Glad to see you posting over here, Ed. Here's one in return:
businessweek.com
<<AUGUST 11, 2000
STREET WISE
By Sam Jaffe
Businessweek.com
Is Cisco Falling Prey to Optical Illusions?
It may not be able to dominate optical networking the way it has routers and switches, and that
could take the sheen off its stock
John Chambers must be wondering what he needs to do to get a rise out of investors. After all,
few companies can ever boast the kind of numbers Cisco Systems (CSCO) reported on Aug. 8.
The company beat analysts' estimates by a penny per share, claiming revenues of $5.7 billion for
the fourth quarter, ended on July 31. That's up 61% from last year's fourth quarter. A huge $1.2
billion of that was profit, which was 69% higher than the comparable quarter a year ago. In
addition, executives raised their expectations for growth through the rest of the year. "The
company continues to dominate the networking market," gushes Dain Rauscher Wessels analyst
Sanjiv Wadhwani, who kept a "strong buy" rating on the stock.
Nevertheless, Cisco's stock didn't exactly soar on the news. The day after the announcement, it
rose a respectable 4%. But Aug. 10 saw it fall almost 6%, to $64. Hardly the kind of reception
you'd expect from such a boffo earnings announcement.
Why? There are lots of excuses. For one thing, Cisco stock had already run up from a low of
$60.93 a week earlier, so one could argue that the market had already anticipated the good news.
Also, this is one expensive stock -- the company has a market cap of $454 billion. It's pretty
hard for any single institution or group of traders to move a stock that big.
SCIENCE FICTION. But both explanations ring a little hollow to me. The earlier runup wasn't
enormous. And Cisco's stock is plenty volatile, despite its girth. Something else is dragging this
stock down.
Cisco CEO Chambers seemed to offer a hint during his conference call explaining results to
analysts. He mentioned that one of the core optical products due to ship this year, a high-end
wavelength router used to send data over long-haul networks, wouldn't reach full production
until 2001. A complete rollout was expected sometime in the next few months.
One product delay shouldn't set off alarm bells, especially in a cutting-edge technology area like
optical networking, where machines are being produced that would have been considered
science fiction a couple of years ago. But the problem might be just the tip of an iceberg that
could mean trouble for Cisco in the future.
20/20 FORESIGHT. Optical networking, after all, is Cisco's future, according to Chambers. In
the late 1990s, he gave a speech predicting that networks built on light waves, rather than
electrons, would one day power the entire Internet. His foresight proved to be 20/20, as that
vision is quickly becoming reality in the form of optical networking.
Problem is, Cisco isn't the market leader. Competitor Nortel Networks (NT), the Canadian
telecom-equipment manufacturer, has bet its entire business on becoming No. 1 in optical
products. But until a few weeks ago, Nortel had a very visible hole in its product line: the lack of
a terabit router, the ultra-high-end device that relays data to optical networks.
Cisco, on the other hand, has been producing terabit routers for some time, and that had given it
a more rounded product line. But in late June, Nortel announced an alliance with Juniper
Networks (JNPR), which makes a router that has beat out Cisco's product for several
high-profile contracts. Now Nortel will sell Juniper's router.
NO SPECIAL VENDOR. Suddenly, Cisco is the one playing catch-up despite having been on a
big buying spree. In all, Cisco has bought four companies over the past year, for a combined
total of about $13 billion, in order to create its line of optical products. "One year ago we had no
optical business whatsoever," boasted Kevin Kennedy, vice-president of the service provider
division. "The momentum is significant." Indeed, Cisco's near-overnight construction of such a
huge division (which accounted for $1 billion in sales in the fourth quarter) can be seen as yet
another miracle engineered by Chambers.
But collecting a group of products might not be enough to let Cisco dominate optical networking
as it does the router and switch business. For one thing, the customer base is different. Routers
and switches were bought by startup Internet service providers and IT departments that grew up
with Cisco. But the main customers for optical networking gear are phone companies that have
long-established purchasing guidelines and view Cisco as just another vendor. The Baby Bells
and AT&Ts of the world are apt to buy the best product, period. Says Robertson Stephens
analyst Paul Johnson: "There's an assumption out there that Cisco dominates the carrier market
as much as it dominates the enterprise market, and that's false." He rates Cisco a "buy," although
on Aug.11 he removed the stock from his firm's Focus List of favorite stocks to own.
Johnson points out that the typical enterprise buyer's main job is to keep the network running so
that the company can execute its business. "At the end of the day, the enterprise buyer goes
home knowing that he's in the insurance business or the dry-cleaning business," says Johnson.
"But the buyer from a carrier is essentially in the networking business. He's going to buy the
absolute best product that optimizes his network, and that won't always be Cisco's product."
JUST ANOTHER STOCK? Another obstacle in the optical networking business is the extremely
competitive environment. Every other day seems to bring with it a new optical-related initial
public offering boasting groundbreaking technology. In addition, telecom equipment
powerhouses like Nortel and Lucent Technologies (LU) are fighting just as hard in this arena,
and they already have solid relationships with the phone carriers who buy these devices.
"Chambers has said that he wants to own 40% to 60% of every market he enters, and he seems
to always get there," says CIBC World Markets analyst Martin Pyykkonen, who rates the stock a
"buy" and expects it to reach $85 in the next 12 to 18 months. Cisco currently has about 15% of
the telecom carrier market for optical networking equipment. "[Optical networking] is no slam
dunk. It's a much more competitive environment."
Pyykkonen isn't too worried, though. He's betting that Chambers will pull an optical rabbit out of
his hat and beat the competition. But he will be watching one product line's sales figure very
closely in the next earnings report. He wants to see a big increase in sales of Cisco's main terabit
product, the GSR IP router. Sales of those routers increased 60% in the third quarter, but then
managed only a 10% increase in the fourth. Pyykkonen hopes that figure increases by far more
than 10% in the coming first quarter. If it doesn't, he says, it will be a sign that Cisco might be
hitting a wall with its router business.
Robertson Stephens' Johnson is blunter. "John Chambers runs a great business, and Cisco does
a great job," he says. "But by this Christmas, Cisco will have lost its glow and will be seen as just
another company." If that happens, Cisco's stock will suffer the fate of becoming just another
stock.>>
Jaffe writes about the markets for Business Week Online
Edited by Douglas Harbrecht
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