Is It Wrong to Write Off Cisco?


By Robert Barker Most Wall Street analysts have been falling over themselves to cut sales and earnings estimates for Cisco Systems (CSCO) and downgrade Nasdaq's most spectacularly fallen angel. Except, that is, for Tad LaFountain.

The veteran tech analyst at Needham & Co. on Mar. 13 boosted his rating on Cisco, then at $21 a share, from hold to buy. Next, on Mar. 30, with Cisco having dipped to $15, LaFountain upped his rating on the stock again to strong buy.

Since then, it has sunk as low as $13.25. But on Wall Street, serious money gets made by going against the crowd. The trouble is, being contrary doesn't always mean being right, and my own suspicion is that Cisco still has farther to fall (Check out my take on Cisco in my weekly magazine column, The Barker Portfolio.)

Just the same, I wanted to hear another view. LaFountain, whom I reached by phone this week at his Manhattan office, makes a thoughtful case. To clue in, as well as to see what German philosophers Georg W.F. Hegel and Karl Marx have to do with investing in Cisco and the Internet, read the edited excerpts of my conversation with LaFountain:

Q: What are your reasons for upgrading Cisco?

A: We had a very interesting situation last week where, due to the current business conditions, I lowered my [Cisco earnings] estimates for this year and next. I trimmed my five-year-growth rate estimate, which led to a $2 reduction in my price target from $23 to $21. But with the stock selling off down to $15, we then had enough potential gain, even to the lower price target, that I could get the 35% potential appreciation necessary to implement a strong buy.

Q: O.K. What had you been expecting Cisco to earn in the next two full fiscal years, and where did you lower those estimates to?

A: What we did is take our revenue estimates for this July [fiscal 2001] down, from $26.6 billion to $25.2 [billion], and our pro-forma earnings, [at] 59 cents, down to 50 cents. For next year, the July '02 year, we took our revenue estimate from $32.9 billion to $29 billion and our pro-forma earnings from 74 cents to 53 cents.

Q: Why's that bullish?

A: Our belief is that the underlying growth rate for [Internet infrastructure] demand is relatively intact -- that what we had was pretty weird behavior over the last two years as capital flowed to the [telecom network] service providers in a way that basically was unsustainable. And I think it has been pretty well documented that virtually all the equity and a great deal of the debt that went to the competitive [telecom] service providers that cropped up over the past few years like mushrooms after rain are basically going to disappear.

Q: Mmmm. These were Cisco's customers.

A: That leads to some excruciating short-term revenue trends, but as I said to [Needham's] sales force this morning, it's important to understand network equipment isn't like office buildings in Houston after the oil boom. The stuff that's out there has a finite technological life. And...while these competitive suppliers are going away very rapidly, the incumbent suppliers are still out there. There have been some people raising concerns about the willingness or the capability of the incumbent suppliers to spend on equipment, but I think that there's a [long-term] trend there for the incumbent suppliers, the Bell telephone guys...

Q: ...Say, an SBC Communications (SBC) or a Verizon (VZ)?

A: ...Yeah, to get more aggressive in their spending. Did you ever study philosophy?

Q: Just enough to be dangerous.

A: You know Hegel and Marx with their thesis and antithesis, and then synthesis? This happens in business, too. The incumbent suppliers had an overwhelming focus on [telecom] network robustness. The startups...have had a focus on increasing bandwidth through greater speed and lower cost.

Q: O.K.

A: Well, the incumbent suppliers are going to have to focus on increasing bandwidth and reducing cost to the customer. The startups that survive are going to have to increasingly incorporate robustness into their network offerings. Over time, those that survive will end up looking more alike because the market will dictate how evolving networks should look.

What we need to...not lose sight of is that with all the bad news right now, Cisco is still going to report revenues higher this quarter than a year ago. Extreme Networks (EXTR) would have to have their March revenues drop 54% sequentially to match where they were a year ago.... At the low end of the guidance Foundry has been offering for this quarter -- $100 million -- it's still 42% higher than a year ago. Now, over the next couple of quarters, the sequential rates will continue to be under pressure, and the annual comparisons will become negative.

Q: This is bullish?

A: These are comparisons to a period last year that everybody now recognizes was fictitious. So, let's talk about the future, not the past, and it seems to me that to write off these companies, which by and large have excellent balance sheets, represents a major investment error.

Q: Cisco has benefited from the strength of its stock over the past five years or so by being able to buy technologies and little companies to plug holes in the product line, using the stock as a currency in deals. Do you think it will be more difficult for Cisco to do that now?

A: Cisco has engaged willy-nilly in the "buy" part of the "make or buy" decision for expanding their product portfolio.... Because Cisco was willing and able to pay so much for those companies, that led to the venture capitalists expressing greater willingness to underwrite people leaving established companies to start new ones and sell them off.... I think...maybe Cisco doesn't have the same absolute capability to go out and buy those companies [now].

Q: Right.

A: But keep two things in mind. First of all, the people selling those companies aren't going to be having expectations of valuations anywhere near like what we saw. And, secondly, there's going to be fewer companies started up, because the mechanism that promoted that is broken. So, I see that as a wash.

Q: What else is important to note about Cisco right now?

A: Cisco has been able to extract a handsome price premium in the marketplace over the last couple of years because they offered a [level of customer] support that was unparalleled in the industry. I think that was driven by two things.

Q: Go on.

A: Network managers over the last couple of years have had a gun to their heads to grow their networks' capabilities as rapidly as possible -- and do it in a period of acute human-resource shortage. So if you've got people hammering you to build out your network as fast as possible, and you can't find bodies to help you do it, the supplier that can work you through that has a value.

However, slow down your growth rate...and over time, you naturally grow the number of people who understand this stuff. Then, it would seem there's a very good chance that people could shift from the handholding and support characteristics of Cisco to the best-of-breed-at-a-lower-price strategy used by people like Extreme, Foundry, Riverstone Networks (RSTN).

Q: So Cisco could face stiffer competition?

A: I would see this as a critical juncture for Cisco. I believe that in the wide-area networking market segment, the potential for [market] share gains represented by Lucent's (LU) disaster could make Cisco look pretty darn healthy. And the real trick over the next couple of years will be to ascertain whether, in fact, picking up share from such a halt-and-lame competitor as Lucent masks the possible deterioration in Cisco's historic core business.

Q: Easy pickings?

A: Breathtaking.

Q: Of Cisco's competitors, which are your favorites?

A: I think Juniper (JNPR) is the most impressive. It's also, under our valuation [model], the least-impressive stock because everybody recognizes how good the company is.

Q: Others?

A: For the other companies, it's like being a kid in a candy shop. I mean, these things have all gotten ridiculously cheap. [Look at] Foundry at seven bucks. It's got $250 million in cash investments, no debt. Somehow I think bankruptcy isn't around the corner, yet the stock is being priced as though this will be the first company taken into Chapter 7 [bankruptcy] with no debt. How does that work? I'm still trying to figure that one out. Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BW Online.

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