ANALYST WATCH: Crystal ball time for Cisco

Cisco Systems will report its third-quarter earnings next week and while analysts are expecting year-over-year sales growth of around 50 percent and the usual upside earnings surprise, they're more concerned about what Cisco will look like two or three years from now.

Such is the nature of technology investing these days. The fact that Cisco's stock has split four times in the past five years and appreciated more than 111,000 percent since going public in 1990 doesn't mean much to analysts rightfully consumed with the future.

Cisco: What does your crystal ball say?

Even after the recent pullback in technology stocks of all stripes and colors, Cisco (Nasdaq: CSCO) shares are trading at a price-to-earnings ratio of around 180. For all you value shoppers out there, Nortel Networks (NYSE: NT) is trading at 157 thanks to its recent run-up, and Lucent Technologies Inc. (NYSE: LU) is perched at around 57.

Analysts generally agree that while that's a pricey premium, Cisco surely deserves the benefit of the doubt.

But the third quarter has historically been one of the company's more challenging periods—- if you can call 50 percent year-over-year revenue growth and quarterly profits approaching $1 billion a challenge.

First Call Corp. consensus expects Cisco to earn 13 cents a share in the quarter, though most people could easily see 14 cents a share this time around.

"Going forward, the valuation will probably remain on the high end unless they give us something to revise estimates higher," said Martin Pyykkonen, an analyst at CIBC World Markets. "Right now, it's a question of how much competitive distance they can put between themselves and Lucent and Nortel."

While Cisco holds a commanding lead in the IP network-equipment market, pundits are more concerned about how Cisco will sustain its growth as the information technology world continues to evolve.

A huge part of Cisco's unparalleled success has been a result of its aggressive acquisition strategy. In recent years, Cisco's picked up a company or two or more every quarter while gobbling up market share and fattening its top line.

On Friday, Cisco said it will pay $5.7 billion for ArrowPoint Communications.

With Cisco's Internet infrastructure, ArrowPoint's products will enable ISPs, Web hosting companies and other customers to create faster, more reliable content delivery.

But the migration to optical-based switching and data transport will be the key to Cisco's future.

"That's the No.1 question for Cisco right now," said Ariane Mahler, an analyst at Dresdner Kleinwort Benson. "They could run into a potential problem if they don't make an aggressive move into the optical switching market. This year, they might derive 3 percent of their sales from this area."

That 3 percent will likely be anywhere from $500 million to $1 billion in sales. Not bad, but merely a drop in the bucket.

Analysts conservatively estimate this optical-based market will grow at between 80 percent to 100 percent in the next five years. That's one of the main reasons Nortel shares have taken off in the past two months.

In the past, the simple solution would be for Cisco to go out and buy a company like Ciena (Nasdaq: CIEN) and perhaps a couple other start-ups in the optical-equipment arena. But that would be an expensive option and one that some analysts believe wouldn't work for a variety of cultural reasons.

"I have complete confidence that Cisco will get into this market," Mahler said. "But it's not as easy to find optical networking targets. Two years from now, Cisco must be a radically different company than the one we see today. They need to get into the wireless side and the software side if they're going to maintain their terrific growth rate."

Mahler maintains a "buy" recommendation on Cisco and a 12-month price target of $90 a share, though she doesn't see the stock appreciating at the pace investors have come to expect. She's predicting total sales of $4.75 billion in the quarter and a profit of 13.5 cents a share.

Pykkonen sees sales in the neighborhood of $4.68 billion and earnings-per-share of 13 cents.

Last quarter, Cisco easily topped Street estimates, earning $906 million, or 25 cents a share, on sales of $4.35 billion.

Thirty-two of the 33 analysts following the stock rate it either a "buy" or "strong buy."

Cisco shares hit a split-adjusted high of 82 in March after falling to a low of 25 15/16 in June.