Why Cisco Investors Switched Off


On Feb. 3, Cisco Systems (CSCO) reported fiscal second-quarter results that seem solid. The networking giant boasted $5.4 billion in sales -- 15% growth over the same quarter a year ago and 6% better than the previous quarter. Net income was $1.3 billion, or 18 cents a share -- one cent better than analysts were expecting and up from 15 cents a share a year ago.

Yet in the conference call discussing the quarter's results, Chief Executive John Chambers was subdued. While the businesses that buy Cisco equipment are getting a bit more optimistic about the overall economy, he said, they continue, "perhaps surprisingly," to be cautious about their own capital spending and hiring plans. In the third fiscal quarter (typically one of Cisco's weakest), Chambers forecast sales growth of just 1% to 3% vs. the second quarter.

INSIDE-THE-PARK RESULTS. He went on to explain that Cisco's core switching and routing products were selling well and that its "advanced technologies" divisions, which supply equipment for such high-growth markets as storage, wireless, security, and voice-over-IP (VoIP) networks, were growing briskly and gaining market share. But in total, "advanced technologies" still made up just 15% of Cisco's sales in the quarter. For future growth, "GDP will continue to be the best indicator of what you should expect over the long run from Cisco," Chambers said.

That was hardly the message that investors were hoping for. Out-of-the park results posted by networking-equipment providers Juniper Networks (JNPR) and Nortel Networks (NT) had raised expectations for a home run from Cisco. The stock, which had traded up to $29 ahead of the earnings report, dropped nearly 10% the next day. It has continued to fall, closing on Feb. 17 at $24.25.

The problem at Cisco isn't execution -- although there was unsettling word of manufacturing snafus and component shortages during the quarter that most analysts dismiss as a temporary misstep.

"EVEN MORE EXPENSIVE." The real problem is more fundamental -- and tougher to solve. Investors are beginning to realize that the market for Cisco's core routers and switches is maturing. Lee Doyle, an analyst who covers networking equipment for IDC, forecasts that the market for networking equipment that businesses buy will grow in mid-single digits in 2004 -- about how the economy is expected to perform. That may have been where Chambers came up with his projection that Cisco would grow roughly as fast as the overall economy.

Viewed in terms of that unexciting prospect, the stock is getting pricey. "I thought Cisco was expensive before," says Henry Asher, president of investment firm Northstar Group in Manhattan. "After listening to the earnings call, I thought it was even more expensive."

Cisco's price-earnings ratio is now about 34, vs. an average of 18 for stocks in the S&P 500-stock index. Peter Hofstra, senior investment analyst at AIC funds, says following its recent decline, the stock is fairly priced. But he thinks it would have to get below $20 to be a great buy.

LITTLE CHOICE. Cisco's plan for faster growth is to dominate new, high-growth markets like Wi-Fi and VoIP. The problem there, says Stuart Phillips, a general partner at U.S. Venture Partners, is that some of those markets may be only a $400 million to $500 million sales opportunity for Chambers' company for years. "For Cisco that's a rounding error," he says. Worse, trying to dominate these markets can require a great deal of management focus. Even so, Cisco has little choice but to go after them, since one could "suddenly explode" and become a $4 billion to $5 billion opportunity, says Phillips.

Meantime, Cisco's core business of selling routers and switches to businesses is getting tougher. Economic recovery or not, Cisco is simultaneously facing more pressure from competitors and less-than-roaring demand for its biggest products, which means profits are harder to come by. In the recent quarter, Cisco reported a slight decline in gross margins from 68.7% in the first fiscal quarter to 68.5% in the second (year-earlier gross margins were 70.4%).

"Two or three years of exploiting customers' lack of alternatives is over," says Jim Slaby, president of IT consultancy Union Park Research in Boston. What's more, Cisco's suppliers are enjoying a pickup in orders from other manufacturers -- and are no longer willing to take the router king's pressure to keep prices low. "Cisco is getting bitten on both ends," Slaby adds.

SURPRISE COMING? None of this means Cisco's presence in the networking business is any less dominating. Indeed, some analysts believe that investors are being way too quick to write off Cisco. They think Chambers' cautious remarks are positioning the outfit for a positive surprise in its fiscal third quarter. "We believe it very likely that Cisco will be able to exceed the expectations of newly skeptical investors" in its third fiscal quarter, wrote Sanford Bernstein analyst Paul Sagawa in a Feb. 4 note.

Plus, the recent dip in margins was mostly due to rapid growth at Linksys, a Cisco unit that sells consumer-oriented Wi-Fi gear. Linksys has margins closer to 30%, points out Legg Mason analyst Timm Bechter. He continues to see huge future growth potential for Cisco in the VoIP market. In the second quarter, Cisco reported weak demand for IP phones -- yet another reason some investors may have been disappointed with results. But that market is sure to pick up, predicts Bechter.

That's a long-term perspective worth keeping in mind. But for now, with Chambers' cautious comments still echoing and the shares carrying a hefty p-e, lots of market watchers think Cisco doesn't stand out as the kind of exciting growth opportunity that many tech investors are hankering for. By Amey Stone in New York, with Olga Kharif in Portland, Ore.


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