Tempted by a Cheaper Cisco?

Way off its highs, this tech powerhouse is still formidable. Its mixed near-term prospects, though, are something to ponder

By Margaret Popper

As a bellwether of the New Economy, Cisco Systems (CSCO ) is one company that's expected to survive the tech correction. But that doesn't mean it has been untouched. Since December, the stock price has hovered at around $38 a share. That's less than half its late March high in the low $80s. Of course, during the same period, the tech-laden Nasdaq index also dropped about 50%. And compared to many of the companies in that battered index, Cisco isn't so badly off.

Its market capitalization still accounts for 3% of the value of the Standard & Poor's 500-stock index. Its price-to-earnings ratio for projected 2001 earnings is 40, vs. 22 for the benchmark S&P index. The fact is, Cisco's sheer size as the biggest seller of data-networking equipment and Internet network solutions in the world practically guarantees its survival.


  But in the near term, the real question for Cisco isn't survival but whether it can make its revenue projections of 30% to 40% annual growth given the failure of many of its telecommunication clients and a fundamental shift in how surviving telecoms are building their networks. Indeed, Cisco is already backpedaling.

On Jan. 10, CEO John Chambers made a speech at an analysts' conference about the bleakness of the industry outlook for the next couple of quarters, setting the stage for disappointing earnings. But in addition to revenue-growth slowdown, the company faces some stock-dilution issues that might make investors want to wait a few quarters before jumping in to buy Cisco -- even though the stock is cheap right now.

While Cisco's end-to-end networking-solution approach -- in which it sells entire systems to clients -- has worked well with Fortune 500 companies, some analysts argue it hasn't been so successful with telecom clients that prefer to pick and choose products and services. To use a cooking metaphor, "it's Lean Cuisine vs. David Bouley [the celebrated New York chef]," says Steve Kamman, executive director and analyst for CIBC World Markets. "Are you selling prepared meals for the harried housewife or the finest cuisine made of the best ingredients?"


  Truth be told, Cisco has both types of clients. Those that aren't in telecom -- the company's so-called enterprise clients -- make up anywhere from 45% to 75% of its revenue mix, depending on which analyst you believe. Enterprise clients want to spend minimal time and effort on their telecom systems, according to Kamman. They're only too happy to buy an integrated end-to-end solution from Cisco because they know everything will be compatible.

That's great for Cisco because it means its customers are locked into their equipment forever. But total information technology (IT) spending is going to drop dramatically this year. After a 20% to 25% jump in 2000, most analysts think IT will grow just 10% to 15% in 2001, making it difficult for Cisco to maintain revenue growth via enterprise clients.

The situation is even worse on the telecom side. Capital-equipment spending among this group, or what analysts call service-provider clients, will be nearly flat in 2001, growing a mere 1%, according to Kamman's research. For Cisco, this presents particular problems, as service providers are more interested in building proprietary systems from scratch and want to buy select products and services rather than an end-to-end solution. The big ones, such as the regional Bell operating companies, want the best components and have the technology and knowhow to figure out how to make their systems compatible.


  There's one exception. Cisco's end-to-end solutions for networking and communications are popular with local-exchange carriers known as CLECs. A host of these small companies came on the scene over the past few years to challenge the regional Bells. Because they lack the heft of their Bell rivals, they tend to like the same sort of integrated solutions enterprise clients do.

Unfortunately, many of these companies are going out of business because they expanded too rapidly. Recent bankruptcies include ICG Communications, Darwin Networks, Digital Broadband, and GST. And others -- such as NorthPoint (NPNT ), Covad (COVD ), and Rhythms NetConnections (RTHM ) -- are struggling to make their cash last beyond the first half of 2001, according to Kamman.

Cisco's "broadband strategy has been more successful with the emerging telcos," says Nikos Theodosopolous, a managing director and telecom-equipment analyst for UBS Warburg. But in light of what has happened to those emerging players, Cisco has to figure out how to do better with the regional Bells, he adds.


  While Cisco has relationships with SBC Communications (SBC ) and Qwest (Q ), it doesn't have all the product offerings they want. Particularly when it comes to digital subscriber line (DSL) technology, Cisco lacks a product line that would allow the regional Bells to sell DSL via so-called remote nodes in their high-speed fiber-optic networks.

Most analysts assume the company has something in development, but Cisco may be behind the curve if it wants to gain a dominant market share in this rapidly growing market. "Thirty percent to 50% of U.S. lines for voice are now delivered via remote nodes, and that percentage is growing," Theodosopolous says.

CIBC's Kamman says Cisco doesn't have to kill itself to lead in this market. Better the company focus on defending its lead in its core router business, he says. In this bread-and-butter business, Cisco is by far the kingpin with roughly a 70% market share. But that doesn't mean Cisco can rest on its laurels. It used to have 100% market share until competitor Juniper Networks (JNPR ) muscled its way in and grabbed 30%. And things are going to get only more competitive from here on out, analysts say.


  From Kamman's point of view, revenue-growth estimates should be reduced from 30%-40% to 20%-25% to become realistic. In Cisco's fiscal 2000, which ended July 31, the company probably drew $13.3 billion in revenues from its enterprise business, according to Kamman's estimates. Using aggressive estimates, that should grow 40%, to $18.5 billion, in fiscal 2001 and an additional 20%, to $22.3 billion, in fiscal 2002. But to hit its 30%-40% growth target in the next two years, Cisco would have to increase its $5.6 billion service-provider revenues 100% in 2001 and 55% more in 2002. An unlikely scenario considering the current telecommunications-industry debacle, Kamman believes.

Kamman is clearly one of the more pessimistic analysts on Cisco. While his research report pegs the stock's worth somewhere between $30 and $34, UBS Warburg's Theodosopolous has a $60 12-month target price. Theodosopolous is predicting earnings per share of 77 cents for fiscal 2001, up 48% from 52 cents in 2000, and 21% growth for fiscal 2002 to hit 93 cents a share. And his estimates are fairly close to Wall Street's consensus estimates.

Cisco declined to comment further about revenue projections at this time. Chambers' Jan. 10 speech, available on the company's Web site, acknowledges that the industry and economic environment have changed -- and not for the better. But he says the bear market has presented him with terrific buying opportunities that could improve Cisco's growth scenarios. It has been an aggressive acquirer in the past to build out its product and service offerings. But CIBC's Kamman is skeptical. As Cisco's stock drops in value, it has to swap more shares for each acquisition, and that would dilute share value for existing shareholders.


  Chambers also says an economic downturn should loosen a very tight labor market and give his company access to more talent at competitive salaries. But potentially disgruntled employees, 50% of whom own $50 and $60 stock options, may push for an option revaluation or threaten to jump ship, figuring they can get more cash and fewer options elsewhere. "We expect retention problems as well as option repricings and/or increases in cash compensation," Kamman wrote in a negative Jan. 10 research report.

But if Cisco revalues those options or increases cash compensation to workers, shareholders' stock would be diluted even further. As an investor, you need to decide whether you agree with Chambers when he says, "our strategy has never been more sound, our customer relationships have never been stronger, but we are limited by capital spending and the economy. Still, we'll survive it better than other IT companies."

People have been able to boast stellar returns by putting their faith in Chambers in the past. Says Kamman: "Cisco is a great company, but maybe you want to let the recent news wash through before you go back into the stock." If he's right, sit tight.

Popper covers financial markets for BW Online in New York

Edited by Beth Belton

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