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Cisco: Investors Still Aren't Convinced

By Peter Burrows For the last 18 months, Cisco Systems (CSCO) has been trying to convince investors to value it like the fast-growth company it used to be. Indeed, many analysts expected the networking giant to soundly beat expectations for its fiscal fourth quarter that ended July 31 -- possibly providing a big catalyst for that change in sentiment.

That didn't happen. When Cisco announced quarterly results on Aug. 9, it didn't have any upside surprises to share, and it fell short of some analysts' hopes. Making matters worse, Cisco issued its first annual sales projection in years in the hopes that it would boost investors' confidence, but it may have raised more questions than it answered.

"The quarterly results were respectable, but the fact of the matter is that they're trimming expectations," argues Pacific Growth Equities analyst Erik Suppiger. Cisco's stock fell nearly 4% in after-hours trading, to $18.92 -- well off a high of $29 in January, 2004.

MORE DIVERSIFIED. Cisco's news was by no means bad. Quarterly sales increased 11%, to $6.6 billion, and sales for the full year grew 12.5%, to $24.8 billion. That's right in the middle of the 10% to 15% long-term growth goal Cisco laid out in early 2004. Thanks to improved gross margins and impressive productivity gains (Cisco now gets more than $700,000 in revenue per employee, up from $400,000-plus just four years ago), it posted record quarterly earnings of $1.5 billion and churned out a record $2.4 billion in cash for the quarter.

Best of all, CEO John T. Chambers pointed out during a conference call with analysts, the quarter showed how Cisco has now become a more diversified company that can post more stable results -- partly because one or more of its businesses can compensate for softness in others. Besides basic corporate networking equipment, Cisco is becoming a bigger force in everything from Net-based office phones to consumer gear.

"The home run for the quarter was the continued balance we've been able to achieve," said Chambers, who noted that it was the 13th consecutive quarter in which Cisco has posted a net margin of at least 20% -- an amazing achievement for a company of Cisco's size.

Still, investors didn't want evidence of balance, but of momentum. Among their concerns is the lack of any significant pickup in Cisco's biggest business -- selling routers and switches to big corporations. Sales of those products to smaller companies were brisk, but sales growth from phone companies slowed significantly after a bang-up third quarter.

GROWING SEASONALITY. After the Net boom went bust, Cisco stopped projecting annual sales, choosing to project out only one quarter. But this time, Chief Financial Officer Dennis Powell told analysts on the conference call to look for 10% to 15% growth in fiscal 2006. Trouble is, that's no different than the multiyear goal Cisco had set almost nine months ago. Worse, Powell urged investors not to assume Cisco was suggesting it would hit the high end of that broad range -- something investors had not been dissuaded from doing in the past. "It's going to create some confusion," says Pacific Growth's Suppiger.

What's more, Powell warned analysts that revenues in the October quarter may decline a bit sequentially, notes Precursor Group analyst John Freeman -- rather than remaining flat from the July quarter, as they typically have in the past. Powell tried to explain that this wasn't due to any new weakness but resulted from the fact that Cisco's sales are increasingly driven by seasonality as a result of growing success in markets such as consumer electronics and phone company gear (see BW Online, 8/5/05, "Cisco's Consuming Ambitions").

The good news, Powell claimed, was that just as Cisco's sequential sales growth might disappoint in the first half, it would more than compensate in the latter half. Trouble is, that leaves analysts having to take management at its word for the next few quarters. "They're basically saying, 'just trust us,'" says one analyst.

HUGE EXPECTATIONS. What do Cisco's numbers mean for the networking segment as a whole? It's hard to tell. Clearly, Cisco has a huge head of steam in its so-called Advanced Technologies group, particularly in voice-over-Internet-protocol phone systems for offices, wireless networks, and storage networking gear. That means rivals such as Avaya (AV), Aruba, and Brocade Communications (BRCDE) will have a fight on their hands. Said Chambers: "Not only are we achieving the No. 1 position [in many of these markets], but we're continuing to gain market share."

Of course, Cisco's executives have never lacked much for confidence, and for good reason. But relative to the huge expectations they've set, they may have to put together a nice long string of happy surprises before Wall Street feels the same.

Burrows is BusinessWeek's Computer editor in Silicon Valley

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