Pricing Pressure, Slower Growth To Hurt
Networking Cos.' 1Q
By JOELLE TESSLER
Dow Jones Newswires
NEW YORK -- Networking companies should report mixed
results for the first quarter as the industry continues to adapt to
substantial pricing pressure and slower top-line growth, analysts
said.
Local-area networking-equipment makers could also show
some seasonal weakness in the period since many
corporate-enterprise customers don't approve their
information-technology budgets until a month or two into the
new year.
But even while Lazard Freres & Co. analyst Michael Duran
expects industry revenue to be sequentially flat in the March
quarter, he believes growth will pick up through the rest of the
calendar year, driven by strong demand for ATM technology,
layer 3 switches and remote-access products.
Duran also believes growth will accelerate as spending revives
once IT budgets are approved and as prices stabilize.
"We think there's a return to growth in 1998," he said.
The networking business is in its second year of moderate growth
coming after a number of years of robust expansion - with
annual growth rates hovering around 50% earlier in the decade.
Credit Suisse First Boston Corp. analyst Peter Rubicam expects
20% to 25% top-line growth in the networking industry in 1998,
compared with about 20% last year. "Before last year, the
industry had been growing at 30% to 50%," he said.
While unit demand appears to be healthy - particularly for
carrier ATM switches and LAN switches - the industry has been
facing heavy pricing pressure, analysts agreed.
Sanford Bernstein & Co. analyst Paul Sagawa said pricing
declined 18% across the board in 1997, and predicted prices will
fall another 15% to 16% in 1998.
According to Cowen & Co. analyst Chris Stix, pricing is coming
down in part because component prices, including silicon costs,
are falling.
In addition, Sagawa said, the adoption of application specific
integrated circuit - ASIC - technology, particularly in the
enterprise market, is pushing prices down.
ASICs are semiconductor circuits optimized for a single
application. Because networks have become so standardized, the
technology enables networking companies to leverage a single
design over a wide range of customers, Sagawa said.
CIBC Oppenheimer Corp. analyst Martin Pyykkonen believes
pricing pressure is not as severe in the wide area networking
industry because carriers and Internet service providers need to
build out their networks to compete for users who want strong
performance and uptime.
"They are jockeying with each other for position, so they are in a
spending frenzy," Pyykkonen said, adding that Cisco Systems Inc.
(CSCO) and Ascend Communications Inc. (ASND) have a lot
of opportunity in the wide area business.
In the LAN market, on the other hand, many enterprise
customers see "a less compelling need to upgrade," Pyykkonen
said. Also, he noted, many corporate customers don't make up
for lower prices by buying more equipment.
Pricing pressure is also more pronounced in the LAN market
because many vendors are "trying to play in each other's
sandbox" in that business, leading to overlap and a lack of
product differentiation, Pyykkonen explained. This generally
benefits Cisco since it is usually the incumbent in vying for
business.
The economic slowdown in Asia is also hurting growth rates in
the networking industry, of course, and "will cost 4 to 5 points of
growth this year relative to where it would have been" if the
market there hadn't slowed, said Sagawa of Sanford Bernstein.
Still, Cowen's Stix pointed out, the region accounts for less than
10% of sales for many in the group. He added that Europe is
seeing "phenomenal" growth.
Duran, of Lazard Freres, stressed that he sees "a return to growth
in 1998" driven by strong demand for ATM technology, remote
access products and layer 3 switches.
Many analysts expect layer 3 switches, which take many of the
functions of routers and put them into hardware, to offer
customers a cost-effective networking solution, particularly in
LANs. Layer 3 switches can cost 10% to 15% as much as
comparable routers and can perform as much as 75% of the jobs
as routers, Sagawa said.
3Com Corp. (COMS), Bay Networks Inc. (BAY) and Cabletron
Systems Inc. (CS) are all touting new layer 3 switches and Cisco
will ship a layer 3 product later this year. "They are all expecting
it to be important ... as a strategic new product line," Duran said.
Sagawa warned, however, that the spread of layer 3 switches
could impact revenue growth since "fundamentally less
expensive equipment is being substituted for fundamentally more
expensive equipment."
Rubicam of CS First Boston believes layer 3 switches could
eventually push down prices on high-end routers. This could
impact Cisco, the leading router vendor, Duran said.
Duran nevertheless believes pricing could finally be stabilizing
since the fast Ethernet market has matured. Pricing fell in 1997
because Fast Ethernet offers customers 10 times the networking
performance for only about twice the price of Ethernet products,
he said.
Early indications from the networking companies have been
mixed. Cabletron missed even scaled-back expectations for its
fiscal fourth quarter, ended February, and reported a loss of 4
cents a share, compared with earnings of 45 cents last year.
Sagawa said Cabletron is having trouble partly because some of
its traditional customers are defecting to Cisco for end-to-end
solutions. Analysts said the company is also hitting bumps
because it needs to build up an indirect sales channel and because
it faces competition from Cisco, Bay Networks and 3Com,
particularly in the switching market.
But Cabletron's recent acquisition of Digital Equipment Corp.'s
(DEC) Network Products business should help it build up its
indirect sales channel. And its purchase of Yago Systems has
given the company a high-end switch router that
Oppenheimer's Pyykkonen believes will be "a key variable" in
Cabletron's ability to turn its business around.
3Com reported operating earnings of 2 cents a share for its fiscal
third quarter, also ended in February, compared with 50 cents a
year earlier. Sales out of the distribution channel in the quarter
declined sequentially, Duran said.
But many analysts said 3Com's outlook is brightening because it
has reduced excess channel inventories and put in place a new
business model that calls for lower gross margins but also lower
expenses.
Duran of Lazard Freres also has high hopes for several new
products from 3Com, including its 56K modems and two new
layer 3 switches - the CoreBuilder 3500, which started shipping
in the latter part of 1997, and the CoreBuilder 9000, which will
start shipping this spring.
Hambrecht & Quist Inc. analyst Farrokh Billimoria projects
industry-leader Cisco will report 45 cents a share for its fiscal
third quarter, which ends in April, compared with 35 cents last
year. He noted that all eyes will be on Cisco, which - as the
industry bellwether - provides a good indication of how the rest
of the sector is doing.
Cowen's Stix said Cisco is "continuing to outpace the
competition based on its really strong product flow and its focus
on the fastest growing parts of the business," including remote
access concentrators and LAN switching. Stix said Cisco's
StrataCom business, which makes frame relay and ATM
switches for the WAN, is also seeing strong growth.
Still, Sagawa of Sanford Bernstein warned that some Cisco
customers may be holding off on making purchases since the
company is planning to ship a number of new products -
including the Catalyst 8500, which is being positioned as a
high-end layer 3 switch - in the months ahead.
Oppenheimer's Pyykkonen projects Bay Networks earned 11
cents a share in its fiscal third quarter, ended March, compared
with 10 cents a year earlier. Bay has already warned that it
expects revenue, operating earnings and gross margins to be
below second-quarter levels.
The company's troubles were partly the result of timing issues
since Bay's new Accelar line of routing switches, which began
shipping in December, is ramping quickly but not quickly enough
to offset weakness in older products like shared media hubs,
according to Duran.
In addition, Pyykkonen said, orders for Accelar products did not
come in as quickly as expected since many customers are still
evaluating the line and since some may be awaiting a similar
product from Cisco.
At the same time, Bay cut prices on its BayStack 350 switches by
25% to 30% to preempt competition from Cisco and 3Com in
fast Ethernet workgroup switches, a market Bay once had to
itself, Sagawa said.
Bay Networks has also cut prices on the BayStack 350 to move it
through the channel because it is introducing a high-density
version of the product, the BayStack 350T-HD.
Rubicam of CS First Boston believes the June quarter will be the
one to watch for Bay since Accelar is now on track.
Billimoria estimates Fore Systems Inc. (FORE) earned 10 cents
a share in its fourth quarter, ended March, compared with 9
cents a year ago. Duran believes ATM port shipments at Fore, a
leader in ATM technology, will be strong again after rising 36%
sequentially in the third quarter.
Stix estimates Ascend earned 25 cents a share in the first
quarter, compared with a restated 31 cents last year. He said the
company has resolved quality problems with its remote access
platform products and is seeing strong growth from its ATM
switching business.
According to First Call Corp., the consensus estimate on Xylan
Corp. (XYLN) for the first quarter is 16 cents a share, compared
with 13 cents a year ago. Duran said he expects double-digit
revenue growth in the first quarter after a 20% sequential
revenue increase in the prior quarter.
-Joelle Tessler; 201-938-5285 |
