Dear Mang:
Thought this might be of interest as you have been touting the new technology that CSCO doesn't have all along. But when will Wall Street and the carriers/enterprises catch on?
February 3, 1998
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WHEN Cisco Systems
(CSCO) reports
second-quarter earnings
after today's market
close, the networking
industry's leader is
widely expected to meet
consensus projections of
$2 billion in revenues and
42 cents a share in
earnings, versus $1.6
billion and 34 cents in last
year's comparable
quarter. The company's
shares are branded a Buy
by 36 of the 38 analysts
that follow the stock, and
its stock price has hit an
all-time high of 64 15/16,
gaining 13 points over the
past three weeks.
On the face of it, there is
every reason for the
continued strength of
Cisco's stock. The
company now trades at 36 times fiscal (June) 1998's expected earnings of
$1.75. If Cisco met this target, it would have increased earnings per share by
28% -- only about half the company's growth rate between fiscal 1996 and
1997. But Cisco's growth is slowing at a time when its trailing 12-month
P/E is expanding. Over the past five years, Cisco increased earnings by an
annual average of 58%, while its average P/E was 37. In the next three to
five years, analysts expect the company to grow by 31% a year. Meanwhile,
its trailing 12-month P/E is now 44. "Right now every one is running to
invest in Cisco, but this euphoria may not be supportable by near-term
earnings prospects," says Peter Lieu of Adams Harkness & Hill, an
institutional research firm in Boston, who rates the stock a Hold.
Valuation isn't the only issue facing the industry leader. A new product by
rivals Bay Networks (BAY) and 3Com (COMS), known as a Layer 3
switch, is threatening Cisco's bread-and-butter business of routers. Cisco
built its industry domination on routers, a software-laden networking
application that plays traffic cop to data streams. Routers contribute about
40% of Cisco's $6.8 billion in revenues, as well as juicy gross margins,
estimated at about 65%. The Layer 3 switch, which Bay boasts to have 10
times the performance at one-tenth the price of a router, is vying to replace a
good deal of these $100,000 machines' functions. "Layer 3 switches are
basically the remaking of the traditional routers," says industry watcher John
Armstrong of San Jose's Dataquest.
Armstrong explains that the Layer 3 switch has moved some of the router's
software-based functions onto a microchip. Chips are cheaper and easier to
produce than software packages, which keeps the cost to the end user down.
This isn't about the death of Cisco; rather, it is about a nightmare that could
come true, where all the functions of a router are moved to a chip. "We
would be seeing higher sales of routers were it not for Layer 3 switches,"
says Armstrong. "This is a device that can evolve and include more services,
and won't have to be discarded," he adds. Even Cisco bulls agree that the
Layer 3 switch offers an opening for other networking companies, such as
Bay and 3Com, which are already shipping product. "The challenge and
opportunity for the other Layer 3 switch makers is: Can they use it as an
opportunity to get into Cisco's customer base, and get repeat business?" says
Martin Pyykkonen of CIBC Oppenheimer, who has a Strong Buy rating on
the company.
Unseating the incumbent is never easy, nor is it easy to introduce a new
technology. And Cisco itself is hardly standing still. "Cisco will be in the
thick of things when second generation Layer 3 switching will be important
to the market," says Steven Koffler networking analyst with Donaldson,
Lufkin & Jenrette. But all are wondering how Cisco will manage the
transition to a lower margin product. "There is definitely a sales challenge
going on, because you are getting less revenue and profit per unit," says
CIBC Oppenheimer's Pyykkonen.
If the Layer 3 switch doesn't bother you, how about the prospects of
Lucent (LU), Nortel (NT) and Ericsson (ERICY) licking their chops to
get into your business? After all, compared to the 4% a year growth rate
predicted for purchases of telecommunications equipment, networking looks
like a gold rush. Right now they don't have the product breadth to compete
with Cisco, but these three telecommunications giants have been buying
companies to begin offering network systems. The merger of voice, data, fax
and video into one wire and one network is a very real occurrence, and is
coveted by many internationally renowned players. Lucent has announced 30
new product launches in this area over the next 18 months. And if router
functions are migrating toward microprocessors, you can bet that Intel is not
far behind. "Intel has quietly been assembling a fairly good product line.
Now they have to step up to the plate with enterprise-level solutions," says
Dataquest's Armstrong. Texas Instruments (TXN) and Compaq (CPQ)
have also slated networking product introductions in 1998.
The bulls argue that Cisco will gain leadership in Layer 3 switching once that
technology becomes important. But past experience has shown that Cisco
isn't as good as everyone believes at entering new markets. For instance, it
has been battling in the remote access concentrator businesses for the last
couple of years, but it is still a far third to the likes of Ascend
Communications (ASND) and 3Com.
These days, Cisco has a great deal of expectations built into its lofty stock
price. The key question will be how the company handles the inevitable
technological shift. "Bay has undergone the pains of shifting from routers to
switches," says Armstrong. "3Com has gone through the pains and
Cabletron (CS) is going through these pains. Cisco has still yet to make the
transition."
Back in COMS again,
JF Dowd |
