Cisco: Don't Believe Everything You Hear

Rumors of all sorts are flying around about what's next for the tech bellwether. What really counts, though, is the long-term outlook

By Sam Jaffe

If you're a Cisco Systems (CSCO ) investor, you've probably heard the speculation in recent weeks. I certainly have. One source tells me Cisco is about to preannounce lousy earnings for its fourth quarter ending July. No, says another source, its quarter is going to be fantastic, and visibility is improving for the better in the next two quarters.

That's not it, another analyst tells me. The real story, he says, is that Cisco is about to acquire a major competitor. That's flat-out wrong, says another. What's happening is that the iconic CEO John Chambers, while not headed out the door, has lost some of his luster within the company, say some former employees.


 A company spokesman dismisses the negative rumors as rubbish. But Wall Street continues to gossip. And Cisco's stock chart resembles a double-Dutch jump rope much more than the flat line it should be, considering that the company has provided no major news since its third-quarter earnings report in mid-May. In the past few weeks, shares have jumped 33%, from $18 to a high of $24, and then back down 25%, to $18, while the broader tech sector has had a swing of 11% in either direction in the same period.

In its heyday of recent years, such speculation wouldn't have fazed investors who believed in Cisco's overpowering dominance. But the fact that such unsubstantiated rumors can move the stock is itself an indicator of how much anxiety surrounds this tech bellwether.

So what is a Cisco shareholder to do? Keep your ear to the ground, but don't believe everything you hear. And remember to keep a long-term view of Cisco's future. In coming weeks, if Chambers can strongly reiterate his long-term annual growth targets in the 30% range, then the stock looks cheap. In the near term, however, this stock could be facing more than its fair share of price volatility.


  Consider what could happen if Cisco reports disappointing earnings this quarter, which ends July 31. That's not an unreasonable worry, considering what has happened in the past two quarters. At the end of 2000, Chambers saw smooth sailing ahead and expected the company to continue its usual 35% to 40% annual revenue growth for the year ahead. Then, at the end of its fiscal second quarter, which ended Jan. 31, the brakes were slammed on.

In that quarter, Cisco's earnings increased only a penny, to 12 cents a share, compared to the same quarter in the year before. The fiscal third quarter was worse. The company lowered earnings guidance on Apr. 16. Revenue actually declined 4% from the year-ago quarter. The company decided to write off $2.2 billion worth of inventory. More disturbing still, Chambers said he saw no end to the downturn in sales. "Visibility going forward is more difficult than any of us have ever seen before," he said during the conference call announcing the results.

Analysts expect Cisco to post earnings sometime in mid-August of 3 cents per share for the quarter, compared to 16 cents in the same period last year, according to First Call. Most Cisco watchers don't see any more earnings warnings. "I've talked to most of their main suppliers, from chip foundries to circuit-board assemblers, and they've all told me the same thing: This is going to be a normal quarter," says Paul Johnson, an analyst at Robertson Stephens. But if the company were to disappoint, watch out. Its stock -- and the tech sector in general -- might be in for another bruising.


  Far more important, though, will be the company's forecast for the next few quarters and the next two years. Some analysts argue that the telecom companies that buy Cisco's equipment have networks up and running and have little reason to buy large amounts of new equipment. "Every telco vice-president I've spoken to says that they won't be buying anything new for at least two years," says one former Cisco executive. That would mean Cisco's recovery could be awhile coming. I think his pessimism is overdone, but even if he's half-right, disenchantment with Chambers could intensify.

While some investors and analysts clearly blame Chambers for not calling the slowdown in sales sooner, it would be hard to find a person better-suited to the job of getting the company back on track. "There's no one you would rather have in that position," says Frank Dzubeck, president of Communications Network Architects. Chambers has been a relentless cheerleader for the New Economy and is a salesman without peer.

Yet the company may need more than the Chambers magic to jump-start revenue. That leads us to the last rumor, and the one with the most legs: Cisco is on the hunt for a major acquisition. This might be true for many reasons. One is to manufacture some revenue growth by acquiring a competitor with bright prospects. Or Cisco might make a big buy to get into a new market with a bang. Cisco denies it's looking for a big buy. But the speculation continues.


  By far, everyone's favorite partner for Cisco is Ciena Corp. (CIEN ), which makes high-end optical equipment for big telecom networks. "It would be a fantastic combination," says Johnson. "There's almost no overlap in lines of business, Ciena's management is marvelous, and it would fill a gaping hole in Cisco's product line."

This idea has been bandied about before, and it has failed to materialize. Right now, "there's no reason to think that Ciena's currency isn't more valuable than Cisco's stock," says Dzubeck. "For that to happen, it would need to be a very generous deal."

Another target could be Sycamore Networks (SCMR ), which competes in the optical transport and networking marketplace. "It would be a marriage made in heaven," says Dzubeck. But Dzubeck says he recently spoke to top management at Sycamore and found no interest in merging with Cisco.

A third possibility is Redback Networks (RBAK ), a networking player with successful products in the digital subscriber line marketplace. Cisco already has a viable DSL product, but Redback is certainly ripe for the picking. Its stock has dropped from a 52-week high of $181 to a June 14 close of under $12, for a market capitalization of a little more than $2 billion. That's certainly affordable for Cisco, which has $12 billion in cash.


  For now, these companies all decline comment on merger talk. But there's no better time to go shopping than when your rivals' share prices are in the basement. As for Cisco, despite the stock's sharp decline from $70 a share in August, 2000, to below $20 today, some say it still looks expensive with the company's price-to-2000 earnings ratio hovering around 34.

However, this company will eventually regain its footing as the world's largest supplier of the hardware needed to build out the Internet. Even if Cisco's short-term path looks rocky, the long trip home is what you should be focusing on.

Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column

Questions or comments? Please visit our Ask Sam Jaffe interactive forum

Edited by Alex Salkever

    Before it's here, it's on the Bloomberg Terminal.