interactive.wsj.com
November 3, 2000
Cisco Keeps Growing,
But Speed Is an Issue
By SCOTT THURM
Staff Reporter of THE WALL STREET JOURNAL
SAN JOSE, Calif. -- Every three months for the past two years, John
Chambers, chief executive of Cisco Systems Inc., has told Wall Street
analysts that Cisco's revenue can grow 30% to 50% a year in a healthy
economy.
Just as routinely, analysts and investors largely ignored Mr. Chambers'
statements as too conservative. The economy was plenty healthy, after all,
and Cisco was growing faster than his target -- at a 61% annual clip in its
most recently reported quarter.
But now, for the first time in years, there is
serious debate about how fast Cisco can grow.
Telecommunications companies, which have
accounted for a disproportionate share of Cisco's growth in recent years, are
curbing their budgets for new equipment. Some telecom start-ups are
running out of money. Dot-coms are vanishing, and with them some
purchases of Cisco gear. The economy is showing signs of slowing, which
could curtail spending by big businesses, Cisco's core customers.
The result: Many investors are starting to take Mr. Chambers literally. Some
are trimming projections for Cisco's long-term revenue growth to around
40% a year. That's still impressive for a $20-billion-a-year behemoth such as
Cisco, the leading maker of switching equipment for the Internet. But the
forecasts come at the end of a year in which numerous other tech giants
have stumbled, including Microsoft Corp., Dell Computer Corp., Intel Corp.
and Cisco rival Nortel Networks Corp.
Off Its Peak
The possibility of slower growth at Cisco gives investors the willies. Long
among the most reliable stocks on Wall Street, Cisco has fallen 19% in the
past two months and 32% from its peak in March. It has been more than six
years since Cisco shares performed as poorly over a seven-month period.
At stake are tens of billions of dollars of Cisco's stock-market value, now
$393 billion. And, because Cisco relies on its stock to hire and retain
employees, as well as to acquire promising technology, a weaker stock itself
could further hamper Cisco's business. As the stock stagnated in recent
months, Cisco's attrition rate inched higher, as some employees sought
more-lucrative opportunities.
With so many others stumbling, Cisco is also carrying much of the remaining
hopes of the great bull market in tech stocks. On Monday, Cisco's stock fell
5% following a bearish call by a leading analyst. On Tuesday, it roared back,
gaining more than 12%. "If Cisco were to miss a quarter or significantly
guide down expectations, the stock itself would be crushed, and Nasdaq
would plummet," says Erik Gustafson, a senior portfolio manager at Liberty
Funds Group in Chicago, who remains a Cisco bull.
Another Good Quarter
This isn't a debate about Cisco's immediate prospects. Even the most bearish
analysts say Cisco's business is exceptionally strong. They expect the
company to show an 11th consecutive quarter of accelerating revenue
growth when it reports its fiscal first quarter financial results on Monday.
And no one will be surprised if it beats the First Call/Thomson Financial
consensus earnings estimate of 17 cents a share, excluding some one-time
charges, by a penny. Cisco has topped analysts' earnings estimates by
exactly a penny for 13 consecutive quarters.
In the note that sent Cisco stock reeling on Monday, for example, Lehman
Brothers analyst Tim Luke estimated that the quarter's sales rose 65% to
$6.4 billion and said they could top $6.5 billion. Orders are growing even
faster, leaving Cisco "struggling to keep pace," Mr. Luke wrote.
But the uncertain outlook for telecom spending probably will constrain
Cisco's growth, Mr. Luke wrote. After a three-year buying binge, telecom
carriers may temper equipment purchases next year. Some analysts think
equipment sales could fall. The slowdown is bound to affect Cisco, Mr. Luke
reasoned, even if to a lesser degree than rivals. His conclusion: Cisco is
more likely to grow 35% to 40% over the next few years, and should be
valued accordingly. So he cut his 12-month price target to $60-$65, from
$90. The stock stood at $55.75 in 4 p.m. Nasdaq Stock Market trading
Thursday, up $3.63.
Over at Morgan Stanley Dean Witter, Christopher Stix looks at many of the
same facts and reaches a different conclusion. Businesses are ordering so
much Cisco gear that some have to wait more than three months for the
products. (He should know: A reseller in San Jose says Cisco equipment
ordered by a local Morgan Stanley office in February couldn't be installed
until September.) In a recent Securities and Exchange Commission filing,
Cisco said it had $3.8 billion in unfilled orders on Sept. 25, enough to carry it
through the middle of this month even if it hadn't received a single new order
since then.
Mr. Stix isn't as worried about telecom-carrier spending because, he says, an
increasing share of telecom revenue comes from Internet traffic that runs
through Cisco's equipment. That means carriers will continue to buy Internet
switching gear even if they slow other purchases. His conclusion: Cisco's
revenue growth will continue to accelerate for another three to nine months,
with the company growing faster than 60% this fiscal year and 50% next
year. His 12-month price target: $90.
The difference between revenue growth of 50% and 40% may not sound
like much, but it's crucial for tech investors, who place a premium on growth.
That's why Mr. Luke and Mr. Stix reach such different conclusions on Cisco
stock, with Mr. Luke's projection calling for a rise of 8% to 17% and Mr.
Stix's for a leap of as much as 61%. It's an unusually large spread for a
company as reliable and predictable as Cisco, which has never failed to meet
analysts' expectations in its 10 years as a public company.
Yet as Cisco grows, basic math makes it increasingly hard to keep
expanding at the same rate. To grow 50% in the fiscal year ending next July,
Cisco needs to find roughly $9.5 billion in new revenue, equal to the annual
sales of Nike Inc. If Cisco succeeds, it would need to find a further $14
billion in new revenue next year to grow 50% again, equal to the annual
sales of Eastman Kodak Co.
There are many examples in the tech world of how quickly Wall Street turns
on its high-growth favorites when growth slows. Take Dell: In early 1999, its
revenue was rising nearly 50% a year, and its shares traded at roughly 100
times earnings in the prior four quarters. Today, Dell revenue is growing at a
25% to 30% annual rate, and its "trailing" price/earnings ratio is down to 42.
At $31.81, in Thursday's 4 p.m. trading on the Nasdaq Stock Market, Dell
stock is almost 50% below its 52-week high.
Likewise, a year ago Microsoft was increasing its revenue 25% to 30% a
year, and trading for 60 times trailing earnings. Now, Microsoft is growing at
roughly a 10% annual rate, and its price/earnings ratio has slumped to 40.
By comparison, Cisco's stock trades at 105 times the past 12 months'
per-share earnings. That's down from its P/E of close to 200 last March, but
still higher than Cisco's historical levels. Per-share earnings rose 47% in
fiscal 2000.
Such a valuation should be a warning sign for investors, even for as fast a
grower as Cisco, says Jeremy Siegel, a professor of finance at the Wharton
School. He says there has never been a large-cap stock for which investors
should have paid 100 times earnings, based on how those stocks
subsequently performed compared with broad market indexes.
At some point, Mr. Siegel predicts, Cisco's growth will slow and the
company will be valued like other well-run mature companies, with a P/E in
the low 20s. If Cisco's share price rose 15% a year for the next decade, its
earnings per share would have to rise 35% annually in that time to bring its
P/E down to the low 20s by the end of the decade, Mr. Siegel says.
How likely is that? The fastest earnings growth in the past decade among
the 20 most valuable U.S. companies in 1990 was at Wal-Mart Stores Inc.
The annual rate: 16%.
Not to Worry
Cisco believers say they have heard these arguments before. "Cisco has
always been expensive," Mr. Gustafson says. Considering that Cisco stock
has risen, on average, more than 80% every year since the company went
public in 1990, he says, "its valuation looks reasonable."
Cisco executives remain extraordinarily bullish as well, though they are
reluctant to discuss specifics in advance of Monday's earnings report. "We
haven't seen any sign of a slowdown," says Michelangelo Volpi, chief
strategy officer. He says Cisco has made no changes to its internal plans
since the beginning of its fiscal year in August. "We have guided the Street
accurately, and we can execute to plan."
The last time Wall Street offered such contrasting opinions of Cisco was in
1997, when its growth slowed sharply as large and midsize companies
completed the task of connecting once-isolated computers inside their offices
into networks.
By early 1998, Cisco's growth rate had dipped below 30%. The company
was trying desperately to break into the telecom market against traditional
powers such as Lucent Technologies Inc. and Nortel. Meanwhile, Lucent
and Nortel were busily buying computer-networking expertise to compete
with Cisco on its own turf.
Cisco revived its fortunes by hitching itself to the Internet. Businesses found
they needed computer connections not just within their walls but also to the
broader world. Telecoms needed Cisco gear to move the flood of computer
traffic coursing across their networks. Lucent and Nortel had trouble
digesting their acquisitions and failed to make inroads in Cisco's core
data-networking markets.
The result: The market for computer-networking products has exploded and
Cisco has grabbed an increasing share of that market. In the first half of
2000, Cisco commanded 56% of the $10 billion-plus annual market for
switches in corporate networks, up from 48% last year and 44% in 1998,
according to market researcher Dell'Oro Group in Portola Valley, Calif.
Three of Cisco's traditional rivals have quit the field in the past 15 months:
International Business Machines Corp., 3Com Corp. and Lucent, which
recently spun off its corporate-networking division, now called Avaya Inc.
Cisco now has 12 different products that account for more than $1 billion in
annual sales.
Now as in 1997, there are questions about whether the industry, and Cisco,
can continue to grow at these rates. Many economists expect growth in
business spending on information technology to slow next year, particularly if
the economy cools.
Fewer than half of the 58 large companies recently surveyed by ISI Group, a
New York economic-consulting firm, plan any increase in
information-technology spending next year. More than one-fifth of the
companies actually plan to cut spending on computers, software and
networking gear.
Less Next Year
That could hurt Cisco. Farmers Insurance Group in Los Angeles has spent
$26 million on Cisco gear this year to build a network connecting its
8,000-plus agents to headquarters and allowing policyholders to file and track
claims online. With the network built, however, Farmers will spend less than
$2 million on Cisco gear next year, says Kent Linduff, associate vice
president for operations.
Discount retailer Burlington Coat Factory Warehouse Corp. is a regular
purchaser of Cisco's newest products. Two years ago, it installed a network
that connects 340 stores and routes telephone calls as well as computer
traffic through Cisco equipment. Now, Burlington (which isn't related to
Burlington Industries Inc.) is installing Cisco wireless networks in new and
remodeled stores. But its spending on networking equipment is likely to
decline next year "because we made the investment and have the network in
place," says Chief Information Officer Mike Prince.
Companies are always at different stages in adopting technology. To
maintain its growth rate, however, Cisco almost needs to find two Farmers
or Burlingtons next year for every project completed this year. Many
analysts consider that unlikely. Lauri Vickers of market researcher Cahners
In-Stat Group in Newton, Mass., says Cisco and other vendors have been
talking about combined telephone-computer networks for years, "but I've yet
to see the serious volumes suggesting that it's going to hit next year." For
more-basic switches used in corporate networks, Cahners predicts that
industry sales will grow 29% next year, down from a 38% increase this
year.
Companies that sell Cisco gear have a very different view of the market.
San Antonio-based SBC Corp. uses Cisco gear in its network, but it sells
even more Cisco equipment to companies for which it is building and
managing networks. SBC executives say their sales of Cisco gear have
more than doubled this year, and the growth rate is still accelerating.
At Alpine CSI, a networking consulting firm in Holliston, Mass., sales of
Cisco gear will more than triple this year. "The demand is very intense," says
marketing vice president Mark Bireley, with some clients planning to spend
as much as 10% of their revenue on information technology, up from 3% to
5% a year or two ago. "If I had extra money, I'd be putting more in Cisco
stock," says Glenn Fund, an Alpine consultant.
Big Appetite
Corporate sales this year "have surprised even us," Cisco's Mr. Volpi says.
Cisco executives say companies increasingly are using Internet technology
to streamline their own operations. By the end of 2002, Eaton Corp., an $8.5
billion-a-year diversified manufacturer, expects to conduct 95% of its
transactions with customers, suppliers and employees via the Internet. It's
shifting most corporate training to its computer network, for example. So
after two years of relatively flat spending, Eaton next year will increase its
purchases of Cisco gear to handle the added traffic, says Bob Hazleton,
director of infrastructure engineering.
By moving much of its internal operation to the Internet, Eaton boosts Cisco
in a second, less-visible way. Every time an Eaton employee in London or
Los Angeles logs on to watch a training video or to change information about
a retirement plan stored on Eaton's computers in Cleveland, the 1s and 0s of
computer code must travel across the networks operated by companies such
as AT&T Corp. or WorldCom Inc., which in turn must buy more gear from
Cisco or its rivals. It is this second group of customers, where Cisco had
little presence three years ago, that has accounted for much of Cisco's
recent growth. (It's difficult to know exactly, because Cisco doesn't break
down its sales by type of customer.)
Now, there are clouds over these telecom companies as well. WorldCom,
SBC, BellSouth Corp. and Williams Communications Group Inc. all say
capital spending will hold steady or fall next year. Others, such as Qwest
Communications International Inc., are planning only small increases. And
start-ups, which accounted for a big chunk of the growth in equipment sales
in recent years, are trimming forecasts and running out of money. North
American sales of telecom equipment, which are projected to grow roughly
30% this year, will grow less than 20% next year, according to many
analysts.
Cisco won't feel the worst effects of that slowdown, because it doesn't
make any of the telephone equipment whose sales are dropping. Qwest,
which is a big Cisco customer, said in a recent SEC filing that it would
re-direct its capital spending next year toward Internet applications and
high-speed Internet access. BellSouth, which isn't a traditional Cisco
customer, said this week that it would use primarily Cisco equipment to build
an "Internet exchange" in south Florida.
Still, Cisco is unlikely to remain immune. Even sales of fiber-optic equipment
-- the hottest sector in telecom, and a big growth area for Cisco -- will be
affected. Market researcher RHK Inc. in South San Francisco, Calif.,
predicted last week that sales of fiber-optic gear would grow 38% next year,
down from 60% growth this year.
New Markets
There's another wild card: Cisco could acquire technology to tap a new
market and fuel additional growth. Indeed, acquisitions account for much of
Cisco's growth since 1993. The most dramatic recent example was the 1999
acquisition of Cerent Corp., which became Cisco's first entry in the
fiber-optic arena. Analysts expect Cerent to account for more than $1 billion
in Cisco sales in 2000. "They keep incrementally finding new business," says
Paul Sagawa, an analyst at Sanford C. Bernstein & Co. who generally is
skeptical of Cisco's growth prospects.
Historically, Cisco has been able to acquire the technology it wanted in part
because its stock kept rising. A flat or falling stock makes acquisitions
tougher, by reducing the shares' allure to entrepreneurs and by increasing the
dilution to existing shareholders. "The stock price is the currency with which
they fund their research and development," says Walter Casey, co-manager
of the technology portfolio for Banc One Investment Advisors. "If they have
trouble using the stock to make acquisitions, that would be a big deal for
them."
So far, that hasn't seemed to be an issue. Mr. Volpi notes that entrepreneurs
frequently weigh competing offers, and stumbles by rivals have made
Cisco's stock more attractive by comparison. "We haven't even talked about
adjusting our acquisition strategy," he says.
But he acknowledges that Cisco's recently languishing stock price may be
contributing to a small increase in employee turnover. Stock options are a big
part of compensation among Cisco's 35,000 employees. Attrition remains
below a 10% annual rate, Mr. Volpi says, but is up "a percentage point or
two" from a year ago.
Write to Scott Thurm at scott.thurm@wsj.com |
