Cisco dinged by ''challenging'' quarter, downgrade

Shares of former high-flier Cisco Systems (Nasdaq: CSCO) hit some turbulence Wednesday after an analyst issued a pessimistic report and the company's chief executive described the current quarter as "challenging."

A CIBC World Markets analyst said in a research note that the networking giant's glory days may be over. In response, Cisco shares tumbled more than 8 percent in early trading before recovering.

A few hours later, however, the shares once again dipped some 8 percent after CEO John Chambers described the company's current second fiscal quarter, as "more challenging" at a Morgan Stanley Dean Witter investment conference in Phoenix, Ariz.

The one-two punch of the analyst report and Chambers' comments resulted in record trading volume for Cisco shares: volume topped 212 million shares.

Chambers sent mixed signals on the economy and its effect on Cisco. In many respects, Chambers sang the same tune he does on the company's earnings conference calls. However, Chambers also seemed to be prepping Wall Street for a potential slowdown in revenue growth.

"Is the economy slowing? Absolutely," said Chambers. Cisco's second quarter is "a little bit more challenging" because of the slowdown and the company lacks "good visibility into the next two quarters," he said.

But Chambers was sure to draw distinction between short-term turbulence and long-term problems. The double-talk led to a few interesting observations. "Let me say this directly, our customers business is slowing, not our business with customers," said Chambers, who indicated that the Federal Reserve should have cut interest rates at its December meeting. "They describe it in the same way, the economy was like hitting a wall or like hitting the light switch."

Although he noted Cisco wasn't immune to a slowdown, which occurred "at a faster pace than people realize, he added that the networking giant "won't be as affected as some segments of the IT community."

Chambers frequently returned to his familiar mantra that the industry will grow at a 30 percent to 50 percent clip in the long run. "If we can execute as we have in the past, I'm more comfortable about our future than we've ever been," he said.

Chambers' presentation was just another key item in a volatile trading day.

Cisco, which has been downgraded recently, took another knock when CIBC World Markets analyst Steve Kamman downgraded Cisco, along with several networking equipment companies including Juniper Networks (Nasdaq: JNPR), which was dropped to a "buy" rating from "strong buy," and Redback Networks (Nasdaq: RBAK), which was cut to "hold" from "buy." Lucent (NYSE: LU) was upgraded to "buy" from "hold."

Kamman's downgrade of Cisco to "hold" from "buy" wasn't a new idea, but his take that the company will become a bloated giant was interesting. Based on short and long-term concerns, Kamman said the company is fulfilling the prophecy of Clayton Christensen's book "The Innovator's Dilemma," where dominant companies falter because they cling too long to a business model based on sustaining technologies rather than disruptive ones.

The gist of Kamman's thesis is that Cisco won't be able to continue its rapid acquisition pace to keep a technological edge. Kamman joins an increasingly vocal minority of analysts doubting Cisco's growth potential. "All acquisition-driven strategies inevitably must end," said Kamman.

Not all analysts agree. In a research note last week, Lissa Bogaty, an analyst with CS First Boston, said Cisco's quarter is "in good shape." Coupled with a cut in interest rates that should boost capital spending, Cisco should be able to continue its traditional growth rates," she said.

Kamman said it's doubtful that Cisco can continue its current growth.

"We believe Cisco will not make consensus revenue estimates in fiscal year 2002 and expect will it no longer be able to rely on appreciating stock as a currency," Kamman stated in his report. He said 30 to 40 percent revenue growth is now mathematically unlikely, and expects a long-term revenue growth rate of 20 to 25 percent from now on.

Kamman said Cisco is likely to see a slowdown over the next six months. He also said the company's failure to develop an OC-192 interface card, and its loss of 30 percent share to Juniper (Nasdaq: JNPR) does not bode well.

He recommended that investors wait the transition out. He said Cisco will stay dominant in the enterprise market, but may falter in the service provider business.

The company is not "well positioned to meet an expected tsunami of changes in the telecom market," because its "end-to-end" strategy and "intelligent network" vision run counter to fundamental trends in the industry, said Kamman.

He described a coming telecom shakedown where carriers cut costs by building out lower-cost network designs, rather than increasing revenue by adding new features and services, as Cisco currently expects them to. Kamman also noted a trend towards specialized horizontal service providers which will to look to buy from equally focused equipment suppliers.

Brain drain will also continue as Cisco loses high-level execs, said Kamman. To keep employees, the company may re-price options.

The analyst painted a grim picture for the company; he expects it will "either increase cash compensation or option grants to try and stem the tide ... (creating) a strong negative feedback loop, with re-pricing/cash grants spurring further stock drops, leading to further departures."

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