Cisco: Hours of Darkness before the Dawn


By Alex Salkever With Cisco Systems hitting what appears to be a bottom, market optimists are now saying the worst of the tech wipeout is officially over. After all, Cisco is the bellwether of tech bellwethers, the company that powers computer networks for everyone from international phone giants to small businesses. It sure sounds like capitulation when you hear the company's once-irrepressible CEO, John Chambers, claiming that his company has suffered the equivalent of a 100-year flood and that the world economy is headed into the drink. Are the streets now clear for Cisco bulls to run wild? Not necessarily.

Chambers laid his dud hand out on the table in a conference call and braced for the worst. The networking giant's CEO preannounced fiscal third-quarter earnings after the markets closed on Apr. 16, 'fessing up to a monstrous write-down that could reach $3.7 billion and a stunning 30% quarter-over-quarter decline in revenues. The Street held its breath in anticipation of an apocalyptic Nasdaq reaction. But investors kept their cool on Apr. 17, sending Cisco shares down just 3.2%, from $17.20 to $16.55.

Yet hardly anyone thinks the company is out of the woods. Chambers himself admitted in the conference call that sales should go down for another quarter yet. What's more, some analysts believe that Cisco shares, down 80% from a 52-week peak of $80, still have a ways to slide. Investment bank Epoch Partners released a note on Apr. 17 stating, "We do not believe the stock has hit rock bottom and recommend investors stay away until the tone in the industry improves." According to Richard Shannon, an analyst at the firm, Cisco right now is worth about $10.50 per share. That's a full 35% off the current valuation.

UPHILL BATTLE. Could it really be that bad? Yes, but not because things are going to get markedly worse. Rather, things aren't going to improve, and that fact may not yet be reflected in the share price. The former high-flying, can-do-no-wrong tech giant faces an uphill battle to return to the 35%-a-year growth the Street had become addicted to. "You will hear a lot of people tell you that all the bad news is on the table. The problem is, it doesn't get any better either. People are underestimating how long it will take for Cisco to really show improvement," says Paul Sagawa, an analyst with Sanford Bernstein. Cisco likely won't return to its 2000 earnings figure of 53 cents per share until at least 2003, he adds.

That's bitter medicine to swallow for Nasdaq groupies still desperate to believe data networking stocks will rebound before the year is out. Although Chambers' flood analogy was a tad melodramatic, it's clear that a raft of coinciding woes could keep Cisco's head underwater for some time to come.

For starters, the crisis in telecom is far from over. Over the past three years, the big guns such as WorldCom, Level3, and 360Networks spent billions building mammoth data networks. Cisco was one of the prime suppliers of gear for these networks. But Sagawa says the telecom industry is stuck with so much debt that it's paying $1 in interest to bondholders for every $10 in revenue it takes in. That, according to Sagawa, is an unsustainable debt-to-revenue ratio and means weaker companies without strong revenue streams could go bankrupt.

DOUBLE BLOW. The upshot? Telecom spending is in a deep freeze until the shakeout is finished and revenues rise enough to justify the debt levels. That's what Chambers alluded to when he said visibility for future earnings was at an all-time low. It's a double blow to Cisco, which makes money from these carriers not only in selling core routers (computers that serve as data traffic cops for big networks) but also optical transport gear used to move reams of information. Throw in the ongoing slaughter of the upstart competitive local exchange carriers (known as CLECs, which compete with Baby Bells in providing local data and phone service) and a sizeable chunk of Cisco's customer base is mired in debt or could be headed for Chapter 11.

But there's more. Things don't look a whole lot better for Cisco's strongest line of business: selling data-routing equipment to big corporations outside the telecom industry. This market's dominant player, Cisco makes between 50% and 60% of its revenues here, according to Epoch Partners' Shannon. Corporations spent massively on routers as part of their quest to upgrade systems to make them Y2K-compliant. Now they're reluctant to drop more cash into these systems, particularly as corporate earnings growth decelerates. That could be more pronounced as office closures and furloughs reduce demand on networks.

Meanwhile, in the post-Internet bubble era, companies no longer fear getting "Amazoned," an irrational reaction that once drove them to overspend on information technology. The pendulum has swung all the way in the other direction, making router sales much tougher.

BRUTAL COMPETITION. And Cisco has struggled to crack the optical routing and switching market where Nortel, Lucent Technology, and Alcatel are duking it out against a handful of nimble upstarts. Cisco's strategy in this arena was to buy smaller companies with competitive technologies. But in March, Cisco phased out an optical router it acquired in its $500 million purchase of Monterrey Networks in August, 1999. And Cisco's December, 1999, $2.15 billion purchase of European conglomerate Pirelli's optical-systems division has yet to bear real fruit. Only Cerent Systems, a $7 billion acquisition in August, 1999, has proven a winner for Cisco.

Finally, Cisco faces brutal competition in two areas that it had hoped would provide the strongest growth. In the fast-expanding market for so-called core routers used by Internet service providers and telecoms, voracious Juniper Networks has grabbed a 35% market share, most of that from Cisco. Juniper offers better products at lower prices, analysts say, and Cisco has yet to react with a comparable product. Cisco obviously disagrees. Nonetheless, "the obvious eyesore is the core router market where Juniper has continued to eat away at them," says Shannon of Epoch Partners.

Still, let's not forget that Cisco remains a profitable company. While the speed and the severity of this downturn has been devastating, the company averaged 55% growth in 2000 when others, such as networking and phone gear companies Lucent and Nortel, struggled. And Cisco's gross margins remain amazingly high at 50% and above for many product lines. That compares to 20% for most competitors. Furthermore, Cisco's recently maligned acquisition strategy, which used highly valued stock in lieu of cash, hasn't hurt the company's balance sheet in the slightest.

"SPEED BUMP"? At the same time, the unparalleled customer-service culture that Chambers created will continue to make Cisco the default choice for corporations when they do go looking to build or upgrade internal computer networks. "Demand will come back. Right now, it has hit a speed bump. But demand will be there," says Erick Marona, direct of research for Newbridge Partners, which holds Cisco stock in its portfolio. Marona expects the company to recover and hit its stride again, although he's not sure when.

But investors looking for the jolly times with John Chambers to resume in the near term could instead be in for a dreary vigil waiting for the stars realign for Cisco. Salkever is BusinessWeek Online's technology editor


We Almost Lost the Nasdaq
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