J.P. Morgan analysts Rod Hall, Ashwin Kesireddy, Greg Schuck and Rajagopal Raghunathan downgrade Cisco Systems, Inc. (NASDAQ:CSCO) from Neutral to Underweight, as the company shows weakness in emerging markets service providers and the switching market pause in spending is a negative.

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In conjunction with a larger 2014 Outlook report also published today we are downgrading our Cisco Systems, Inc. (NASDAQ:CSCO) rating from Neutral to Underweight and lowering our December 2014 price target to $17. We believe that weakness in Emerging Markets Service Providers called out by Cisco Systems in their QTR earnings report combined with delayed spending in the switching market driven by SDN are negatives. We also update our bare metal impact analysis in EPS and find that lower OS pricing has materially lowered our central case “SDN translated” EPS to $1.67. A detailed price comparison of bare metal solutions with Cisco shows a large pricing gap that we believe will have to close for Cisco to  maintain share.

Switching price comparison

We publish a new pricing comparison of Cisco products to bare metal solutions and find bare metal to be 47%-52% less expensive per server on an Apples-to-Apples basis. We calculate that much of Cisco Systems, Inc. (NASDAQ:CSCO)’s premium is linked to support/license fees which may have to be reduced.

Emerging markets risk continuing for Cisco

Carrier revenue trends in major emerging markets look likely to weaken further in 2014. Specifically, Indian SPs revenue growth is forecast to decline to 5.3% (2013: 8.2%), Russian SPs to 3.4% (5.3%), Brazilian carriers to 3.8% (4.9%), Chinese carriers to 10.9% (14.6%) and Mexican SPs to remain at ~1%. We believe that these negative revenue trends combined with weak local currencies are likely to drive lower capital spending. We believe Cisco Systems, Inc. (NASDAQ:CSCO) has outsize exposure to these markets.

Switching market pause negative

We believe that the key US market is likely to pause for much of 2014 ahead of SDN product availability. Cisco Systems, Inc. (NASDAQ:CSCO)’s own products do not ship until April/May and we expect customers to then engage in testing which pushes purchases toward the end of the year. We see potential downside risk to our current switching market growth expectation of 1.5%.

Longer term bare metal impacts increasing

We update our EPS impact calculations first rolled out on July 1, 2013. Since then we have learned that switch OS prices are lower than we had anticipated. This causes our Central Case Cisco SDN EPS scenario to drop to $1.67 from $2.18 published in July.

Valuation rich vs. earning potential

Given that our central case now points to EPS of just $1.67 when SDN has had its full impact we find it tough to support Cisco Systems, Inc. (NASDAQ:CSCO)’s current share price. We apply a 10x PE to our central case EPS scenario and arrive at a $17 December 2014 price target for Cisco.