October 27, 1998

SECTOR SCOPE by James A. Anderson


What a difference a day makes, the old song lyric goes. Make the time period four years, and the saying is true for the computer networking industry as well. Not so long ago, it seemed that four companies -- Cisco Systems (CSCO), 3Com (COMS), Cabletron Systems (CS), and Bay Networks (NT) -- fought hand-to-hand over the market for routers, switches, hubs, and other networking gear that links computer to computer, corporate outpost to corporate outpost, and surfers of all stripes to the Internet.

Today, such battles seem like a distant memory, with Cisco dominating the field as its rivals lick their wounds. Many of those competitors have good enough products to challenge Cisco, but they don't have the market share, installed base, or marketing firepower to blast it from its throne. The result is that Cisco now controls up to 70% of the market for equipment that guides vast flows of data around both the Internet and computer networks. In fact, Cisco's predominant role in networking gear is comparable to Microsoft's in operating system software or Intel's in semiconductors. Its annual revenues of $8.46 billion surpass the sales of its five biggest competitors combined. And its market capitalization of more than $90 billion easily eclipses that of the next-largest company in the group, 3Com, with $11 billion.

Gaze over the performance of networking stocks this year, and the differences become all the more startling. Standard & Poor's computer networking index of eight stocks is up 37.1%, in large part thanks to Cisco, which has gained roughly 50%. 3Com, by comparison, ended 1997 at $36 a share and has only recently peeped above $30 once more, closing last week at $32.81. Cabletron Systems started 1998 at $15 and has since fallen as much as 50%. It ended last week at $10 a share. Xylan (XYLN), which fetched as much as $67 a share two years ago, has since shrunk to the low teens, finishing last week at $14.81. Of all the other competitors in the index, only Ascend has posted a gain so far in 1998, up nearly 70% at its close of $43.63 last week.

Cisco has distanced itself from the rest of the pack partly because it dominates the market for routers, devices that speed information around the Internet. According to market researcher Dataquest, Cisco has 70% of the router market, vs. 11% for its closest competitor, Bay Networks, which was recently taken over by the Canadian telecom-equipment maker Nortel. Analysts say Cisco firmed its grasp of the market by making small, key acquisitions a few years ago to broaden its product line and become a one-stop boutique for networking gear. Then there are the benefits of girth. In an industry where good companies can expect to devote roughly 10% of sales to research and development, Cisco's revenues of $6.4 billion in its most recent fiscal year funded some $700 million worth of work in its labs. 3Com, by comparison, had sales of $5.4 billion, and spent $581.6 million on R&D, in its fiscal year ended May 31.

That's not to say that the Cisco juggernaut has chugged forward with nary a sputter. The stock, after all, weakened in early October, on reports that financial companies might cut back on big networking purchases. Then, there's the persistent worry that a stock so popular on Wall Street might have grown too big for its own price-to-earnings multiple. Cisco trades at a steep multiple of nearly 40 times Wall Street's consensus earnings estimate -- as compiled by Zacks Investment Research -- of $1.46 a share for its fiscal year ending next June 30. Before slipping this month, Cisco was trading as high as 48 times projected earnings. That's far in excess of the 29% annual growth rate Wall Street analysts expect in its revenues over the next five years, an indicator that the stock is pretty fully valued.

There are also worries that a slowing stock market or the world's spreading economic malaise might catch up with the company, a concern that already has dragged Cisco down from a 52-week high of $70.17 a share.

All the same, Wall Street seems O.K. with giving Cisco a premium p-e because its operating margins are 30% or higher, rare for technology companies outside the software business. It doesn't hurt that the company has been consistent. "People have been predicting the demise of Cisco's margins for some time, and it just doesn't happen," says Paul Krieger, an analyst for J&W Seligman's Communications & Information Fund (SLMCX). "The opportunity cost of owning one of its competitors with a history of disappointments and having that stock go down 30% to 50% when they miss on earnings is so great that I'd rather own Cisco and sleep at night."

Krieger isn't alone in holding this view. Currently, Zacks reports that all 29 of the analysts following Cisco rate the stock a strong buy or buy. So why the rough going in October? The reason, says Megan Graham-Hackett an analyst with Standard & Poor's, could be that Cisco was one of the few companies that hadn't been hit by profit-taking in late summer and was bound to swoon sooner or later. The stock has since rallied as worries that it might be facing a weak quarter have subsided.

Beyond that, Cisco faces the same threat every technology company does: innovation. In fact, analysts say its router business will see serious competition in the next year or so from advances that help switching equipment better channel flows of data on the Internet, says John Armstrong, an analyst for Dataquest. Cisco has developed a technology to compete in the new market but is in a dead heat with competitors such as Fore Systems (NASDAQ: FORE) and 3Com. "It's too early to say there's an established, dominant leader in the market," says S&P's Graham-Hackett, "but the fact that Cisco has a large installed base with many Internet access providers and telephone companies bodes well for its chances."

Those relationships will only grow in importance over time. As local phone companies and long-distance carriers upgrade their systems to carry voice and video, networking companies stand a chance to crack a $150 billion market for telecommunications equipment, says Mike Hahn, co-manager of the PBHG Technology & Communications Fund. The problem: That will lure telecommunications equipment heavyweights such as Lucent Technologies (LU), Nortel (NT), and Alcatel Alsthom (ALA) onto Cisco's playground. The Lucents of the world are determined not to let Cisco lunch on their long-standing ties with telcos worldwide. To underline the point, Lucent has been on a buying spree, taking over smaller firms with cutting-edge ATM technologies that can transport video, voice, and data on telephone networks, while Nortel recently absorbed Bay Networks.

Despite the hiccups and a stack of concerns, Cisco still looks like the sector's best bet. Its mainstay router market has legs enough to carry it through the next year or so, says Armstrong. Also, current customers aren't likely to switch from Cisco to another company despite new advances. "Cisco's going to keep a slice of the market if only because regional phone companies aren't fond of bringing in forklifts and changing equipment every couple of years," says Jeff Wrona, portfolio manager of PBHG's Technology & Communications Fund. Finally, Chairman John Chambers' crusade to maintain his company's lead in the industry, and his efforts to make Cisco a household name with a TV ad campaign, have made believers of analysts and fund managers alike.

With Cisco such a strong buy in most analysts' eyes, you might be tempted to ignore the other stocks in the group. Companies such as Xylan, Cabletron, or even 3Com, which have all declined or at best treaded water, certainly look cheap alongside Cisco's fattened multiple. Still, many stocks in the group have struggled amidst worries that Asia and a wobbly global economy might soon rattle profits. Even though most of Cisco's peers can boast nifty technology, Wrona says Cisco's big share of the overall market limits their appeal. "With some companies, your investment is pretty much a play on a six-to-nine-month product cycle or else a bet that a company like Cisco or Lucent might buy it out," he says. Indeed, the Wall Street rumor mill has helped 3Com rally.

Persistent rumors also have linked Ascend Communications to potential suitors such as Lucent or even Cisco. Ascend, a maker of so-called ATM equipment, which is used to shoot voice, video, and data across the telephone network, may rack up a 40% increase in earnings this year, Wrona says. At its current price of $43.63, Ascend trades at 26 times next year's projected earnings of $1.65 a share. One note of warning, however: Its recent merger with Stratus Computer could prove distracting for a while.

Another interesting possibility is 3Com. Once a darling in the networking sector, it ran awry after its acquisition of modem maker U.S. Robotics two years ago. Things might be about to change, however, if the company's strong showing the past two quarters is an indication of things to come. S&P analyst Graham-Hackett, who has an accumulate rating on the company, notes that 3Com has cultivated a niche on the periphery of the local-area and wide-area networks with traditional modems, modem hardware designed for cable networks, and adapter cards that function as an on-ramp to broader corporate networks or the Internet.

The networking business straddles a number of technology sectors -- including telecommunications equipment and computer hardware -- and a number of mutual funds cover the same territory. The PBHG Technology & Communications Fund (PBCTX) leads the group with an average annualized total return over the past three years of 21.64%. As of the end of September, the fund was down 2.77%, though it recently rallied as technology shares have firmed up.

The continued growth of the Internet likely means that the networking group will be where the action is for the foreseeable future. If you don't like risk, you can always bet on the Goliath called Cisco. And if you've always had a soft spot for David, you have plenty of candidates from which to choose.

James Anderson writes the Sector Scope column every other week for Business Week Online and teaches journalism for the City University of New York.

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