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Some smaller networking companies have dropped even more sharply recently. Juniper Networks (JNPR), for example, reached a high of $244 a share in mid-October but had plunged to $116 on Nov. 30. Extreme Networks (EXTR) reached a mid-October high of $129 a share but on Nov. 30 closed at $57 a share. RIDICULOUSLY OVERPRICED. Truth is, these declines are long overdue. Many of the new companies making what analysts call "next generation" networking equipment had become ridiculously overpriced. And with price-to-earnings ratios in the triple digits, some high-growth data-networking companies may have even farther to fall. Juniper still has a p-e of 378, and even more reasonably priced Foundry Networks (FDRY) has a p-e of 70, compared to 26 for the Standard & Poor's 500-stock index. "What they say about catching a falling knife applies here," says Paul Johnson, an analyst with Robertson Stephens. "You try it, and you might get cut." The big question for this group -- and technology stocks in general -- is the size of the capital-spending slowdown that's under way. If problems plaguing the telecom sector are part of a larger economic slump, it could be just the beginning of suffering for the networking group. On Nov. 20, citing an expected downswing in early 2001, Morgan Stanley Dean Witter analyst Christopher Stix downgraded Juniper and Redback Networks (RBAK) and cut his target price on Cisco Systems (CSCO) and Extreme. He acknowledges in his report that all the companies have recently reported "stellar" quarterly numbers. "So why the cut in target prices and ratings? It's all about the macro environment and our valuation work," he writes. If this is just a tech slowdown, Ken Pearlman, director of research at Firsthand Funds, thinks the networking sector will be weak for no more than three to six months. "The problem isn't so much that we are going to have a slowdown but that things are going to be a little bit slower," he says. Tam Dell'Oro, founder of Bay Area research firm Dell'Oro Group, thinks service providers need to learn how to operate their new networks before continuing to expand. The big telcos may cut spending on voice services, but Brean Murray analyst Gina Sockolow says her surveys of sales managers show spending on data services will be up 25% to 35% in 2001. CISCO ON TOP? Investors should probably still stay away from the larger networking companies, which may be stuck with weaker customers, such as smaller dot-coms or poorly funded startups that are unlikely to generate new sales, says Christopher Bonavico, a portfolio manager with Transamerica Premier funds. Of the "gorillas" -- including Cisco, Lucent, Nortel, and Tellabs -- Cisco is the only one Sockolow recommends. But companies that provide the most-sophisticated data-networking equipment have plenty of opportunities. The ones that allow providers to add valuable services for extra fees and that will help retain customers have the best shot at building sales, say analysts. Ciena (CIEN), a holding of Firsthand Funds, for example, should prosper because its switches are used in more sophisticated data networks. CoSign Communications (COSN) is a smaller niche company that Robertson Stephens' Johnson believes will succeed because the box it makes helps providers add services. Similarly, Bonavico likes Redback on this score. Juniper has been a clear favorite of investors because it has managed to take market share from Cisco for high-end routers. "To me, it is unbelievable that anyone could come in and take 30% of Cisco's core business away," says Peter Cohan, a Marlborough (Mass.) Internet consultant. Juniper is the most expensive stock in the group, which makes it vulnerable if the broader market slides. Firsthand Funds had stayed away, but one of its analysts, Xin Huang, says Juniper is "getting interesting again." TAPPING BROADBAND. While one concern plaguing the group is that service providers have already created too much capacity, analysts say this is really only an issue of timing. Though there's extra capacity in the backbone or core of the Internet, the network still needs to be built out to reach the edge, where residential customers can tap into broadband connections. When more users can sign up for broadband access, the extra capacity at the core will quickly be utilized. But for now, companies with products that go to the edge of the network may be better investments. Sockolow likes Extreme, which makes high-speed switches. Johnson recommends ONI Systems (ONIS). Firsthand Funds also owns Sycamore Networks (SCMR), which Huang says serves as a hedge for the group since it has a broader product line. Sockolow, however, lists Sycamore among companies she has concerns about, including Foundry, ONI, and Avici Systems (AVCI). One point analysts agree on is that the success of these young companies depends on how well management can execute their strategies and keep a technology lead on the competition. In the heady days of 1999 and much of 2000, investors could feel like geniuses by buying almost any stock in the group. Now they need to be choosy. But with the best stocks in a free fall, it still probably isn't the time to go on a buying spree. Even though she's optimistic on the group, Sockolow says, "We think it is going to take the January earnings releases to affirm what we've been saying." Her advice: "Wait until stocks turn up before you commit capital." Stone is an associate editor at Business Week Online EDITED BY BETH BELTON |
