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2HRS2GO: Challengers ready for Cisco

Be ready for a gradual changing of the guard in the world of networking equipment.

The stock market loves Cisco Systems Inc. (Nasdaq: CSCO), which currently dominates the market for IP routers and switches. Cisco likes to note that 80 percent of all Internet traffic passes through its hardware, a figure that no doubt has been in the back of investors as they drove Cisco to all-time highs earlier this year.

But the present doesn't always indicate the future.



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"I'm not convinced the IP leader will be Cisco in five years," says Paul Johnson, analyst for BancBoston Robertson Stephens. "Cisco has been an excellent company, but it's lost its technology lead."

The network equipment analyst was speaking between company presentations at the "Investing in Innovation" conference, organized this week by his employer. The event focused mainly on companies often portrayed as organizations with cutting edge technologies or business models. It's an approach that tends to leave out established giants, especially when it comes to hardware.

Johnson is far from being alone in seeing credible threats to Cisco's iron rule; Inter@ctive Week recently published a piece on the same topic. But the Robby Stephens analyst is the one of the few to raise the issue on Wall Street -- according to Zack's Investment Research, more than half of 36 analysts polled about Cisco maintain the equivalent of a "strong buy" rating on the stock.

Shares of Cisco have fallen roughly 13 percent since early July, but that pretty much parallels the decline of the Nasdaq as a whole, so it's likely nothing more than the usual summer doldrums. At worst, Cisco is falling because of a general lack of faith in technology- or Internet-related markets. But if you believe Johnson and others, Cisco faces a deeper issue of its own.

Most of the Internet runs on equipment adapted from hardware designs for internal corporate networks. That's slowly being replaced with devices specifically meant for public, high bandwidth uses: DSL, cable modem traffic, multimedia applications, video conferencing and such. And as far as Johnson is concernced, the companies to look for in the future are what he calls the "new next generation" companies, as opposed to "next generation" ones like Cisco or "old generation" firms such as Lucent.

Some of these cutting edge outfits aren't publicly traded yet, but two of Johnson's favorites -- Juniper Networks (Nasdaq: JNPR) and Redback Networks Inc. (Nasdaq: RBAK) -- recently went out with IPOs that shot past the level mere success into the and landed in the realm of dreams come true. Juniper and Redback are both trading at several times their initial offering prices, although it's anyone's guess how much of that comes from short-covering, since short-selling has become a popular thing to do with attention-grabbing IPOs.

Bargains rarely appear in the network sector, because investors jump the moment anything remotely decent hits the market. But like most analysts following growth sectors, Johnson doesn't worry much about valuations anymore. The growth guys always prefer the conventional wisdom approach: stay with a company if it's good, buy on large declines as long as the fundamentals hold up.

Juniper and Redback happen to be holding up very well. The former posted 76 percent sequential revenue growth in the second quarter, while the latter saw business rise 51 percent. Both boast impressive clientele lists as they seize share from Cisco, according to market observers; assuming the current pace keeps up, even casual observers will recognize Juniper and Redback as leaders within two years, Johnson says.

Many investors have absolute confidence in Cisco's abilty to acquire whatever it needs for market dominance. "That's the pablum Cisco has been feeding you reporters for the last five years," Johnson says. "But name one acquisition Cisco has made over the last couple of years that's amounted to much."

Umm. Can I get back to you on that?

If these next generation network equipment makers wanted to sell out to Cisco, they could have done it already, Johnson believes. Many top-notch engineers simply don't want to work for such a huge company, particularly one like Cisco, which has a tendency to prop up its old technology as long as possible.

Once the current pipeline of network equipment IPOs exhausts itself (probably within 18 months or less), you'll see mergers and acquisitions. "But I think the consolidation will be among the next generation vendors themselves," Johnson says. "It won't be one of the old guys buying in."

Cisco has a fat wallet, so I'm not so sure I'd rule it out in that scenario. But the king is definitely showing signs of weakness.

Other issues:

  • Internet Capital Group Inc.
  • (Nasdaq: ICGE) Investors are seeing this IPO as an easy way to hit every possible sector of e-commerce, since Internet Capital is just a holding company with stakes in all sorts of business-to-business commerce sites. Sounds like a poor man's CMGi.

    Broad market indices were higher in mid-afternoon trading. The Nasdaq Composite Index had risen 12.47 to 2552.47, the S&P 500 had gained 5.27 to 1310.60, and the Dow Jones Industrial Average had picked up 86.12 to 10760.89. 22GO>