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Cisco optimism may be misplaced

Signs that the networking giant's business is improving might be nothing more than a "head fake," some analysts say.

Wall Street's optimism about Cisco Systems' fourth quarter may be short-lived, as signs that the networking giant's business is improving might be nothing more than a "head fake," some analysts say.

In recent days, Wall Street has been hopeful that Cisco's business is stabilizing and improving somewhat, but the company won't comment until it reports earnings early next month. Some analysts seem to be jockeying for position to say the worst is over for the company. Yet many of their peers are telling potential Cisco investors to beware.

"The short-term sentiment may switch on the stock, but I can't see the (telecommunications) capital-spending cycle getting much better," said Bill Schaff, fund manager for the Berger Information Technology Fund. "I don't believe their growth numbers and wouldn't be a buyer much beyond the very low teens."

Cisco shares were one of the few gainers Monday, closing up 28 cents to $18.27, a level Schaff says is too expensive.

Nevertheless, UBS Warburg analyst Nikos Theodosopoulos upgraded Cisco shares to "buy" from "hold" Monday and raised his price target to $24 from $20. "Based on our channel checks, we believe Cisco is not going to miss consensus expectations for the July-ending quarter," he wrote in a research note. "Distributors and salespeople indicate that there has been no big sales push during the final two weeks of the quarter."

Theodosopoulos went on to describe a "sense of calm" about the fourth quarter, indicating Cisco will at least meet First Call's earnings target of 2 cents a share on sales of $4.35 billion. The UBS outlook comes just days after Salomon Smith Barney said in an internal memo that the networking giant is placing orders with its contract equipment manufacturers, a sign that may mean business is picking up.

Analysts said the fact that Cisco is potentially comfortable with its earnings target may be viewed as a good sign, but they note that investors shouldn't get too excited. The company projected that revenue would be flat to down 10 percent from the third quarter. Despite a relatively upbeat research note, Theodosopoulos is still predicting that fourth-quarter sales will be down 8 percent from a year ago.

In any case, fourth-quarter sales will be down sharply from the $5.72 billion reported a year ago.

"It's all a matter of expectations," said Paul Sagawa, an analyst with Bernstein. "There's no reason to cheer a revenue decline. It shouldn't be assumed that things are getting better."

Sagawa said Cisco's third-quarter deferred revenue--money a company collects before it actually delivers a product--was higher than his estimates at $2.58 billion, up from $1.99 billion in the second quarter. According to Sagawa, that deferred revenue provided Cisco a "running start" in the fourth quarter.

To Sagawa, the deferred revenue issue just shows that Cisco is "taking steps to manage its business" in a weak economic environment. Analysts will closely watch to see if Cisco was able to bank future sales for the first quarter. Sagawa said Cisco probably won't provide an outlook for fiscal 2002 because economic conditions remain weak.

And Sagawa isn't the only analyst with that view. Many analysts said a rebound at Cisco could take awhile. Yes, Cisco is likely to be a winner once the telecommunications dust settles and it has a lot of cash, but it will take months--if not a year or more--for the company to show growth again.

Indeed, Theodosopoulos alluded to a slow rebound even though he upgraded the stock. Theodosopoulos said Cisco's first quarter ending Oct. 31 could be weak and it's possible that telecommunications capital spending won't improve until mid-2002, if not 2003.

Nikos Papageorgiou, an analyst with Fulcrum Global Partners, also noted that telecom spending will remain weak and came up with a different conclusion than UBS Warburg; he initiated coverage with a "sell" rating.

"Any improvement is a head fake," Papageorgiou said.

Papageorgiou is predicting Cisco's fourth-quarter sales will be down 11 percent sequentially, slightly worse than the company's outlook in May. He also said he expects Cisco to cut its targets for the first quarter. In other words, it's possible that Wall Street will be debating Cisco's growth prospects this time next year.

For Papageorgiou, a lot of things have to go right before an investor should hop on the Cisco bandwagon. For starters, telecommunications carriers have to get their houses in order. Papageorgiou said capital spending won't increase until telecom carriers "improve their profitability, digest their prior spending, improve their balance sheets, and the capital markets re-open." And so far there's little evidence that any of those events are happening.

Papageorgiou acknowledged that much of Cisco's business comes from corporations, but healthy telecom carriers are needed for the networking company to return to its historical growth rates. "Everyone is trying to catch the bottom, but it's a little premature," he said. "At a minimum, Cisco's revenue is six to nine months away from a turnaround.

"Things will probably get worse before they get better."