CISCO SYSTEMS: AN UPDATE
By Joe Arena
Editor
The High Tech Arena 11/23/98
Over the past few years, we have reiterated our assertion that not owning Cisco Systems would be
like not owning the leading railroad stocks in the 19th century. In addition, we continue to focus on the
prolific growth potential of the Internet by citing such facts as:
The Internet gains 45 new users every minute, which equates to 24 million per year
Only 3% of the global population currently has access to the Internet
Half the world's population has never made a telephone call
Given the dominant position that Cisco has in terms of building the Internet, it remains our best idea,
and as company and industry trends unfold, the reasons to overweight the stock in a portfolio become
more compelling.
The carrier market, which represents a $300 billion opportunity for Cisco, provides the greatest
potential for revenue growth, and is the single most important reason to own Cisco. Regardless of
what happens in the short run in terms of capital spending, Y2K issues (Year 2000), or other
macroeconomic factors, this market potential is not going to change significantly. The market is
comprised of ISP's (Internet Service Providers), CLEC's, (Competitive Local Exchange Carriers),
and LEC's, or Local Exchange Carriers. By 2002, depending on the execution of Cisco's acquisition
strategy and the strategic alliances it forms, a case can be made for Cisco garnering $40-$50 billion of
this. Almost certainly, the carrier market, which accounts for about 30% of Cisco's business today,
will be the company's primary source of revenue two years from now.
This forecast represents the best case scenario over the next few years. More realistically, incremental
revenue of about $20 billion by 2002 seems probable. This revenue mix in terms of applications could
be broken out as follows:
Packetized Data - $3 billion (remember, the business is transitioning from Circuit
Switching to Packet Switching, playing to Cisco's core competency versus Lucent's
expertise in Circuit)
Multi Service Platforms - $3 billion
Access - $3 billion
Voice Systems - $11 billion. (Recent acquisitions of Summa Four and Lightspeed have
already begun to address this opportunity)
Given this, it is not difficult to project Cisco revenue of around $30 billion by 2002, which would be
more than triple sales of $8.4 billion in fiscal 1998. With this dramatic rate of growth, it is also not
inconceivable for Cisco to trade at twice its rate of earnings growth, or 55 to 60 times forward
earnings.
One of the keys to Cisco's success has been their acquisition strategy, and we continue to be
impressed with their execution in this area. Despite how large a company Cisco has become, they
have been able to retain an entrepreneurial culture while assimilating these acquisitions and achieving
synergies. Maintaining such a culture is crucial if Cisco is to continue its proactive approach to
reinventing itself in the rapidly evolving networking business. Although our assessment of this aspect of
Cisco's business is admittedly a subjective one, there is also a quantitative measure of Cisco's adroit
style of managing their acquisition strategy. The bottom line here is that the company has been able to
retain more than 90% of employees from acquired companies. This number is exemplary when
compared to the industry average of 20-30%, and is an excellent indicator of just how judiciously
Cisco pursues this strategy.
Despite the many new revenue streams which will drive Cisco's growth, the current state of their core
router business cannot be ignored in any analysis of the company. In the most recent quarter, the
router market grew 8% sequentially and 13% versus last year's third quarter, which equates to roughly
$1.5 billion, according to The Dell ' Oro Group. Cisco continued to gain share, growing to 67%
market share, which is up from 65% in the prior quarter. To put this in perspective, Bay (recently
acquired by Nortel) has a 12% share. In the low end of the router business, Cisco's share is even
greater, in the 70% range. Another aspect of this business which is important to watch is average
selling prices, which were flat sequentially for the quarter. Versus the quarter last year, average selling
prices declined 5%, underscoring the commoditization of this business. This also magnifies the
importance of Cisco's strategy to provide end to end solutions, leverage their installed base, and
increase penetration of their proprietary IOS Software. Without these advantages to differentiate them
from the competition, it is doubtful they would be able to maintain their dominant market share. (Is it
any wonder that Cisco is already appearing on the Department of Justice radar screen?)
However, Cisco is not dominating every segment of the business. It is noteworthy that Ascend
(ASND) has now taken the number one position in the rapidly growing Remote Access market. In the
September quarter, Ascend grew their share by four points to 29%. Cisco is now second in this
business with a 28% share and 3 COM (COMS) is third with 25%. Overall, the Remote Access
market grew 8% sequentially in the quarter, and was worth about $600 million for the quarter
according to The Dell ' Oro Group.
From an investing standpoint, we remain long Cisco since taking a position in May 1996, at an
average cost of $24.60.
Jack.....LU and CSCO.....great longterm holdings! |
