James,
you've hit on the isssue that worries me most about our Cisco investment. Cisco is one of the all time truly great companies. However, even truly great companies hiccup when they go through significant transitions and even truly great companies are affected by the economy. Consensus numbers for FY99 require Cisco to sustain 35%+ YoY growth - management has been explicit about op exp. (36%), GM (declining 20bp a quarter), tax rate (33%). Do the math, the top-line has to grow 35% or more.
Now consider that FY98 YoY top-line growth was 31.3% with several reasons to be fearful that FY99 growth will be less rather than more:
1. The economy - 20% of Cisco revenues come from financial institutions - these companies have seen their earnings cut in half and are in the midst of laying people off. I have seen survey data that suggests that IT spending in financial industry will grow in the mid single digits in 99 after pushing 15% last year. Maybe Asia will come back strong and save the day, but then again...
2. LAN switching market - 57% of Cisco's FY98 growth came from its LAN switching business, where it increased its overall market share from 36% to 50%. Not only is overall LAN switching growth expected to slow to ~25% but Cisco would have to boost its share from 50% to 80% to get the same bang in 99. Furthermore, pricing has been very aggressive as of late, and I suspect it will get worse rather than better. Finally, the implosion of Cabletron has bottomed out and Cisco may find it harder to poach its accounts in 99 than it did in 98.
3. Router market - Cisco has 70% share overall, 87% share of internet class routers. This market share is not going to get higher. Overall router growth is expected to be low teens. Since this is 36% of Cisco sales, its tough to imagine it contributes positively to the needed 35% growth. Finally, new competition is unlikely to badly damage Cisco, but its hard to imagine that Cisco can sustain the 75% GM it makes on its high end routers today.
4. Carrier network products - Although carrier sales are 30% of Cisco revenues, Chambers concedes that half of that is sales of enterprise equipment resold to enterprise accounts with carriers acting as resellers. That leaves ATM/fr, dial access, high-end routers, and xDSL/cable sales to carriers as no more than 15% of sales. I believe that Cisco's new ATM products will lead to significant new contracts, however, there is a 6 - 9 month lag between winning contracts and seeing revenues. Cisco has not won significant contracts in the last 9 months, so it is unlikely that we will see market share gains in the next 9 months. Cisco's dial access business is less than 5% of sales and appears to have stalled - where are the carrier customers? Cisco owns high end routers, but see point 3 above. xDSL/cable - here is a possible bone of contention. I don't think that these products will reach a large enough volume in 1999 to make up for the rest of the issues here.
5. Cisco's vision for next generation carrier networks is extraordinary. However, revenues from these products won't really be there in FY99.
So my concern, will investors overlook a deceleration in 99 looking to the extraordinary future prospects. I believe Cisco will make January, but April and July are highly suspect. Management has little visibility to CY99 and is hoping that the economy rebounds enough that they don't have to guide analysts down. Maybe Asia will bail them out. However, I worry we will see downward revisions - I don't think Cisco would risk missing a quarter.
In the long run, I am a true believer in CSCO. With a P/E multiple twice the consensus growth rate, any earnings revision could be punished in the short term. |
