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Cisco: Strong for How Long?

By Olga Kharif Fears that Cisco is no longer a fast-growing company began to surface during the economic downturn, when the networking giant's sales plummeted. Those worries didn't abate after the recovery began. Revenues for its bread-and-butter business of corporate routers wouldn't grow much faster than the pace of gross domestic product (GDP), or about 4% a year, through 2008, according to networking consultancy Dell' Oro Group. At this rate, it's hard to turn in double-digit earnings expansion.

However, Cisco's (CSCO) fourth-quarter earnings release on Aug. 10 proved the naysayers wrong. It reported record net profits of $1.4 billion, up 42% from the year before on sales of $5.9 billion. Sales were up 26%, with sequential order growth in the mid-teens for five quarters straight now, according to CEO John Chambers, who spoke to analysts and investors in a conference call. To be sure, he warned that next quarter won't be nearly as strong, which pushed the stock down nearly 6% to just under $19. Chambers says price-cutting and efforts to improve products will cut into gains next quarter.

BUYING OPPORTUNITY? While these stellar results are no match for year 2000's 55% top-line growth, they indicate that Cisco's sales are increasing at a pace that's at least three times that of GDP. And Cisco bulls say it will continue to do so. Analysts polled by financial service Thomson Financial expect the company's revenues to grow 14.5% in fiscal 2005, to $25.2 billion, and its 2005 earnings to jump 16.2%, to 86 cents a share. And these estimates could prove conservative.

Indeed, Wall Street's expectations of Cisco might have fallen too far, offering a buying opportunity, says Larry Eakin, who co-manages $3.5 billion at Armada funds, where Cisco is a core holding. At $20 a share, the stock is trading 32% below its 52-week high of $29.40 in January. The shares will be particularly attractive below $20, he notes. The reality is, "there are still opportunities out there for Cisco," Eakin says.

That's because Cisco has made the changes needed to cope with a changing competitive landscape. Previously focused on corporate routers, it now derives about 18% of its revenues from new markets like network storage and Voice over Internet Protocol (IP), which allows voice and data communication over the Internet, estimates Gabriel Lowy, an analyst with Blaylock & Partners in New York.

REGAINING SHARE. These markets are growing at 20% to 40% a year, and Cisco has been gaining share. In the 1 1/2 years since entering storage networking, for instance, it grabbed 17% of the pie for large storage switches, estimates Stephanie Balaouras, an analyst with market consultancy the Yankee Group. In the next 12 months, Cisco could overtake No. 2 market player, Brocade (BRCD), which has a 19% share, she says.

What's more, about 25% of Cisco's sales come from telecom and cable company clients, up from 20% two years ago. The carriers' spending on routers, for instance, should nearly double from 2003 to 2008, to reach $4.3 billion, figures Shin Umeda, an analyst with Dell' Oro in Redwood City, Calif. As a result of the giant's alliances with other gearmakers and telcos, its orders from carriers grew 31% year over year in the third quarter.

Furthermore, Cisco has developed competitive products for this market. Its new switch, CRS-1s, which is expected to become available in volume in 2005, contains new software that makes it easy for carriers to scale. The switch could allow Cisco to regain some share lost to rival Juniper (JNPR). "This brings Cisco back into the ball game," Umeda says.

SQUEEZING MARGINS? However, Cisco is still struggling with some of the fallout from the tech bubble's bursting (see BW Online, 8/9/04, "A Downside to the "Cisco Standard""). Its aggressive pricing as it moves into new markets could erode the company's stellar, 69% gross margins. If the gearmaker is forced to expense its employee stock options, as expected, that would pressure margins and net income as well, says Timm Bechter, an analyst with Legg Mason Wood Walker. More important, worries about the strength of this economic recovery could put a brake on the tech bellwether's growth.

Still, information technology managers are fond of saying, "Nobody has ever been fired for using Cisco." For years, that has been the case in routers. And chances are, Cisco can enjoy as much success -- and growth -- in other markets.

(Editor's note: This story was updated after initial publication to include details of Cisco's quarterly earnings.) Kharif writes for BusinessWeek Online in Portland, Ore.

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