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FEBRUARY 20, 2003 STREET WISE By Olga Kharif Cisco's Juicy Margins: Too Rich? The networking giant has been able to surprise Wall Street, thanks to its high prices. That, however, could open a door to rivals
Yet trouble could be brewing for this San Jose (Calif.) tech survivor. It has charged a premium over rivals' products for years. Even during the economic boom, when dozens of startups flooded the market with faster and cheaper switches and routers, Cisco gear cost more. But big companies back then had the money to spend and were in a rush to build out their telecom networks. As much of these no-names' gear rots in the junkyards, Cisco continued to perform, able to maintain its high prices even during the ugly downturn. There's the rub. Cisco has kept shareholders happy despite a revenue slowdown by improving margins that were already plush. Its latest quarterly results surpassed the Street's wildest dreams. While sales dipped 2.1%, to $4.7 billion in its second fiscal quarter ended Jan. 25, Cisco's gross margins skyrocketed to 70.4%, up from 57.6% in a year-ago quarter. "MILKING THE CASH COW." Thanks to cost cuts, lower component costs, and higher prices, "we have achieved some of the best financial metrics in our company's history," said CEO John Chambers during a Feb. 4 earnings call. Investors cheered, sending the stock up 22%, to $13.42 in late-morning trading the day after the announcement, and it closed at $14.42 on Feb. 19. Yet the way some industry watchers see it, Cisco's high prices may end up being a problem for it and investors. Even after discounting most of its most popular products by 20% to 25% in the past six months, Cisco charges up to 70% more than some rivals, says Jim Slaby, an analyst with tech consultancy Giga Information Group. "They're milking the cash cow -- the customer," he says. "But some of it could be coming at the expense of goodwill. Some customers are sick of getting squeezed like that." While switching vendors is expensive, some users are starting to make that move, says Slaby. And competitors Alcatel (ALA ), Nortel Networks (NT ), Dell (DELL ), and several Asian vendors are more than willing to step in. "We see this as an opportunity to gain market share," says Malcolm Collins, president of Nortel's enterprise-networks division. MARGIN OF ERROR? Vendors such as Nortel have recently stabilized their businesses, despite gross margins that are less than 40%, nearly half Cisco's. And they've recently come out with new products that work as well -- or better -- than Cisco's but cost a lot less. Most important, thanks to advancements in interoperability, rivals are gearing up to make their products run seamlessly on networks originally built with Cisco parts. This means Cisco could be in for an unpleasant surprise from some of its cash-strapped customers, experts say. It told Wall Street it can deliver 68% to 70% margins in the current quarter, says Slaby. But if they don't drop to the low-60% range, some customers will walk, he predicts. Says one IT manager, who preferred to remained unnamed: "When I saw Cisco's margins last quarter, I sent a note to my guy negotiating pricing with Cisco and told him to be sure to mention [the high margins] to them. I don't want to pay too much of a premium." Because Cisco doesn't expect an uptick in sales anytime soon, lower prices would result in a lower income. Alternatively, it could keep prices high -- and suffer in the long term. The dilemma helps explain why 19 of 41 analysts covering the stock rate it a hold or a sell.
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