All: from the Cisco board
Mar23/98
Panelists
Peter Lieu, Senior Vice President, Research at Adams Harkness Hill.
Christin Armacost, Networking Analyst at EVEREN Securities.
Q&A
Briefing: Which areas of the networking industry hold the most room for
growth and which companies are best positioned to capitalize on that growth?
Peter Lieu: Although investors tend to group these companies as one, it is important to remember
that networking is heterogeneous and one needs to consider the sub-groups. Having said that,
though, the networking group is reminiscent of the computer industry about 15 years ago, with
Cisco as the clear dominant player. Bay has attempted to challenge Cisco in routers but it has
suffered dislocations in merging its predecessors companies (Synoptics and Wellfleet) and lost
market share to Cisco .
In terms of growth, switches - high, medium, and low-end - offer significant potential for this group,
with low-end switches offering the best growth potential. Bay holds the lion's share of sales in
low-end switches with about a 40% market share. 3Com and Cisco have recently come into this
market and pricing has become vicious.
Routers are more difficult to produce than switches and very few companies have router capacity.
Cisco is the clear leader in routers with Ascend following well behind. The router switch market,
which represents a challenge to the router market, is emerging as another significant growth area.
3Com and Bay are out in front with their products and it is expected that Cisco will come into this
area as well. The remote access area was strong through last year but consolidation among ISPs
has slowed growth and Ascend had disappointing growth because of this and competitive
displacements.
Christin Armacost: Holding the most room for growth are Local Area Network (LAN) and Wide
Area Network (WAN) switch routers along with remote access. Each of these areas is growing in
excess of 20% which is a noteworthy development in this very competitive marketplace. Given the
rapidly changing environment in the networking industry, it would be more germane to say that those
companies which currently stand the best chance of success in these respective markets are
Ascend, Cisco, and to a lesser extent, Newbridge Networks, 3Com, and Northern Telecom. When
considering the remote access market, it is a very close race between Ascend, 3Com, and Cisco.
Ascend and 3Com lost share in 1997 while Cisco went from nothing to mid-teens in market share,
and potentially, could emerge as the leader in absolute dollars for the quarter. With WAN switches,
Newbridge Networks, Ascend, Cisco, and Northern Telecom are all fairly close.
Briefing: Bay Networks and Cabletron Systems warned that earnings would
fall short of expectations due to weak demand and margin pressures. Do you
think that these are isolated cases or is there an industry-wide demand problem
and if so, what are the contributing factors?
Peter Lieu: I think that these are not only isolated cases, but that the factors contributing to the
warnings for CS and BAY are very different. CS is under extraordinary management transition.
They have a new CEO, Don Reed, a new distribution model, and are moving toward new product
lines. Cisco and CS used to be marketing partners, but Cisco has now become a direct competitor.
We see CS slipping very badly in the near-term. The Yago Systems acquisition may prove to be a
positive step in getting CS back in the router ball game, but it remains to be seen if CS can right the
ship.
Bay has gained market share in the last three quarters against peer companies. They have been
victimized by product transition pressures and a weak macro environment (Asia and competition in
low-end switches). Demand appears to have softened because of product cycle transition issues.
Bay announced that they have new products in the works and customers are holding orders until
these products are available.
Christin Armacost: I would agree that it is a widespread issue as industry growth is slowing
dramatically. Consider that from 1993-1997, the industry was growing 30%-50%. In 1998, we're
expecting growth of only 15% due to reduced average selling prices, and an already saturated
market. Also worth noting is that since January 1, 1997, six of the seven largest networking
companies have reported an earnings shortfall at least once. Cisco remains the only company not to
have disappointed, yet it stands to reason that it can't be isolated forever from the obvious, and
significant, product transition and pricing pressure trends that are hitting the industry.
The whole issue of product transition started with the customer, namely corporations which view
their corporate networks as being absolutely critical to the way they operate. As such, they are
reducing the number of their suppliers, and moving more toward strategic suppliers. This shift has
fostered a wave of consolidation in the industry as networkers endeavor to become single-solution
providers. While making this change, all vendors find themselves exposed to some product that has
reached the end of its life cycle, and this is one of three, contributing factors to the competitive
pressure gripping the industry. The second is that smaller companies are either being acquired, or
being forced out of business, since they can't compete with the larger players in terms of R&D
spending, product breadth, and distribution methods. Finally, the myriad of technology available to
customers is just plain confusing, and is causing customers to delay purchasing decisions. All of
these factors are forcing a smaller number of vendors to compete for customers, and subsequently,
many of them are occasionally lowering prices in an irrational manner to maintain a declining market
share. Prices, which normally fall 15%-25% a year, are now down 35%-40%. At this rate, there is
no doubt that only the strong will survive.
Briefing: How will the increasing competition from telecom equipment makers
and semiconductor companies change the competitive landscape?
Peter Lieu: There is no doubt that the telcos will continue to get into the business that has
traditionally belonged to the networkers. Northern Telecom, announced just yesterday that it had
acquired Aptis Communications which will put them in competition with Bay, 3Com, Shiva, and
others in the remote access space. Semiconductor companies have been getting into the networking
business at the low-end as it is in their best interest to expand the communications capability of PCs.
Intel, for example, is making NIC cards and low-end switches. Its value-added is in networking
switches where Intel brings the formidable ASIC Design capability. It is interesting that we have not
seen Intel do as much damage to 3Com as we would have expected given that Intel has been in this
business for roughly five years.
Christin Armacost: The telecom equipment makers are a serious threat because they are
aggressively re-directing employees and resources to develop data networking solutions since this
area has a faster growth rate and higher margins than voice technology. The stiffest competiton will
come from Lucent, Ericcson, Alcatel, and Northern Telecom. Since the start of this year, all of these
companies, with the exception of Lucent, have made product announcements, or acquisitions, aimed
at winning business in the data networking market. As for Lucent, it has always had some
involvement with data networking since its spinoff from AT&T.
In contrast, the presence of semiconductor companies is not exactly new as they have been
partnering with networkers for a while. Thus, they present more of an opportunity than a threat,
because more features can be included on silicon which, in turn, has the potential to offset to a
certain degree some of the price erosion on the products. The use of silicon, and continued silicon
enhancements, is an ongoing part of the networking vendors' existing relationship with the
semiconductor companies.
Briefing: Which stocks are you recommending and/or avoiding?
Peter Lieu: We just took Shiva (SHVA) off the Buy list because of the Northern
Telecom(NT)/Aptis acquisition. We were looking for Shiva's relationship with NT to improve, but
the acquisition places any improvements in jeopardy. We do not think that Bay will be the only
networker to disappointment in earnings and because the market tends to overreact to bad news
creating buying opportunities, we are waiting for those buying opportunities.
Christin Armacost: The four companies I cover include Shiva, 3Com, Cisco, and Ascend. Of the
four, Ascend (ASND) is the only stock on which a BUY rating has been issued. I believe the
company has weathered the worst of its product and earnings troubles. They have made good
changes internally with management and with their product transition problems. As such, I feel they
have re-positioned themselves to regain market share lost in the second half of 1997.
3Com (COMS) is rated NEUTRAL, because I think its earnings estimates are too high, and its
inventory transition efforts will take a lot longer than most analysts are expecting. Shiva (SHVA) is
also at a NEUTRAL rating. While its business strategy is improving, it is still too early to call it a
success. Finally, I have a NEUTRAL rating on Cisco (CSCO) based on valuation, and the fact that
widespread product transition and pricing pressure in the industry is just too great to overlook--
even for one of the best managed companies in the industry. |
