Cisco: At the Top of Its Climb?


By Olga Kharif

As the market rally gains strength, investors have been rushing back to the leaders of the tech boom. Take Cisco Systems (CSCO), the mostly widely held tech stock. Its share price has gone from around $14 in April to the $20 range recently -- a surge of more than 25% in five months. The stock hit a 52-week high of $21.05 on Sept. 9.

There's no mystery why. Cisco managed to keep revenues steady at $18.9 billion in fiscal 2002 and 2003, which ended in July. The real eye-popper, though, was that the switching and routing king's profits nearly doubled, from $1.89 billion in 2002 to $3.6 billion in fiscal 2003. Cisco's secret ingredients: internal cost-cutting and success in pressuring component vendors to lower their prices.

While it may look like a good time to join the rush to the stock, conservative investors might want to bide their time. Cisco has little left to cut, analysts say. The only way it can keep earnings growing is by increasing revenue.

OVERDONE OPTIMISM? On the plus side, in its fiscal fourth quarter ended July 26, Cisco reported a 2% consecutive increase in sales, to $4.7 billion. Yet investors seem to have ignored CEO John Chambers' cautious sales outlook in the conference call. Many viewed the 2% increase as the beginning of a run-up -- and jumped back into the stock.

Such optimism may be overdone, even if Cisco can deliver on revenue gains. The consensus view among analysts is that its shares' fair value is closer to $17. With Cisco trading at a 20% premium to that, some portfolio managers are thinking about unloading their holdings. If the rest of the market continues to rally and some big money moves out of Cisco and into other stocks, it could lose its crown as the most widely held tech stock.

Cisco is now trading at 33 times its expected fiscal 2004 earnings of 64 cents a share, according to research firm First Call -- in line with shares of other networking companies. Still, the spectacular growth priced into the stock might not materialize, says Timm Bechter, an analyst with Legg Mason, which is a market-maker in Cisco shares. It's not that Cisco is stumbling. Rather, it's a question of expectations run amok. "To support the current stock value, they need to execute to perfection," says Peter Hofstra, senior investment analyst at the $113 million AIC Diversified Science & Technology Fund, which recently trimmed its Cisco holdings from 8% to 6% of the total.

MORE RIVALS. Perfection may not even be good enough. Bob Straus, portfolio manager at the $338 million Icon Information Technology Fund, recently reduced his Cisco holdings because its price assumes an annual growth rate of 23% a year. Most analysts expect a 17.5% rate. Cisco's future sales growth hinges on a recovery in corporate spending. While some recent anecdotal evidence indicates that information-technology spending is picking up, much of that is expected to be on what was neglected during the downturn, such as replacing PCs, rather than infrastructure, Bechter says.

Bechter, who is more pessimistic than most, expects Cisco's revenue increase to be 4.3% for fiscal 2004. High-growth businesses, such as security products and switches used in storage, account for a mere 17% of Cisco's revenues -- and it faces increased competition in many of those markets. Meanwhile, the more mature 83% of its business will grow at 2% to 4% a year, Bechter estimates, holding total growth down.

What's more, Cisco could grow at a slower rate than overall IT spending due to increased competition, says Jim Slaby, an independent IT analyst based in Boston. A slew of rivals -- including Nortel Networks (NT), Dell (DELL), and Alcatel (ALA) -- are cutting prices. That's partly why Cisco's gross margins declined to 69.9% from 70.8% in the fourth quarter, Slaby says. The margins will fall to 67% to 68% in the current quarter, estimates Steve Kamman, an analyst with CIBC World Markets.

How worried is Cisco about eroding margins? "We take all competition seriously," says a Cisco spokesperson.

HIGH-GROWTH MARKETS. Meantime, telecom spending -- which accounts for about 15% of Cisco's revenues -- remains iffy. On Sept. 9, Baby Bell SBC (SBC) announced that capital expenditures for 2004 will be $5 billion, down from $6.8 billion the previous year. And BellSouth (BLS) just announced it will allocate 13% to 14% of revenues to capital spending this year vs. the 15% expected previously. Cisco's hopes of receiving 40% of its revenues -- or 10% to 15% of total telecom spending, up from 3% today -- might get crushed, says Kamman.

Cisco is counting on new, high-growth markets -- storage, security, voice over Internet protocol (VoIP), and Wi-Fi -- to spur growth. Since entering the storage market last year, it has made strong progress, grabbing about 5% share of unit shipments, estimates James Opfer, an analyst with market consultancy Gartner. And on Sept. 8 and 9, Cisco introduced several storage products that "give them a full product line, comparable" to that of main rivals Brocade (BRCD) and McData (MCDTA), says Opfer. "I am pleased," says Soni Jiandani, Cisco's vice-president for storage. "But we have a long road ahead of us."

The storage area should contribute an estimated $40 million in revenues in the current quarter, according to investment bank C.E. Unterberg, Towbin. That doesn't add much to Cisco's bottom line, however. And it has had to offer price cuts of 35% to get there. "In storage, we made the decision to reduce prices in our continued focus on market share and profit contribution," replies a Cisco spokesperson in an e-mail. "After the pricing reduction, orders grew sequentially by approximately 45% [in the fourth quarter]."

"THE CLEAR LEADER." As a result, the division's profits might not increase as fast as investors hope, says Unterberg Towbin. What's more, price competition has already shrunk estimates of the market's potential size, currently standing at $847 million.

In VoIP, a technology for sending phone calls over the Internet, Cisco is No. 1 in terms of revenue in the corporate market. That category is projected to grow 51.8% this year, to $2 billion worldwide, estimates Jeremy Duke, president of market researcher Synergy Research Group. Still, Cisco lost 11.8 points of market share, bringing it to 27.4%, thanks to an onslaught from rivals such as Avaya (AV).

"Cisco is the clear leader in IP telephony," writes a Cisco spokesperson in an e-mail. "We have gained market share in Q1-Q2 calendar 2003 in most every category, [according to other analysts's research]."

NOT ENOUGH OOMPH. Networking security is another growth area for Cisco, and its 27% market share last year makes it the leader. Check Point (CKP) is a distant second with 13%, estimates Aaron Vance, an industry analyst with Synergy. This market should grow from $3 billion this year to $3.65 billion in 2007, according to Synergy, but those numbers don't add much oomph to a company of Cisco's size.

"The [business'] current profit contribution is extremely attractive and supports Cisco's own long-term business model and profit margin target of 20% net profit aftertax," according to a Cisco spokesperson. "The home networking market represents a major growth opportunity for Cisco."

The same holds true for much-talked-about Wi-Fi -- which gives users high-speed, wireless Internet access. While Cisco's other businesses enjoy margins of about 70%, the home Wi-Fi unit's margins are at 30%, according to Unterberg Towbin. It accounted for only $20 million in revenue in the latest quarter, and it's expected to grow to $115 million in sales in the current quarter, according to management.

BIG BUYBACKS. Again, that's peanuts for a company as large as Cisco. So, in the next six months, it plans to announce six more growth areas, each with the potential of $1 billion in sales. However, these new markets likely won't contribute to sales in a big way for two to four years.

No doubt Cisco's growth strategy is sound. And an aggressive stock buyback program -- it already purchased 3% of its shares this year -- will help keep up the share price, says Kamman. Cisco's government business is booming. And it has benefited from market-share gains in areas such as routers, used to direct Internet traffic.

With $20.7 billion in cash and equivalents, Cisco remains the strongest networking player. Indeed, it's one of the strongest tech companies around and a true bellwether. But until it can prove capable of meeting the Street's high expectations, investors might consider passing this one by for a while. Kharif covers technology for BusinessWeek Online in Portland, Ore.


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