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Why Cisco Isn't Going Anywhere Fast

By Olga Kharif John Chambers, the 52-year-old CEO of Cisco Systems, began his keynote speech at the Bank of America Securities conference in San Francisco on Sept. 23 by asking investors to pay no heed to his body language. "I'm in a good mood because I spent the weekend with my adult children," he said. "If I look tired, it's because I ran about 20 miles, and my body doesn't handle that as well as it used to." Yet neither his mood nor his fatigue could mask Chambers' message to analysts: The networking giant (CSCO) has little to smile about when it comes to the short-term outlook.

After corporate executives returned from their summer vacations in September, they didn't rush out as predicted to buy Cisco switches and routers, which are used in telecommunications networks. Its order backlog fell 30% over the past year, to $1.4 billion, while its book-to-bill ratio is below 1 -- suggesting that sales could fall off from current levels. A 10% decline in bookings could lower Cisco's revenues sequentially for 2003's fiscal first quarter, which ends Oct. 31, according to Salomon Smith Barney. Cisco's guidance has been for flat to slight sequential revenue growth in the same period.

Its stock is trading near its September, 2001, low of $11.43 -- cheap if you're in this sector for the long haul, but still a bit high for the near term, says Brian Miller, senior equity analyst with Invesco's $389 million telecom fund (ISWCX), where Cisco is a top-three holding. Its current stock price assumes a 12%-plus annual revenue growth rate. But if Cisco's sales rise only 5% to 10% a year, as the current outlook suggests, its shares would be fairly valued at around $7 or $8, Miller says.

MARGIN PRESSURE? Slower growth seems inevitable. Cisco's corporate customers, contributing almost 80% of revenues, are stalled themselves. Internet service providers (ISPs) and phone companies, accounting for more than 20% of sales, have cut capital spending 42% in the U.S. this year -- and could slash budgets further, according to Lehman Brothers. Case in point: On Sept. 27, telecom SBC Communications (SBC) announced it would reduce 2003 capital spending to a range of $5 billion to $6 billion, a drop of 25% to 38%.

Cisco's gross margins could also come down in the months ahead. In 2002's second quarter, they climbed to 67.7%, up from 63.1% in the previous quarter and 57.6% in the one before that. "We are at our pre-bubble financial metrics," Chambers told the San Francisco conference. But much of the increase came from favorable inventory accounting and can't be expected to last, cautions Michael Davies, an analyst with investment bank Caris & Co., who downgraded the stock from buy to neutral on Sept. 27.

Cisco declined to comment on its margins. But they could slip back to between 62% and 63% because it has been selling more low-margin products, estimates Davies. While routers contributed 30% of Cisco's revenue and the less-expensive switches accounted for 40% in its fiscal third quarter, the revenue mix in the final quarter, which ended July 27, had changed to 27% from routers and 42% from switches. That's because so-called layer 3 switches, where Cisco holds 70% market share, are cannibalizing router sales. The switch performs many of the router's functions in directing calls and data through a telecom network but costs less.

HONING ITS EDGE. Certainly, Cisco has shown remarkable resilience. Its revenues in the quarter ended in July rose 12% year-over-year, to $4.8 billion, while rival Juniper Networks (JNPR) suffered a 42% year-over-year revenue decline for its latest quarter. Cisco had $9.5 billion in cash as of July and is profitable, with net income of $772 million in its latest quarter. "It's managing its affairs as well as it can, given the environment," says Henry Asher, who runs New York-based Northstar Group, which holds some Cisco shares. Adds Asher: "They are simply not able to grow at an appreciable rate."

That doesn't help the stock in the short term, but Cisco is laying the groundwork for regaining its momentum as an Internet product king. Even though it lost 6.6 percentage points of its share in routers in the past year, reducing its dominant position to 65% of the market, the losses shouldn't be mourned, says Paul Strauss, research director of networking at IDC. Cisco lost share at the low-end of the market, where margins are slim, says Strauss. But it increased share in pricier routers, rising from 58.3% in the second quarter of 2001 to 66.4% in the same period of 2002.

Still, that's not enough to offset the shift to lower-margin switches. Its share in the popular level 3 switches rose from 58.4% in the second quarter of 2001 to 69.7% in the same quarter of 2002, Strauss estimates.

WIRELESS OPPORTUNITIES. Cisco hopes to gain a competitive edge by expanding its noncore lines. New products, such as optical switches, could eventually allow it to take some ISP and telecom business from entrenched vendors like Nortel Networks (NT), analysts say. That's doubtful, says Nortel spokesperson David Chamberlin. "We've held the No. 1 spot for a long time," he says, "and we'll continue to."

Yet Cisco watchers say it should be able to make inroads. And Cisco has been ramping up efforts in fast-growth areas, such as wireless. That business is growing four to five times faster than Cisco's core business and should provide significant revenue in a few years, estimates John Gonsalves, a vice-president at tech consultancy Adventis.

With its existing products, along with a new wireless Internet-access device introduced in April, Cisco is well positioned to take advantage of the growth in wireless local-area networks, which allow users to access the Web without land lines. That market should double from 2002 to 2005, to $2 billion, according to Bear Stearns. Cisco also has been making splashes with a new network-security switch. The security market should grow from $3.1 billion in 2002 to $5.7 billion in 2005, according to tech consultancy IDC.

JUST RESTING? Storage equipment might also provide substantial revenue years down the road. Cisco's new storage switches, available by yearend, will require 6 to 18 months of testing before gaining acceptance, says Nick Ellen, research director for storage networking at tech consultancy Gartner. Cisco's Ed Chapman, director of product management for the storage-technology group, believes his company can move faster.

Still, Cisco will likely want to wait until overcapacity in the storage industry is cleared out (see BW Online Special Report, 10/1/02, "The Surplus in Storage"). Plus, equipment sales for voice-over-Internet protocol, a technology that lets voice calls and data flow through the same network, might take five years to a decade to ramp up, says Jim Slaby, an analyst with Giga Information Group. It requires a costly overhaul few customers can afford. "We already see the steady progression of the technology," counters Cisco's Larry Birenbaum, senior vice-president for its Ethernet access group.

In the near term, Cisco's prospects are glum. The kind of growth investors once counted on isn't likely to return soon. Ironically, because of its cash, Cisco is still among the safest tech stocks to invest in, says Donald Luskin, chief investment officer at economic consultancy TrendMacrolytics. And further down the road, most analysts expect Cisco to regain its status as an Internet blockbuster. Until then, however, neither investors nor Chambers have much to smile about. Kharif writes for BusinessWeek Online from Portland, Ore.

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