HP -- Cisco's Worst Enemy?

SAN JOSE, Calif. ( TheStreet) -- Embattled Cisco, ( CSCO) which reports its third-quarter results after market close, is starting to feel the switching strain as one-time partner HP ( HPQ) continues its attack against Cisco's core networking business.

"It is very obvious that HP is gaining market share in the switch business," said Kaushik Roy, an analyst at Wedbush Morgan, in an email to TheStreet. Roy said that HP competes aggressively with Cisco on price of core gear. "Many customers are comfortable buying switches from HP because of the HP brand and support, even if these switches don't have all the bells and whistles of a Cisco switch."
Cisco's decision to enter the server market may be coming back to haunt the networking giant.

Cisco's networking gear is widely lauded, particularly when it comes to handling with high-volume enterprise traffic.

But rivals -- specifically HP -- are eroding Cisco's market share. HP estimates that it gained 2.3% of switch revenue share in 2009 and 2010, and the trend looks set to continue. Revenue from HP's enterprise servers, storage and networking division climbed 22% during the company's recent fiscal first-quarter results, with HP noting particular strength in its networking products.

At the same time, Cisco's struggles in the consumer market signal that strength in its core networking products is more important than ever. Switch sales accounted for about 40% of Cisco's revenue during its recent fiscal second quarter, but they dipped 7% year over year.

Tech Giant Frenemies

Relations between Cisco and HP soured rapidly after Cisco unveiled its UCS server technology more than two years ago, effectively stomping on its partner's toes. HP, like a spurned Silicon Valley lover, hooked up with switch maker 3Com in a $2.7 billion deal, and started to throw resources at its own ProCurve products, clearly a move to get back at Cisco.

HP's latest jab at Cisco occurred earlier this week, when it unveiled its FlexNetwork architecture. FlexNetwork is a way for customers to build highly flexible, open source networking infrastructures, part of HP's broader tech services push to move customers away from Cisco.

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Wedbush Morgan's Roy told TheStreet that HP can happily take gross margins of more than 30% in its switch products because the company's overall corporate margins are at around 24%. "HP has lot of room to cut prices on the switches, without hurting its overall corporate gross margins," he said. "On the other hand, Cisco has been enjoying fat gross margins in the 60s -- it is harder for them to take gross margins in the 50s or 40s."

Even Cisco CEO John Chambers acknowledged his company's switch travails during the recent Wells Fargo technology conference. "Switching is our challenge, it's going to be a tough market for us," he said, adding that unnamed competitors are attacking Cisco on price while others are taking a leaf from Cisco's book and using their own silicon to build switches.

This is a key issue, particularly at a time when companies like Juniper ( JNPR) are also hitting Cisco's key market. "It's not only HP, but Brocade ( BRCD) and Juniper that are putting pricing pressure on Cisco," said Brian Marshall, an analyst at Gleacher & Company, in an email to TheStreet.

Cisco, which is now frantically attempting to resolve its execution problems and revive its flagging share price, can hardly be welcoming this type of distraction.

Despite holding the lion's share of the enterprise switching and routing market, Cisco has launched a major offensive in an effort to reorganize, and is undergoing some major internal changes.

Earlier this week, the company said that David Yen, who led development of Juniper's acclaimed QFabric switch technology, has joined Cisco. In his new role, Yen will head up Cisco's UCS and Nexus server access switching businesses.

As for UCS, Cisco says that the technology is gaining rapid traction among enterprises, with the product's annual run rate increasing to $650 million at the end of the second quarter, up from $500 million in the first quarter. The big question remains whether UCS sales can continue to ramp up quickly enough to offset HP's networking onslaught.

At this stage, though, particularly with Cisco scrambling to get its house in order, the jury is still out on whether the decision to retaliate against HP was a wise one.

In terms of third-quarter metrics, analysts surveyed by Thomson Reuters expect Cisco to quarterly revenue of $10.86 billion and earnings of 37 cents a share, compared to $10.4 billion and 42 cents a share in the prior year's quarter.

Investors will also be watching Cisco's June quarter outlook, which analysts expect to come in at 42 cents a share on $11.67 billion in revenue.

--Written by James Rogers in New York.

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