to warn of an economic slowdown, has seen its revenue growth slow down and its market share slide while competitors have gained share. Let’s take a closer look.

The Infonetics report says that the North American carrier router and switch market has declined significantly. The Europe, Middle East, and Africa region (EMEA) is up, and Asia-Pacific is flat. Cisco, in its recent earnings report, said that the slowdown has spread to Europe, emerging countries and Asia, where Huawei has been a strong performer. Huawei’s cost structure and the infrastructure build-up in China has certainly played in its favor.

Another report on the service provider router market from Dell’Oro Group says that Cisco’s market share has dropped from 57% in Q208 to 51% in Q3. The company’s revenue declined 10% sequentially and though it still tops the market, its top four competitors, Juniper, Alcatel-Lucent, Huawei and Redback have gained share. Juniper has 25%, Alcatel 10% and Huawei 7%. In earlier posts, I have hinted at consolidation among Cisco’s competitors to take on the giant. The recession presents a great opportunity to consolidate, and strike Cisco where their cost-structure puts them at a disadvantage.

According to a report from Synergy Research Group, Cisco’s share in Service Provider Edge Routers market slipped from 60.14% in Q208 to 55.84% in Q308 while Alcatel, Juniper, Redback, Tellabs, Foundry and Extreme have gained share. Cisco has added ASR 9000 to its edge router portfolio, and it remains to be seen if this will help the company increase market share.

Though Alcatel is at No.2 in the edge router market, its weakening carrier business is bringing it down. The company has a new CEO, Ben Verwaayen, who it hopes can turn the company around. Alcatel recently reported a $52 million loss in Q3 versus a $1.1 billion loss in Q2 and has yet to report a profit since its merger with Lucent three years ago. Alcatel-Lucent had annual revenue of $26.2 billion in 2007, and its market cap is around $4.45 billion. It is currently trading around $2 after hitting a 52-week low of $1.74 on November 21. Clearly, a massive restructuring is under way at the company.

Nortel is another company that is ailing due to its optical and carrier Ethernet business and has announced plans to sell it. The company’s 2007 revenue was $10.9 billion and its market cap is around $273 million. It is currently trading around $0.55 after hitting a 52-week low of $0.50 on November 19. Also a massive restructuring going on, and in the current economic environment, both Nortel and Alcatel look positively precarious.

Juniper, with annual revenue of $2.8 billion, is Cisco’s strongest competitor and has its house in order. (Read the latest earnings coverage available here.) It is therefore at No.2 on my Top 10 Networking Stockslist. Juniper is currently trading around $16 after hitting a 52-week low of $13.29 on November 20. Market cap is about $8.6 billlion.

3Com, another rival for Cisco that also has strong ties in China, is currently trading around $2 with market cap of about $807 million. 52-week low was $1.43 on November 21. In 2007, annual revenue was $1.3 billion. Early in the year, the Bain Capital’s proposed acquisition of 3Com fell through. As part of the deal, Huawei would have acquired a minority stake in 3Com. Now, with the Chinese cost structure, 3Com can give Cisco a run for their money with customers who are looking for cost-effective solutions.

Though Cisco has lost market share recently, it definitely is still the strongest company in the sector. It remains to be seen whether this market share loss will continue in subsequent quarters or is an anomaly. Latest earnings coverage is available here. The stock is currently trading around $16 after hitting a 52-week low of $14.20 on November 21. Market cap is about $93 billion and 2007 annual revenue was $39.5 billion.

Overall, the stocks to potentially make money on in Networking are Juniper and 3Com. Cisco, with slowing growth, despite being a great company, is not where investors would make much. Avoid Alcatel and Nortel for a long time yet.

This segment is a part in the series : Sector Overview