Software And Networking Outlook
Profiting From The Networkers Crash
Thursday, April 03, 1997
It's enough to make you run away screaming: Ascend Communications, down from $80 a share to $40; Cascade Communications, down from $91 to $25; even Cisco Systems, the king of networking -- a company Wall Street insiders used to say would be a steal at $60 a share -- is down from a high of $76 to just $47.
What in the world has happened to networking stocks? A year ago, all the talk was about the unbounded growth ahead for the industry. It's a
story that remains largely intact. Yet investors who bought into it have been rewarded with truly brutal losses. Why should anyone ever
consider the sector again?
Money. That's the reason: a ton of money. Because networking stocks will come back. To understand why -- and why a cloud of trouble has infused the group these days -- you need to understand what the networking business is really all about.
In most accounts, networking companies are described as a monolithic group, as if understanding distinctions between them is way too complex for ordinary people to grasp. But the industry is neither monolithic nor unfathomable. When an E-mail message, for instance, is sent from one place to another, it moves through a variety of boxes and switches that help speed it along. Different companies have tended to specialize in producing different products along this chain -- routers, hubs, switches and so forth. And as the Internet and all it implies has come into its own, these companies have seen the markets for their products explode.
What has happened recently to slow the boom has been entirely predictable: Companies once content to capture just one piece of the
networking chain now aspire to deliver products all along the spectrum.
That means they have begun poaching on one another's turf. Established companies are having to fend off competitors; expansionist types are
sacrificing short-term results to gain market share. There is a fundamental restructuring of the sector.
There is, of course, a technological aspect as well: New ways of moving data, such as Internet protocol (IP) switches, are talked about as potential shortcuts in the data flow, threatening the demand for some existing products. New generations of tried-and-true technologies are poised on the horizon prompting some buyers to sit out for a while as they marshal their resources for the next big product transition. All these forces have combined to turn companies (and stocks) that once were viewed as unbeatable into centers of turmoil.
Yet in the past, similar periods of uncertainty proved to be the best times to invest in networking. No one is saying the future demand for networking products will be anything less than enormous. The stocks have been hammered because near-term-oriented investors, who have tended to congregate in the stocks because they were moving up so rapidly, are worried about results in the next quarter or two. Yes, these momentum players will continue to roil these stocks, on the upside and the downside. But investors with a longer-term view, and a stomach for some turbulence along the way, could view the recent drubbing in these shares as a buying opportunity. I don't know that you will ever be able to buy these stocks at these levels again.
Do you think they are done building the Internet? And do you think improving corporate networks is a lower priority than in the past? What drives the industry's expansion is the craving for something called bandwidth -- in essence, the rate at which information can be
streamed from one point to another. And dramatic as improvements in bandwidth have been during the past few years, during the next dozen years, it will increase 700-fold, making possible all kinds of new applications.
But this doesn't mean buying networking stocks is like shooting fish in a barrel. Some companies will undoubtedly succeed, while others will be left behind. In certain parts of the technology world, young upstarts have great advantages because their innovations can get directly to consumers. But with networking, it is the established businesses that have the edge. Customers, particularly on the corporate side, are confronted with such a daunting array of increasingly complex -- and not inexpensive -- products that vendors who can deliver up-to-date, trouble-free solutions engender uncommon loyalty. What follows are snapshot appraisals of six major networking concerns, and what it will take for them to pay off for investors.
Cisco Systems [OTC, CSCO, $47, P/E =30]
Everyone else in the industry wishes they had Cisco's dominance of the market, and they're all gunning to take its place. The company, which
supplies, among other things, most of the routers that direct information across computer networks, said it predicts no fundamental change in demand for its products, which it expects to grow 30 percent to 50 percent annually into the next millennium. "All customers want to talk about," said Cisco Senior VP Selby Wellman, "is how they can deploy this technology faster." Last quarter, for instance, profits jumped 61 percent; revenues were a hefty $1.6 billion. Nevertheless, Cisco's $47 share price is 38 percent off its January high and just 21 times projected earnings for this year. Near-term concerns are causing a few analysts to downgrade the stock, with sequential revenue growth expected to come in at around 5 percent, down from 11 percent the quarter before, due to slowing demand in Europe and Japan (as well as seasonal factors). Some technology buyers may also be delaying purchases as they await the rollout of Cisco's next-generation Big Fast Router and contemplate whether competing switch technologies -- with imposing names such as asynchronous transfer mode (ATM) and gigabit ethernet, as well as IP -- will begin to displace routers.
The fear surrounding Cisco's stock is reminiscent of 1994, the last time the networking group took a significant hit. Back then, there was talk that the routers used in local-area networks would be replaced by
switches. It didn't work out that way, yet Cisco, whose business to that point was made up entirely of routers, adeptly moved into local-area switches, soon becoming the leading vendor.
This proven ability to turn a potential threat on its head makes Cisco a formidable competitor as it spreads further into ATM and other areas, trying to become a one-stop networking resource. Cisco has held its pole position in the industry by acquiring small, leading-edge companies. That is how it entered the market for switching and, more recently, beefed up its presence in remote access devices, which are modem banks that serve as gateways to the Internet or to a corporate network.
Cisco's ultimate competitive advantage, though, is its relationship with its customers, who value Cisco's commitment to making sure that all the disparate pieces of the network mesh together. As Paul Krieger, an analyst at the Seligman Communications and Information fund, said only half-jokingly, "Cisco can sell cars with square wheels and make a lot of money doing it." In each of the past six years, Cisco's return on invested capital (a measure of how efficiently a company uses the cash it generates) was at least 130 percent. In contrast, the return of noted wealth creator Coca-Cola never exceeded 37 percent. In an emerging industry, Cisco remains not only the leader of today, but also the best bet as the leader of tomorrow.
3Com [OTC, COMS, $32.75, P/E = 19]
The company would love to usurp Cisco's place, but has no interest in attacking its key router business. Explains 3Com CEO Eric Benhamou, "Going directly up against Cisco is the wrong approach. Surround and conquer works a lot better." To do so, 3Com plans to merge with U.S. Robotics, a leader in modems and remote access devices -- particularly ones used by corporations to handle workers with laptops dialing in from the road. 3Com already has one of the broadest arrays of switches, hubs and other equipment used in local-area networks. The proposed union extends the company's expertise into wide-area networks, which stretch across multiple locations, while adding a great consumer brand name in U.S. Robotics, Skokie, Ill.
Even though U.S. Robotics and 3Com's businesses complement each other nicely --their combined annual revenue of around $6 billion is just shy of Cisco's -- the merger comes at a time of weakness for both companies. 3Com's market share battles with Intel over modem-like network interface cards and U.S. Robotics' excess inventory are pushing near-term earnings much lower than Wall Street was expecting -- in 3Com's case, about 20 percent lower. There is also the concern, raised by analyst Johnson at Robertson Stephens, that more than half the revenues of the combined company will come from modems and interface cards, which are commodity-like products that can be especially sensitive to pricing pressures. And though one big reason 3Com likes U.S. Robotics is it wants to become a player in the remote access market (which nearly tripled in size in 1996), U.S. Robotics' share of that segment actually dropped last year, from 49 percent to 37 percent, according to research company Dell'Oro Group. Not a good sign.
On the other hand, the valuation of 3Com's stock is tempting: At a recent price of $32.75 a share, it is trading at just 16 times projected 1997 earnings. Long-term earnings growth is estimated by analysts to be around double that multiple.
Ascend Communications [OTC, ASND,$40, P/E = 39]
Cascade Communications [OTC, CSCC,$25, P/E = 35]
Ascend Communications agreed to acquire Cascade Communications for stock valued at about $3.7 billion, the latest move in a consolidation frenzy gripping the computer-networking-gear business. Both companies make various pieces of the plumbing that links computers together in networks. The merger follows other giant deals in that arcane but lucrative field, as networking companies strive to broaden product lines so they can provide one-stop shopping for corporations that are rapidly moving to let employees share data through sprawling networks of computers. Another key market is Internet service providers, which are racing to keep up with the dramatic increase in people surfing the Internet.
Under terms of the deal, Ascend will swap 0.70 share of its stock for each Cascade share. The combination has many synergies. Ascend is a leader in remote access servers, which allow more people to call in and connect to networks or the Internet. Ascend is regarded as having an edge over even Cisco in that area, which is particularly important to Internet access providers. Cascade, Westford, Mass., specializes in advanced switching technologies known as ATM and frame relay. Ascend,
Alameda, Calif., also has begun producing routers, another key piece of network gear that helps shunt information around a computer network. Between them, the combined companies would offer all three of the major technologies Internet service providers require: fast switching technology, high-capacity servers and powerful routers.
It's also a good time to buy, in some ways. Networking-company stocks have been hammered lately because of investor concern about PC and corporate networking growth. Cascade's stock has plummeted 60 percent since late January. Ascend's stock also has been hurt, though not as severely; it has dropped about 50 percent during the same period.
After the acquisition, Ascend's chief executive officer, Mory Ejabat, will remain chief executive and president of the combined companies. Dan Smith, president and CEO of Cascade, will become an Ascend executive vice president and will head its major switching-products
group, which will include most of the product Ascend is acquiring from Cascade in the transaction.
Ascend's proposed acquisition of Cascade is expected to fortify Ascend for more direct competition with network gear-maker Cisco Systems, but the deal's risks frightened investors, who drove Ascend's stock down 22 percent on the news.
Between them, Ascend and Cascade sell most of the major networking products that regional telephone companies and Internet service providers need to provide communications links over large geographic areas. Ascend parlayed an early lead in high-capacity remote devices linking users to networks into an quarterly growth rate of more than 100 percent, and has developed a high-powered router technology.
Routers are devices that direct the data traffic in internal networks.
Cascade is a leader in high-speed switches that link networks. Cisco, San Jose, Calif., once considered launching a bid for Cascade, at one point owning about 5 percent of the company, but instead acquired Cascade's top rival, StrataCom, in a $4 billion stock deal last year.
Ascend now has a lineup to compete head-on with Cisco in the WAN market. "It's a killer combination for the Internet build-out," said
Paul Callahan, an analyst at Forrester Research in Cambridge, Mass. "It's a big hit on Cisco." But venturing from its niche in remote access into direct competition with powerhouse Cisco is a risky proposition. Cascade is already staggering in the switch market, disclosing on Sunday that its revenues for the current quarter would be just $90 million, about 20 percent below Wall Street expectations and that net income would fall about 25 percent short of projections. Moreover, Ascend said the deal would knock 5 cents to 10 cents off its
per-share earnings for the year, which had earlier been estimated at $1.55 a share.
Most analysts agree the deal made strategic sense in the eat-or-be-eaten world of computer networking.
Bay Networks [NYSE, BAY, $17]
Bay, Santa Clara, Calif., has already tried to take on Cisco, and failed. Not because its technology was flawed, but because its bicoastal management provided ambiguous leadership. Formed in 1994 from two of the most promising companies in the industry -- one specializing in hubs, the other rivaling Cisco in routers -- Bay has seen its market shares dwindle away. 3Com's Benhamou said, "Bay is a classic case of a blundered business opportunity." A turnaround is still possible, with new management installed recently.
Cabletron Systems [NYSE, CS, $29.50, P/E = 19]
The company has just about the cheapest stock in the sector: At a recent price of $29, it is trading at just 14 times this year's earnings. Why? For the past two years, new switching technologies have been eating into Cabletron's sales of its primary hub products. But the company has reacted swiftly, transforming itself from a hub company to a switch company. At the same time, Cabletron's network management software is becoming the envy of the industry. The Rochester, N.H., company's projected growth rate is low compared with that of others in the group -- around 25 percent -- but that's because its client base is mature, Fortune 500 companies that already have
installed technology infrastructures, which are expanded only incrementally. And such clients do offer advantages, including a steadier, more reliable revenue stream. Cabletron hasn't missed a quarter in eight years, and could have an earnings breakout as early as this summer. |
