Investors Await Cisco Earnings

Feb. 5, 2001 -- Cisco CEO John Chambers has carefully telegraphed his concerns about an equipment-spending slowdown and a cooling economy that threaten to slow the Internet gear maker's hypergrowth.

Now, investors are looking to Tuesday's postclose earnings report to see if Chambers can navigate a re-entry into what some expect will be a more earthly 20 percent to 25 percent annual growth atmosphere.

"Last quarter, they were growing 60 percent-plus off a multibillion-dollar base," says Paul Meeks, portfolio manager for the Merrill Lynch Global Technology fund. "They can't help from being pulled down by this thing," says Meeks, who has a large position in Cisco.

Though Chambers has said business has softened in the past two months, Wall Street is not fearing an earnings disappointment. The First Call/Thomson Financial consensus points to a Cisco profit of 19 cents a share for the fiscal second quarter. "They've got enough play to still beat that by their customary penny," says one analyst who has a hold rating on Cisco and asked not to be identified.

Company May Have to Quell Optimism

The real concern for Cisco and other networking concerns, namely Lucent and Nortel, is the rest of the year and beyond. Cisco has some specific challenges that include a weak stock price that may stall its growth-through-acquisitions strategy, a slipping lead in its core market and a host of weak customers that appear increasingly dependent on generous financing terms.

An industrywide spending slowdown took Cisco by surprise at the turn of the year, despite mounting evidence that customers were trimming their budgets. Chambers, no slacker when it comes to optimism, had just two months ago forecast annual sales growth in the 50 percent to 60 percent range.

Chambers has since recast that guidance and is now calling for revenue growth of between 30 percent and 50 percent. Chambers is also counting on a quick reboot of the spending process. But as at least one analyst, BlueStone Capital's Susan Kalla, has pointed out, spending cycles can take a year or two to bounce back.

It may take more than sheer will and positive thinking to sustain better than 30 percent growth amid an industry slowdown. Given the strength of the downstream current, Cisco will likely see something on the order of 20 percent to 25 percent long-term growth, CIBC World Markets analyst Steve Kamman wrote in a recent report.

Investors expect Chambers to guide growth expectations with unusual caution this time around. He'll have to temper the company's typical moxie with the humbling possibility that Cisco is not immune from economic woes and the uncertain "visibility" of the industry's spending trends.

"I do expect guidance to come down," says Meeks. "I'm just hoping they take down numbers that won't surprise people too much."

Some Internet Providers Running Short of Cash

The nation's economy aside, many phone and Internet service providers that once spent generously on networking gear, are now running critically short on cash. Some, for example, including ICG and Digital Broadband, both of which received financing from Cisco, filed for Chapter 11 bankruptcy protection in recent months.

So why should a bunch of second- and third-tier carrier failures matter to a $30 billion-a-year company like Cisco?

Well, those companies happen to serve as Cisco's toehold on the telecom-equipment market. Simply put: Cisco is a data-equipment maker trying to sell to a bunch of phone traffic carriers.

Most of the top-tier or established carriers have networks built with phone systems made by suppliers like Nortel and Lucent. With little likelihood of convincing big network operators to tear out their traditional phone equipment, Cisco's real opportunity is selling to start-ups with no old phone gear to fuss with.

Somewhere between half and three-quarters of Cisco's business comes from selling companies their internal information plumbing, the routers and switches that control the data flow between computers. Cisco's leap into the telecommunications market was, in large part, a bold attempt to enter a new growth frontier before its traditional market got too mature.

Investors Concerned Over Potential Risks

To help open some new doors, Cisco has taken up the old phone company practice of lending money to customers. In November, Cisco said it had committed a total of $2.4 billion in vendor financing loans to customers and of that, $600 million had been drawn down.

Investors are concerned that Cisco could turn on the financing in order to pump up sagging sales, potentially exposing the company to the risk of bad debt. In its fiscal first quarter, the company put $14 million aside to cover potential deadbeat customers. That number is in danger of increasing as customers' businesses deteriorate.

And while sales to telecom service companies represents Cisco's primary growth engine, that engine sputtered in the first quarter. Cisco's carrier sales growth slipped to 7 percent, from 16 percent in its fourth quarter.

Cisco watchers are monitoring a few key indicators to gauge how trustworthy their investment vehicle will be in this new terrain.

Among the leading indicators is how quickly Cisco will be able to turn up sales on its new core router, which it announced with great hoopla last week. Some analysts expect router rival Juniper which already took 30 percent of Cisco's market share in the fall quarter, will have snagged as much as 40 percent last quarter. And newcomer Avici is expected to take a growing sliver of Cisco's pie as it continues to push into the market.

Wall Street is expecting to hear a little about Cisco's cost-cutting efforts, which will help keep its profits up while sales growth slows. The company hasn't specified, but people familiar with its operations say hiring has slowed and some contract employees have been let go in an effort to slash expenses.

Inventory is another category to watch. First-quarter-end inventory jumped 58 percent from fourth-quarter levels, to $1.95 billion. Meanwhile, revenue lagged behind, rising 14 percent sequentially to $6.5 billion. One-third of that inventory was finished products gathering dust in warehouses. If inventory levels continue to grow, investors will have a good indicator of slack demand.

Cisco shares are trading at roughly 46 times fiscal 2001 earnings, meaning investors expect healthy growth. If Cisco is prudent about its outlook, it may serve to knock those expectations down a bit. But many Cisco investors, like the CEO, are highly optimistic, and some could see one person's sell-off as a good time to buy.

"If Cisco is at $38, I'm not interested, says Merrill's Meeks. "But at about $30 I am interested and I'd probably take it there."