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Cisco vs. the world

Is the networking giant vastly overvalued or a hugely successful company whose stock is taking an unfair beating?


    Does the networking giant deserve Wall Street's beating?

    By Wylie Wong and Ben Heskett
    Staff Writers, CNET
    February 9, 2001, 1:30 p.m. PT

    If there was ever a high-tech company held up as a blueprint for how to build a successful large business, it would be Cisco Systems. So why are so many investors treating Cisco as if it has the plague?

    Cisco undoubtedly has its share of challenges, many of which Chief Executive John Chambers himself warned of repeatedly in recent weeks. The networking giant was roundly thrashed for missing analyst estimates in its latest earnings report, sending its stock into a tailspin.

    But even Cisco's harshest critics would be hard-pressed to cast it as a faltering company in a dying industry. If anything, chief executives in all sectors of the industry would kill for growth rates that even began to resemble Cisco's numbers.

    Even with its stock price at a 52-week low (shares closed at $28.19 Friday), the company's market value remains above $200 billion. Until recently it has been adding 4,500 new employees per quarter (though it has now instituted a near freeze), while annual growth rates have consistently exceeded the industry average for years. Cisco grew 55 percent for the fiscal year 2000.

    All of which argues in favor of a reality check on the health of this industry leader. That, however, cuts to the heart of the issue: Reality is an elusive concept when it comes to company assessments on the stock market.

    "Wall Street does tend to react with a herd mentality oftentimes. People are momentum investors. They don't care what the stock valuations are as long as the company keeps beating the numbers," said analyst Seth Spalding, of Epoch Partners.

    "And if there is negative (news) from a company, that negative will exceed reality. Cisco has finally not been able to meet the high expectations that have been set for it. Cisco is not a bad company, but I do think Cisco needs to be valued based on the numbers out there, their published estimates (for upcoming quarters)."

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    Analyst: Has Cisco hit a financial wall?
    Don Luskin, CEO,
    Cisco's current price-to-earnings ratio is 44, down from a stratospheric high of 102 in December 1999. The P/E ratio--the stock price divided by the expected earnings per share for the next four quarters--is a common benchmark for determining whether a stock is overvalued. By comparison, IBM has a P/E ratio of 25 and Microsoft's is 34.

    A high ratio indicates that investors believe the company's earnings will rise quickly, thereby justifying the lofty stock price. Depending on who is asked, Cisco is either vastly overvalued and growing far beyond its means or a hugely successful company whose stock is taking an unfair beating among shortsighted and unrealistic investors.

    "If you want to invest today with a 10-year horizon, the investment is a good idea. But if you want to invest with a one-year horizon, it's not a good idea now because of the (economic) down cycle," said Paul Sagawa, analyst with Sanford C. Bernstein & Co.

    Are they really ready?
    Regardless of Wall Street's analysis, this is the same company that has been held up as a model of corporate strategy, management and expertise worldwide. Unlike other large technology companies that have become known for industry strong-arming or corporate arrogance--namely Microsoft and Oracle--Cisco has had a reputation for keeping its nose to the grindstone, sticking to a successful, albeit relatively boring, line of products.

    To many who have followed the company since well before the Internet boom, the culprit for its change in public perception is Wall Street, not Silicon Valley.

    Meta Group says although Cisco's year-to-year gains in quarterly revenue and profitability are certainly impressive, these results are a considerable drop from the company's historical growth rates.

    see commentary

    For example, supporters of Cisco say it should never have been assumed that the networking giant could somehow sidestep the issues plaguing the industry it serves. Logic defies that conclusion, they say. As a result, a wider swath of the analyst community should have lowered its earnings estimates to begin with. Twice in January, Chambers warned Wall Street of potential difficulties in the company's second quarter because of slower sales.

    Signs are everywhere that even the mighty Cisco cannot continue to grow at its usual pace among the wreckage of failed telecommunications firms, reduced spending by existing network operators and a general malaise due to larger U.S. economic concerns.

    Cisco is entering the slowest revenue growth period in its history. Sales for the next two quarters are expected to remain flat sequentially, forcing Cisco executives to slash revenue growth predictions for the current fiscal year from between 50 to 60 percent to 40 percent.

    Analysts say the main factors in Cisco's current financial woes are the slowing economy, a general slowdown in network equipment sales to telecommunications service providers, heavy competition from smaller niche players like Juniper Networks and Redback Networks and a recent brain drain of top-level Cisco executives.

    "It shows Cisco is human," said Sagawa, "It shows all companies are capable of being affected by the economic health of the industry they're competing in. You can't grow too much faster than your customers can grow. And when you have 60 percent market share, it's hard to get more."

    Breakaway or breakdown?
    Despite the slowing economy, Chambers has argued that Cisco can still break away from its smaller competitors, which are good at niche products, but don't have the product depth Cisco does.

    Chambers said during the company's analyst conference call this week that for the past seven years Cisco has maintained that the area it plays in will grow 30 percent to 50 percent each year--and that the company can maintain that growth.

    Chambers has also argued that there are many emerging markets that will drive growth for Cisco, such as networking hardware that speeds content over the Web and devices that allow businesses to make phone calls over the Net.

    "We can break away regardless of market inflections...Almost all the market trends are aligned for breakaway. (We are) strong end-to-end in enterprise and service providers. Many of our competitors are primarily focused on one major line of business."

    Analyst Paul Johnson, of Robertson Stephens, disagrees, arguing that Cisco has lost market share to smaller competitors, such as Juniper Networks, Redback Networks and Extreme Networks. For example, in the high-speed network router market, Juniper in just two years has captured 30 percent of a market that Cisco has historically dominated to such an extent that no one even tried to compete until recently.

    Telco troubles weigh heavy
    Cisco has embarked on an ambitious strategy the past two years to tackle the needs of telecommunications firms--companies that spend billions each year to upgrade their global networks. In doing so, Cisco embraced a new set of competitors head on, such as Nortel Networks, Lucent Technologies and Ciena, among others. Cisco, in typical fashion, has spent in excess of $10 billion to enter the market. But just as it honed this strategy, demand appears to have ebbed--at least in the short term.

    Cisco's carrier-business strategy is centered on new emerging carriers, such as DSL service providers and Internet data operators, some of which are struggling financially. And because the service providers are struggling to turn a profit, Cisco isn't able to sell as much networking equipment. Furthermore, the company has loaned exorbitant sums to some questionable firms, though it maintains that its customer financing practices are conservative.

    "The argument for buying Cisco (stock) was that the demand for the Internet is infinite," Sagawa said. "But broadband isn't rolling out that quickly and people aren't using the Internet that much more. Growth seems to be decelerating. If demand isn't infinite, the same economic rules apply for any product produced in the world."

    Many investors expected Cisco to dominate the carrier landscape like it did in the business market, but that now seems unlikely, analysts said. Cisco will just be one among several suppliers, a slight change from its past when it was the only router-maker in town.

    But there is reason for optimism. Telecommunications spending, despite all the doom and gloom, is expected to grow this year--just at a lower rate than expected. In addition, network operators are putting most of their spending toward newer Internet-friendly equipment, which plays right into Cisco's expertise.

    Despite some recent high-profile executive flights and increased interest in start-ups among Cisco's engineering corps, the company also has what is widely recognized as a deep bench. That could, however, come under further stress since the company's stock has typically doubled every year in recent years--something that won't occur this year.

    And then there is Chambers, widely recognized as one of the great motivators and customer-driven chief executives in the technology business and as savvy a player as they come.

    Spalding, the Epoch analyst, said Chambers has lowered expectations so much for the next two quarters, that Cisco can probably easily beat the numbers. That way, Cisco can build momentum for Wall Street to have faith in the company again, he said.

    "Chambers is savvy and he knows how to manage the Street. He doesn't like to disappoint, but he'll do it all at once," Spalding said. "In reality, he probably has visibility of better numbers. It's all about managing expectations, and Cisco is the master at that." 


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