Posted 11/17/98
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Jubak's Journal
I'll take Cisco's word for it
Growth, earnings and margins at Cisco Systems have been sensational.
Management says it has the power to continue the trends -- and I believe it.
By Jim Jubak
On Nov. 4 Cisco Systems (CSCO) reported the perfect quarter. So what does
the company do for an encore?
What Cisco has done is already built into the stock's price. It's the company's
amazing 62% annual sales growth and its 38% annual earnings growth over
the last five years that have powered the stock to an average gain of 53% a
year over that same period.
But that was then. Five years ago, Cisco's annual sales were just slightly over
$1 billion, or about 15% of its sales in the fiscal year completed in July. Its
sky-high price-earnings ratio means that the market pretty much expects the
company, now doing $8.5 billion in sales, to grow at the same rate as the
much-smaller firm that recorded $1.2 billion in sales in fiscal 1994.
Can the company still deliver that kind of growth? That's the most important
question facing any investor trying to make a buy/sell/hold decision on Cisco.
Fortunately, I think its recent quarter tells investors exactly where that growth
will come from. To me, the numbers say that Cisco is a "buy" at its current
price -- and in Jubak's Picks I'm raising my 12-month price target on the
stock to $80 a share. Let me tell you why I think the numbers add up that
way.
Cisco's rapid growth isn't new
Cisco's growth dilemma is summed up in one set of figures. In its most recent
quarter, the company managed to increase its revenues at an annualized rate
of 38% -- this in a year when industry analysts estimate that global data
network equipment sales are likely to grow by just 14% to 16%.
Growing faster than its industry is nothing new for Cisco -- the company has
done it for years by taking market share away from its competitors. And I
think it's clear that this trend is still in place. Cisco competitor 3Com
(COMS), for example, grew sales by just 2% sequentially in its most recent
quarter. Even in the switching sector, where Cisco faces its strongest
competition, from Ascend Communications (ASND), Cisco was able to show
13% sequential growth, just about matching Ascend's growth rate. The two
companies, industry numbers show, are running neck-and-neck while taking
market share from weaker players.
A slew of new products from Cisco in 1999 is likely to increase the
company's dominance in the networking industry. New high-end routers and
remote access devices will attack markets where 3Com, Ascend and
Northern Telecom (NT) have significant revenues. And Cisco is just beginning
to go after the small- and mid-size business market where the company has
had a negligible presence. Cisco is certainly not yet the leader in that market,
but, according to Lehman Brothers, the company did gain share in that sector
in the most recent quarter.
Great, but it's not enough. Cisco can't possibly continue to grow faster than
its industry indefinitely, since, in many sectors, it is the industry. For
example, Cisco owns 80% of the router market already. And, after lagging for
years, the company now controls about 60% of the local area network
switching market. Robertson Stephens estimates that Cisco today accounts
for 50% of networking industry revenues and 80% of the industry's profits.
It's pretty clear from those numbers that the product initiatives I outlined above
are enough to power Cisco's growth for the next year or two. But by
themselves they can't produce 30% annual earnings growth after 2000. And a
stock trading at a P/E ratio of nearly 70 (or a slightly lower 52 if you add back
all the one-time charges for acquisitions) is certainly counting on far more
than two years of 30% earnings growth. (Cisco now trades at 33 times the
$1.96 a share that the most optimistic analyst is now projecting for the
company's fiscal 2000 earnings.) To make Cisco worth its current P/E ratio,
the company needs another source of growth.
Transition: From whale to trout
Everyone knows what that source might be: the potentially huge revenues
that will go to the companies that turn the current voice-oriented
telecommunications network into the data-dominated network of the future.
But analysts are divided in their opinions on whether Cisco is going to be able
to grab a significant hunk of that business. The transition will be tough, no
doubt about it. Cisco will go from being the whale of the networking industry
to being just a trout swimming in waters ruled by companies such as Lucent
Technologies (LU), Northern Telecom and Alcatel (ALA). Those three
companies alone have annual sales of $77 billion -- about 9 times those of
Cisco. And they have strong relationships, formed by years of sales calls,
dinners and rounds of golf, with the folks who buy equipment for the big
telephone companies.
But I think Cisco's most recent quarterly report shows the company will be
able to grab the growth it needs from this new business. The company
already is having encouraging success in selling into this market. What Cisco
calls its service provider segment (in contrast to the enterprise segment that
includes sales to businesses) now accounts for 30% of revenue. In a
conference call with Wall Street analysts, Cisco said the segment grew by
more than 10% sequentially (Cisco is frustratingly vague about the source of
its revenues) in the recent quarter. More importantly, new orders increased by
50% in the current quarter over the same quarter a year earlier.
This isn't some wild,
fast-growing
technology company
that makes big
promises and then
misses estimates
every third or fourth
quarter. Cisco is one
of the most tightly
managed companies
going right now.
In that conference call, Cisco said it is competing for big contracts to be
awarded by the end of the second quarter of 1999 by MCI WorldCom
(WCOM), US West (USW) and British Telecommunications (BTY). According
to Cisco's management, the end market for its telephone company oriented
products could grow by 100% in fiscal 1999.
If Cisco says 100%, take it seriously
I know that sounds giddy. How often does a technology company project
100% growth -- and then actually deliver? But this company's management
doesn't get giddy. This isn't some wild, fast-growing technology company that
makes big promises and then misses estimates every third or fourth quarter.
Cisco is one of the most tightly managed companies going right now, and if
CEO John Chambers and his team say 100%, I think the possibility is worth
serious study.
After all, look at the quarter they just delivered. Analysts had projected that
sales would come in at $2.5 billion or so; the company reported $2.59 billion.
Analysts had estimated earnings per share of 33 cents; the company
reported 34 cents. Analysts had worried that gross margins would fall -- after
all, Cisco's customers were buying more low-margin switches. But margins
beat Wall Street expectations at 66%. The company booked more than
enough orders for future business to replace the orders it filled and it even
managed to shave a couple of days of supply out of its already tight inventory.
On top of that, Cisco managed to wring cash out of its customers more
efficiently -- accounts receivable fell in the quarter.
I'm not minimizing the task ahead of Cisco, by any means. Or the risk to
investors if the company can't grab a significant share of this new market. But
I think this management has shown that it can execute with the best of them.
I'm staying on board for the ride. OLD NEWS BUT GOOD NEWS FOR CISCO.......HANG TOUGH |
