business

The Fog over Cisco Is Lifting

While it may take more hits, its financial strength is helping it gain share -- and the future looks bright in three emerging markets

By Olga Kharif

Good news from John Chambers is almost always good for the entire market. A positive pronouncement from the CEO of tech bellwether Cisco Systems often launches a rally. Cisco, the largest maker of data-networking gear, is a solid leading indicator of tech investment, as well as one of the most widely owned stocks on the Nasdaq (see BW Online, 8/27/01, "Where Cisco Points, Nasdaq Follows").

So Chambers' declaration on Oct. 3 that Cisco would hit earnings expectations of 2 cents per share in the first quarter of 2002 cheered Wall Street, and investors sent Cisco shares up 21% on the news. Since early October, the share price has soared to around $17 a share, from $11.

The larger question is whether this rebound is temporary or marks the start of a long-term comeback. For sure, Chambers & Co. have felt every bump in the downward slide of information-technology (IT) spending this year. Cisco (CSCO ) posted a $1 billion net loss for fiscal 2001, ended July 28. That's a major reversal compared with the income of $2.67 billion the year before. Some more lumps may be coming.

MIXED SIGNALS.

  Cisco could lay off up to 5,000 employees in the next two months, says Gina Sockolow, an analyst at Buckingham Research Group. That's in addition to the 8,500 workers who got pink slips earlier in the year. The company might also ax some of its less profitable optical and fixed-wireless broadband products, analysts say. Cisco declined to comment about the possibility of a restructuring.

Despite the setbacks, the fog over Cisco appears to be lifting. Analysts see some signs of recovery in corporate IT spending, which accounts for the majority of the company's revenues.

Thanks to its strong financial footing, Cisco is poised to take away competitors' market share in certain routers used to connect different networks. A price war is raging in the lower end of the market, and some of Cisco's rivals are in trouble financially. This could be a moment of opportunity for Cisco, which doesn't have to worry as much about making ends meet and can instead concentrate on the market.

EMERGING SUCCESSES.

  Cisco also is expected to succeed in the emerging markets for wireless local-area networks (LAN), voice-over-Internet-protocol (VoIP) networks, and network storage, says Jim Slaby, analyst with tech consultancy Giga Information Group. Wireless LANs allow for fast data and voice transmissions within a particular area, while VoIP sends voice traffic through the lines that normally handle Internet data, allowing carriers to make the most out of their networks. And storage networking allows companies to easily secure and retrieve data.

All three markets hold promise. The wireless LAN market will reach $1.7 billion by 2004, according to tech consultancy Phillips InfoTech. And VoIP market revenue is projected to increase to $7.6 billion by 2006, from $2.6 billion in 2000, according to Allied Business Intelligence.

That's nothing compared with the revenues Cisco could reap from storage networking. That market is growing at double-digit rates, and just the service-provider portion of it could reach $15 billion by 2005, up from $273 million last year, according to Morgan Stanley Dean Witter.

ROSY SCENARIO.

  As the economy recovers, Cisco will "likely come through smelling like roses," says Slaby. That's why five investment houses have upgraded its stock since August. "Cisco's position in the corporate market is a lot like IBM back in the days when IBM was a scary company," says Paul Sagawa, analyst with investment house Sanford Bernstein. So, what's ahead?

For starters, Cisco, which receives as much as 70% of its revenues from corporate customers, will benefit from the anticipated increase in enterprise spending as companies upgrade their LANs next year. While this segment won't grow at the double-digit rates of the past few years, Slaby predicts that it's likely to at least stay flat for the rest of the year before resuming a cautious climb sometime in 2002.

When spending recovers, Cisco will be ready. It formerly had one department that built systems for corporate clients and another that built the same systems for service-provider clients. Now, these departments have been consolidated, significantly cutting costs. It also now has the experience to appease its demanding service-provider clients, says Bill Nuti, senior vice-president for service provider operations worldwide.

PRESSURE-FREE PRICES.

  In fact, in the midst of this year's economic downturn, Cisco has managed to increase its share of networking gear revenues more than 5 percentage points, to 42% of the total, according to digital communications consultancy Cahners In-Stat. The market reached $49.3 billion in 2000 but declined this year.

Price volatility was the cause of much of the market-share gain. While prices for competitors' low-end gear dipped further, Cisco's high-end equipment remained in demand and resistant to competitive price pressures.

Cisco will suffer -- as will competitors Nortel Networks (NT ) and Lucent (LU ) -- from the continuing decline in telecom service-provider spending, a segment that represents 30% of Cisco's revenues. Carriers, suffering from corporate cutbacks relating to their services, aren't expected to start investing in their networks until 2003, when the U.S. is likely to rise out of the economic downturn. In 2001, carriers will spend 23% less than in 2000, according to J.P. Morgan Securities. In 2002, they will spend 20% less than in 2001.

FILLING A NEED.

  In the near term, the economic downturn means weak demand for some of Cisco's products could continue for a few more quarters, says Jeff Lipton, analyst with J.P. Morgan H&Q, who recently downgraded the stock to long-term buy. Moreover, aggressive, technology-focused competitors in networking are taking bites out of certain product categories. Analysts blame networking rivals Juniper Networks (JNPR ) and Extreme Networks (EXTR ) for some of the market-share losses.

Ironically, the recent bump in Cisco's stock has priced it at levels that some analysts no longer find attractive. Witness the Oct. 15 downgrade by Needham & Co. analyst Tad LaFountain from strong buy to buy. That said, even LaFountain expects the company to start showing mid-single-digit growth in the final months of 2001, and he says it should exhibit a 20% annual rate of growth over five years. "The world needs a successful large-scale networking equipment maker, and Cisco is it," he says.

That's not a bad spot for a company that only a quarter ago was stuck in the doghouse.

By Kharif covers telecommunications from New York

Edited by Alex Salkever

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