Cisco’s Margins Seen Under Pressure



By Hal Plotkin
Silicon Valley Correspondent


Financial analysts who have been talking up Cisco Systems Inc.’s {CSCO} stock say they won’t be surprised to see the company beat consensus fiscal third-quarter earnings expectations next week, but several leading industry observers also warn that Cisco’s profit margins will almost certainly come under increasing pressure going forward.

“It would be very naïve to think Cisco’s next five years are going to be as rosy as the last five years,” says John Armstrong, vice president and chief analyst at Dataquest, based in San Jose, Calif. “It’s going to be more difficult for Cisco to command high margins as it moves past its core enterprise market into the service-provider market.”

Many investors were taken aback last month to see industry-leading Cisco’s stock skid below 60 a share from its 52-week high of 82 hit in late March, just prior to the overall technology-sector selloff.

Cisco 52-Week Stock-Performance Chart

The stock’s recovery got a boost last week from ABN Amro and First Union Securities, which initiated coverage of Cisco with “buy” and “strong buy” ratings, respectively. First Union’s analyst set a 12-month price target of 100 for the stock.

Those moves came shortly after Merrill Lynch analyst Michael Ching released a very positive research note that called Cisco “the stock to own for the long term.”

“A price target of $100 is reasonable,” says George Hunt, an analyst at Wachovia Securities in Charlotte, N.C., whose current 12-month price target, after two upward revisions over the past 12 months, now stands at 80.

Hunt says that he thinks Cisco will beat analysts’ consensus expectations of 13 cents a share for the fiscal third quarter ended May 1, which is 3 cents higher than the same period last year, according to First Call Corp. The company is scheduled to report earnings on Tuesday at 3:45 p.m. EDT.

“We’re very bullish on Cisco and see it as a core holding,” Hunt says. The vast majority of financial analysts following the stock share his sentiments.


Analyst pinions Average Recommendation Earnings Per Share
Strong Buy 21 This Week 1.3 Last Quarter 0.13
Buy 12 Surprise 0.01
Hold 1 Percent 8.33%
Sell 0 Consensus EPS
Strong Sell 0 This Year’s 0.51
Next Year’s 0.69

CISCO SYS INCCSCO ranks 93 out of 99. It is in the Internet industry.

Analyst Ratings compiled using data provided by Zacks Investment Research, Inc.

Making serious inroads into the service-provider market, which is growing faster than the enterprise market, is key to Cisco’s five-year plan to reach $50 billion in annual sales.

Several leading industry analysts who don’t participate in the securities business, however, warn that Cisco’s profit margins will come under increasing pressure as it continues to move into the fast-growing service provider market, where it competes more directly with firms such as Lucent Technologies Inc. {LU} and Nortel Networks Corporation {NT}.

“It’s pretty clear Cisco is not going to enjoy the margins on the service-provider side of their business that they enjoyed on the enterprise side,” says Jim Slaby, senior industry analyst at the Giga Information Group, based in Cambridge, Mass. “They’re going to have to be willing to sacrifice, maybe even into the negative margin range, to capture the strategic accounts they need.”

Cisco currently generates about two-thirds of its revenue from the enterprise market, which focuses on serving the internal networking needs of corporations and large organizations. Cisco’s lead is so great in that area that many other competitors, including Cabletron Systems Inc. {CS}, Lucent Technologies and 3Com Corp. {COMS} have all but thrown in the towel.

It is in the service-provider market, however, where Cisco faces its biggest challenge because of the longstanding ties between leading telecommunications customers and competing providers Lucent and Nortel.

“The war is over on the enterprise side, and Cisco won,” Armstrong says. “But the fastest-growing market is on the service side, and that’s where Cisco needs to ramp up.”

The service-provider market includes Internet service providers (ISPs), as well as telephone companies, such as the regional bell operating companies and their local competitors.

Cisco generates about one-third of its revenue from the service-provider side of its business, where it increasingly must compete aggressively on price and features to wrestle business away from its more-established rivals.

Industry analysts say that Cisco is and will be a formidable contender in that market. But they also say there is little hope the company can come out on top without declining profit margins.

“Their road is definitely going to be rockier,” Slaby says. “But they’ve done an excellent job filling in their gaps with acquisitions, particularly in the core optical carrier infrastructure. I also think their success on the enterprise side will help them in the carrier space.”

Martin Pyykkonen, an analyst at CIBC World Markets in San Francisco says that he is also keeping an eye on Cisco’s progress selling into the service-provider market.

Pyykkonen says that issue, along with Cisco’s still sky-high valuation, are the reasons he has decided to maintain a “buy” recommendation on the stock rather than a more enthusiastic “strong buy.” Pyykkonen notes that it wasn’t long ago that a valuation half as large as Cisco’s was considered to be at the top end, leaving little room for upward appreciation.

“We still have the valuation question,” Pyykkonen says. “The company’s fundamentals are solid. But you do have to ask yourself how rich a price you’re willing to pay for it.”

“The next 18 to 24 months are going to be very interesting,” Slaby says. “I think Cisco has a real chance to demonstrate it deserves as much of a chance as Lucent and Nortel [in the service-provider market]”

That uncertainty is something investors might want to keep in mind in the event that Cisco posts stronger-than-expected earnings on Tuesday. If past is prologue, a better-than-forecast quarterly earnings report could touch off a renewed spate of buying and drive up the stock price, perhaps to near or even past its all-time high.

The industry analysts, however, say good numbers for the current quarter, if they do come in, may disguise the fact that Cisco’s best days, from an earnings perspective, could now be behind the company.

On Friday, Cisco said it will acquire ArrowPoint Communications Inc. {ARPT}, an Internet switch-maker for about $5.7 billion in stock. With the acquisition, he networking giant is hoping to expand its portfolio of networking products.

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