BW E.BIZ: STREET WISE
BY SAM JAFFE March 23, 2000
Why Cisco Is the Atlas of the Nasdaq
Now with a market cap of half a trillion dollars, the Net's plumbing supplier is the primary prop under tech stocks
By now, we've all seen the Nasdaq commercial: "It started when two Stanford professors imagined a seamless network that would connect all networks. Today it drives the Internet." The "It" is, of course, Cisco Systems (CSCO), the networking giant that produces most of the routers and hubs that connect the Internet. And as the commercial says, this company, more than any other, holds the Net together.
Cisco holds together something else as well: the Nasdaq stock market. When Cisco goes up, the Nasdaq is sure to follow. "If Cisco catches a cold, the Nasdaq gets pneumonia," says Michael Davies, an analyst with Gruntal & Co. And you can be sure if the day ever comes that Cisco crashes, it will be the official end of the tech-stock boom.
That's why this company has become more important to investors than any other, and why every buyer of technology stocks needs to be an expert on Cisco, whether or not they own it. "There's always one stock that, without fail, is owned and loved by every money manager I meet with: Cisco," says Ed Yardeni, chief economist for Deutsche Bank. "If I raise its high valuations, they shut their ears and hum. Cisco can do no wrong in their eyes."
MULTIPLE STRENGTHS. The reasons for its dominance in the tech-stock arena are varied. First is its sheer size. By the close of market on Mar. 22, it had joined Microsoft (MSFT) as the only other company to have reached a market capitalization of $500 billion. But here are two other significant reasons for Cisco's leadership: Its central role as an Internet infrastructure company, and its skill in buying smaller companies with promising technology.
When Cisco engineers developed the first routers -- the boxes that connect networks to each other -- back in the 1980s, they saw a huge potential market in universities that wanted a single network on campus. When the Internet took off as a consumer medium, the company realized it was in on the ground floor of a boom era that would rival the 1849 gold rush. And like the barons of that era, Cisco has made a fortune selling picks to gold miners.
One of the biggest expenses for a startup Internet company is the Cisco routers it needs to function as part of a large network. "Cisco saw the opportunity of the Internet before anyone else did and rebuilt the company around the Net long before most executives had even heard of it," says Megan Graham-Hackett, an analyst with Standard & Poor's. "That's one of the keys to their success. They're constantly recreating themselves as the environment changes."
NO LIMITS? Cisco, Graham-Hackett says, uses the Net for every corporate need, from human relations to procurement of staples, so it's able to expand quickly without adding huge costs. "They've streamlined their operation to such an extent that there really is no ceiling to their potential growth. Every other company that I've looked at faces reasonable limits to how large it can become. I can't see any limits for Cisco right now," she says.
In fact, the San Jose company plays an enormously important role in Silicon Valley as the acquirer of choice. It has bought 54 outfits for nearly $30 billion (almost all paid for with Cisco stock) since its first acquisition in 1995. These days, any Silicon Valley company would be crazy to refuse a Cisco offer. It pays handsomely, thanks to its extremely high share price (known in the Valley as "Cisco dollars"), and it keeps acquired companies together after a merger. Its golden rule of mergers is that no acquired employee can be fired without the consent of the acquired company's CEO.
Such a policy is easy to keep when you buy the types of companies that Cisco does. It has never bought a large competitor for market share or customers the way that MCI WorldCom (WCOM) has. Instead, it always buys startups with promising technologies. It gets an inside line to these outfits thanks to its multibillion dollar seed fund. "In some ways, Cisco should be valued as an incubator," says Brett Miller, an analyst with AG Edwards. "Its real value is in all of the technology startups that it has a hand in."
"MELTING POT." In short, Cisco benefits from a virtuous circle: Its high stock price feeds its acquistion strategy, which in turns bolsters its stock. Cisco trades at a price-to-1999-earnings ratio of 188 and a price-to-sales ratio of 31.8. That makes it one of the more expensive stocks to own -- or to accept as payment for the rights to your company. "They pay a lot for the companies they buy, but you can't accuse them of overpaying," says Tom Burnett, president of Merger Insight, a New York-based institutional research firm. "It's hard to fault them for paying a hundred times earnings for a company when they're doing it with stock that sells for 180."
Another factor that makes Cisco so good at acquiring and integrating other companies is its corporate culture. "No one can come up to you and say, 'We bought you, so here's what you have to do' because the person who might say that was just acquired two weeks before," says Miller of AG Edwards. "They are the melting pot of Silicon Valley."
Cisco's stock is so valuable because the company's growth spurt has lasted a decade and never seems to stop -- and because it expertly manages Wall Street's expectations. It makes a habit of urging customers to buy its products at the beginning of each quarter, so that it will be able to have a good picture of the quarter's performance midway through and can inform analysts what's going on in time for them to adjust their expectations. Of course, it doesn't hurt that the company's revenues grow by 50% a year -- every year.
NOT LAUGHING NOW. The other reason Cisco stock is worth so much is that it's one of the few proven leaders among the tech stocks. Like Microsoft and Intel, it has a record of success. "You're paying for leadership in a market that confuses a lot of investors," says Miller. "Let's say you know that high bandwidth is going to be a big trend, but you don't know if it will be through phone lines or cable. You can always buy Cisco because it has a finger in every pie."
Right now, the future looks as bright as the past for Cisco. The company is touting its vision of converged networks: a way for every network to communicate with every other network regardless of the underlying technology. "It was a concept that was laughed at last year, and I thought it would take five years to come to fruition, but now every corporation is clamoring for it," says Graham-Hackett. An example is Sprint (FON), which has built its network using Internet protocol (IP) standards over an asynchronous transfer mode (ATM) network. Previously, such a combination was thought to be impossible.
If converged networks are indeed the future, then Cisco will, once again, be sitting pretty. Thanks to its acquisitions, it already has optical, voice, and data products ready for a market that is just now realizing that it needs them. "They are perfectly positioned for the next wave of telecom infrastructure buying, which is going to dwarf everything that has come before it," says Miller.
The company expects to have $50 billion in sales by 2004. But, as Graham-Hackett points out, it's ridiculous to pretend to know what Cisco will be doing two years from now, no less than four. Whatever happens, Cisco is Wall Street's favorite to become the first company with a $1 trillion market capitalization. Says Miller: "It's hard to see why it won't be the first one to get there."
Sam Jaffe covers the markets for Business Week Online
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