Networking: Definite Signs of Life

The gains in market share Cisco achieved during the downturn make it S&P's top pick to benefit when sales of routers and switches revive

By Megan Graham-Hackett

Recent networking-equipment statistics from the Dell'Oro Group, a market-research firm based in Redwood City, Calif., indicate the computer-networking industry may have seen the worst of the downturn. Based on Dell'Oro's forecast, the switch market already witnessed its lowest sales base in the first quarter of 2002, and the router market was near its bottom as of the third quarter of 2002. One exception is the optical-transport market: It's still expected to slip and may hit bottom in the first quarter of 2003.

Dell'Oro's figures also show that North American telecommunications service providers' wireline capital expenditures may be reaching a low, even though spending is projected to fall next year.


  After declining 7.5% in 2001, sales of switches -- devices that filter and forward packets of data between local area networks (LANs) -- bottomed at $3.01 billion in the first quarter of 2002. Since then, sales have risen sequentially each quarter (although they are expected to show a seasonal downturn in the first quarter of 2003). This growth is impressive given the adverse macroeconomic climate, the slow migration to gigabit Ethernet, and aggressive pricing pressures. The latter is especially the case in the Layer 3 market, the networking layer in the open system interconnection (OSI) model, which facilitates network communications among computers from different manufacturers.

The market for routers -- which move information from one network to another -- may have marked a bottom in the third quarter of 2002, when Dell'Oro estimated sales at $2.063 billion. The absolute bottom may be reached in the second quarter of 2003 at $2.048 billion, based on Dell'Oro's forecast. This would be less than 1% below the third-quarter 2002 level. After falling 25% in both 2001 and 2002, an 18% drop in 2003 router sales is the research outfit's projection.

Capital spending in the wireline area by North American service providers is estimated to fall 53% in 2002, according to Dell'Oro. While it forecasts a sequential increase of 40% in 2002's fourth quarter over the third, few industry analysts are projecting a strong recovery in this market. Likely, the quarterly sequential growth will be driven by a typical seasonal uptick after the lack of spending in the three prior quarters.


  However, most analysts concur that spending in the short term is more likely to be driven by maintenance expenditures, software, and other areas, rather than on new networking equipment. Indeed, most industry analysts wonder if spending by telecom-services providers currently reflects only maintenance expenditures. While Dell'Oro forecasts a further 10% drop in capital expenditures in 2003, this level of decline is substantially less than the prior two years.

Even though there are no immediate catalysts to spur an upturn in the networking-equipment industry, the data suggest it's near a bottom. And although the market's downturn has taken a toll on all its participants, Cisco Systems (CSCO ) has emerged stronger -- not only from a fiscal standpoint but also in light of its competitive market positioning.

Cisco gained some 700 basis points of market share in the Ethernet-switch market from the third quarter of 2001 to the third quarter of 2002, based on Dell'Oro's data. The steady gains over the past year far exceeded our expectations at S&P and are surprising, since Cisco was already the dominant supplier.


  Indeed, given Cisco's competitive position vs. its financially distressed peers, we believe this momentum could likely continue. As this occurs, we believe Cisco will witness much more revenue power compared with its peers once the networking-equipment market turns around. In turn, revenue growth and earnings estimates for the networking giant could be revised upward as a recovery unfolds.

Cisco Systems has used the downturn in the networking industry to its advantage: It has gained market share at the expense of its competitors and has accumulated a net cash position (including investments) of $21 billion. With the shares -- which were around $13.50 as of Dec. 20 -- trading at a discount to their intrinsic value based on our discounted cash-flow and price-to-sales analysis, we view the shares as attractive and have a 5-STAR (buy) recommendation.

Analyst Graham-Hackett follows computer hardware stocks for Standard & Poor's

Edited by Karyn McCormack

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