Time to Dial In to Cisco?

When (O.K., if) the telecom sector starts buying again, it's in prime position to cash in while most rivals remain on hold

By Olga Kharif

Cisco Systems has long been known as the bellwether of telecom equipment stocks, and these days it seems to be pulling away from its rivals. While prudent investors are shunning the shares of most of its rivals, many now believe market leader Cisco could finally be a strong buy.

Cisco (CSCO ) appears to be in the right place at the right time. Networking, its specialty, is the sector of the telecom equipment market that's expected to see the first pick-up in orders. It could happen by late this year, if corporate spending begins to rise again as expected.

Other market segments, such as optical equipment, mostly rely on purchases by big telecom and cable carriers, many of which are in financial distress. It may be 18 months or so before those companies can afford to loosen their purse strings.


  If and when the turnaround comes, San Jose (Calif.)-based Cisco is likely to be the supplier of choice. Chastened corporate purchasers are buying more conservatively than they did during the boom years, and many are expected to favor Cisco over startups. It has the strongest balance sheet in the industry and $5.3 billion in cash, so customers don't have to worry about it going out of business. The company also is expected to nab a bunch of new government contracts in 2002, further spurring its growth, says Gina Sockolow, an analyst with Buckingham Research Group.

Cisco already dominates many of its key businesses, with anywhere from 40% to 70% market share. Morgan Stanley expects it to add share in many of its key businesses this year, partly because Cisco has some attractive new products in its lineup.

Several of its new Ethernet switches are industry leaders and a hit with clients, says Mike Volpi, Cisco senior vice-president for Internet switching and services. Plus, financial troubles at major competitors Nortel Networks (NT ) and Lucent Technologies (


 ) should create openings for Cisco. "This climate of difficulty is first and foremost an opportunity for Cisco," Volpi contends.


  It likely won't be all smooth sailing this year for Cisco, either. The company could be hit by troubles at telecom startup Velocita, which in February laid off 75% of its staff and is restructuring to avoid possible bankruptcy, according to analysts. Cisco made loans to and invested several hundred-million dollars in Velocita but said it has $485 million in reserves to cover such losses if needed.

Analysts polled by financial service First Call expect Cisco this year to post earnings per share of 32 cents, down from 41 in 2001. But the consensus is that it will enjoy a significant earnings turnaround in 2003, to 47 cents per share. Sockolow estimates that Cisco's earnings will fall to $2.67 billion this year, 13% below last year. Next year, however, she figures they'll jump 72%, to $4.6 billion, on a 20% increase in revenues, to $23.5 billion.

If it plays out that way, such a scenario isn't reflected in Cisco's share price. Walloped along with optical-gear stocks, Cisco shares have slid 14% since January, to $16.52. Some analysts believe the stock would be fairly valued at $23, a 35% premium on the current value, and most rate it a buy. "You need to buy at the trough of the cycle," says Alex Henderson, an analyst with Salomon Smith Barney. He and others figure this is it.


  Indeed, most industry indicators point north. The inventories of gearmakers and their distributors are near recent lows. Demand for networking equipment picked up slightly in January, says Sockolow. And while info-tech managers still remain cautious about signing orders, nearly half of the 931 North America-based companies questioned by tech consultancy IDC expect to spend more on technology this year than in 2001.

Networking products that can help cut operating costs and offer new services top their wish lists, say analysts. In fact, Cisco CFO Larry Carter in a February speech talked of "a modest recovery now under way."

With government and military spending on the rise, the company also could book as much as $600 million in new government contracts over the next 18 months, estimates Sockolow. The increase would trickle into Cisco's financials by the third fiscal quarter. In fiscal 2002, Cisco also is expected to record $1 billion in additional revenues from rebuilding networks affected in the World Trade Center disaster, she says.


  What's not to like? Phone and cable markets, which account for 30% of Cisco's revenues, are big negatives. The carriers' total spending on new equipment could fall by 38% this year, according to Salomon Smith Barney, and may not fully recover until 2004.

Yet that sector also represents the biggest long-term opportunity for Cisco, says Edward Jackson, an analyst with U.S. Bancorp Piper Jaffray. Cisco holds only a tiny share of the market, and as the recovery takes hold, analysts like Henderson believe it could significantly increase its revenues and share next year.

To that end, Cisco has established an engineering team focused exclusively on creating systems for service providers and reporting directly to Chief Development Officer Mario Mazzola, said Bill Nuti, Cisco senior vice-president, at a Merrill Lynch investors conference on Mar. 13. While valuations are low, Cisco might also acquire several companies focused on carrier gear, analysts say.


  Rumors abound that a marketing partnership is in the works with Verizon that could extend Cisco's business with phone carriers, according to Lehman Bros. analyst Tim Luke. Cisco declined to confirm or deny that such a deal is under discussion.

Of course, all this optimism could easily turn out to be overblown. It's largely predicated on an economic recovery later this year, which could fail to materialize. Cisco also has a poor track record in some of the businesses in which analysts project the strongest growth. The company hasn't always proved adept at providing the service and hand-holding required to win business from the big cable and telecom carriers.

Meanwhile, French telecom equipment maker Alcatel (ALA ) is making a major push to outgun Cisco -- using the desire to counter Cisco's market dominance as a key selling point. "Everybody is afraid of an arrogant, dominant Cisco," contends Olivier Houssin, president of Alcatel's eBusiness group. "Customers are begging for a strong alternative."


  Cisco's shares aren't all that cheap, either, trading at a price-to-earnings ratio of 38. That's way below the astronomical 141 p-e they reached during the Internet craze, when Cisco shares traded as high as $69. But they could look pricey even at current levels if the expected recovery fails to materialize this fall.

For investors able to handle some risk, the time might be right for Cisco. The telecom slump has to end at some point. If it ends relatively soon, as analysts expect, Cisco could be the big winner.

Kharif covers technology for BusinessWeek Online from Portland, Ore.

Edited by Thane Peterson

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