Steady Earns Seen For Networking Cos. As Pickup Continues
By JOELLE TESSLER
Dow Jones Newswires
NEW YORK -- A definite industry pickup in the second half of 1997 has analysts optimistic that network equipment companies will not deliver any earnings shortfalls for the December period.
After two industry leaders met only drastically scaled back earnings expectations for their November quarters, Wall Street worried that the slow international demand and domestic spending that plagued networkers in the first half of 1997 might be contining.
But, analysts believe a strengthening that began in the third quarter did indeed run through the end of 1997.
Driving demand for networkers is the explosive growth of the Internet and network-intensive enterprise applications, said Lazard Freres & Co. analyst Michael Duran.
"This is a business with huge, huge growth ahead of it," said Hambrecht & Quist Inc. analyst Farrokh Billimoria. "The demand is there and sustainable."
Nevertheless, analysts cautioned that networking prices have come down substantially over the past year and that the economic crisis in Asia is likely to impact the group.
Moreover, a number of networking makers have been plagued by company-specific problems that might not have become such stumbling blocks in a stronger environment. "When the tide is rising fast enough, you can gloss over these things," said Deutsche Morgan Grenfell Inc. analyst Noel Lindsay.
The dismal results posted by 3Com Corp. (COMS) and Cabletron Systems Inc. (CS), which have quarters ended in November, reflected company-specific troubles, but still caused analysts to question whether their difficulties also highlighted some broader industry concerns.
3Com reported net income of 4 cents a share for its second quarter, well below the profit of 50 cents a share, excluding charges, of a year ago.
The shortfall was largely a result of the company's decision to cut high distribution-channel inventory levels of modems, adapter cards and systems products, which include hubs and switches and remote access servers. 3Com inherited the problem of swollen modem distributor inventory levels from its acquisition of U.S. Robotics Corp., but the high modem levels also resulted from the lack of an industry standard for 56K modems.
The company's results provided a warning about Asia since channel sell-through was down in that region.
Cabletron earned 13 cents a share for its third quarter, below the 44 cents a share it earned a year earlier.
Duran said the shortfall reflected slowing demand in Cabletron's main market of Fortune 1000 companies, since these companies have very high network penetration. The analyst said Cabletron has had spotty success in reaching small- and midsize businesses, and is not as successful as it needs to be in selling directly to carriers. He added, though, that the company is addressing these problems.
Lindsay attributed Cabletron's shortfall to a difficult product transition to switched hubs from shared media hubs.
Deutsche Morgan Grenfell's Lindsay believes industry bellwether Cisco Systems Inc. (CSCO) will earn 42 cents a share in its second quarter ending in January, up from the profit of 34 cents a share a year ago.
Cowen & Co. analyst Chris Stix said business is particularly robust for Cisco since the company "has a strong new product suite." These products include Cisco's Catalyst 5500 modular local-area network switch, which began to ship in early 1997; and its AS5300 access concentrator and its 12000 gigabit switch router, which shipped more recently.
Hambrecht & Quist's Billimoria noted that Cisco is one of the stronger networking players because it is in most parts of the business and is not overly dependent on any one segment.
Lazard Freres' Duran projects that Bay Networks Inc. (BAY) earned 25 cents a share in its second quarter, ended in December, compared with the profit of 10 cents a share, excluding charges, last year. The analyst said the company is "getting a lot of revenue from a couple of products," including the Accelar 100, a LAN switch with some routing intelligence; the BayStack 350 Fast Ethernet switch; and the chassis-based System 5000, an older product.
And Stix said Bay Networks' Accelar 1200 routing switch, which started shipping in mid-December, should drive growth in coming quarters. The product has been marketed as a gigabit switch router, but Stix believes it will actually be deployed as a Fast Ethernet switch.
Bay Networks had some trouble focusing on a few key products and meeting delivery schedules in 1996, but appears to be doing well under new management, Lindsay said.
NationsBanc Montgomery Securities' Al Tobia expects Fore Systems Inc. (FORE) to report earnings of 9 cents a share for its third quarter ended in December, compared with the 16-cent-a-share profit, excluding expenses, of a year ago.
The analyst hopes to see strength in sales of Fore's asynchronous transfer mode, or ATM, technology to service providers. Billimoria said Fore has focused largely on the local-area enterprise market, but needs to develop its wide-area network, or WAN, carrier business since use of ATM technology is growing in this market. While ATM is being deployed in the enterprise, it faces competing technologies, including Fast Ethernet and gigabit Ethernet, in that market.
Tobia expects Xylan Corp. (XYLN) to have earned 12 cents a share in the fourth quarter, compared with net income of 11 cents a share last year. Duran said that although much of the company's business is strong - including its OEM relationship with IBM and direct sales - investors are concerned about the company's exposure to Asia, and South Korea in particular. Asia contributed 25% of Xylan's revenue and South Korea contributed 10% of its total revenue in the third quarter.
Ascend Communications Inc. (ASND) has indicated it is comfortable with earnings estimates of 22 cents to 23 cents a share for the fourth quarter, versus 32 cents last year. Ascend is seeing strong European business and is benefiting from a major order from WorldCom Inc.'s (WCOM) UUNet Technologies unit for its MAX TNT WAN access switches, Stix said.
After a number of years of strong growth, the networking industry experienced a slowdown in the first half of 1997.
A pullback in overseas demand, particularly from Japan and Germany, was partly to blame, Deutsche Morgan's Lindsay said.
In addition, many carriers stopped building ahead of demand in the early part of 1997 because they were faced with "a confusing array of products and architectual options," Lindsay said.
Lazard Freres analyst Duran added that this also was true in the enterprise market, which was faced with a choice between existing ATM solutions and anticipated gigabit Ethernet technology.
Hambrecht & Quist's Billimoria pointed out that the industry has been seeing longer sales cycles as networking purchasing decisions are being made at higher executive levels because customers have come to view their networks as strategic assets.
Faced with these challenges, networking companies began to compete more aggressively for business in early 1997, driving prices sharply lower.
Billimoria noted that many vendors are now pricing advanced networking equipment close to the price of previous- generation products, pushing down prices on older technology.
Analysts noticed a definite industry pickup in the second half of 1997, however.
For one thing, Cowen & Co.'s Stix said, "Europe is clearly continuing to recover." Both carrier and enterprise spending are showing signs of a pick-up.
Lindsay added that while pricing is at aggressive levels, "it seems to be stabilizing at least a bit."
Moreover, lower prices may actually be sparking demand, analysts said. In fact, Billimoria explained that by pricing new technology not too far above the price of older technology, networking companies are driving upgrade cycles.
For instance, he said, many customers are upgrading to fast Ethernet from Ethernet technology since they can get "10 times the performance for a small increase in price."
This robust Ethernet cycle should benefit Cisco at the higher end of the market and 3Com and Bay Networks at the lower end.
Most important, Duran stressed that strong demand for networking equipment is being driven by explosive growth in the number of companies connecting to the Internet, which creates demand for LAN equipment, and intensive enterprise applications, including Microsoft Corp.'s (MSFT) Office 97.
Still, the networking business does face risks. For one, of course, the industry will feel the impact of the economic crisis in Asia as capital spending in that region declines.
Billimoria added that "the bigger issue is that ... many companies had assumed that some of their growth would come from those markets and now this is an unknown."
Stix also said a "second order of effects will come into play from Asia" down the road as domestic customers - faced with cheap import competition from Asia and smaller export markets in that region - curb their own spending.
In addition, lower prices and stiff competition have over the last 18 months dragged operating margins down to the midteens from the 20%-to-30% range for most networking companies other than Cisco, NationsBanc Montgomery Securities analyst Tobia said.
Finally, investors also are concerned that the so-called Year 2000 problem could divert spending and staff resources away from network upgrades.
-By Joelle Tessler; 201-938-5285
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