April 25, 2001 The Cisco problem Last week, there was the earnings bombshell. This week, the stock faces more bad news and two analyst downgrades. When will it end?

By David Futrelle

Listen to live conference calls Qualcomm Worldcom I've spent much of the past week and a half pondering investors' peculiar reaction to Cisco's continuing woes. The company's near-catastrophic earnings warning last week caused barely a ripple in the markets, and Cisco itself ended the dreaded Day After down only about 3 percent. And on Wednesday, the stock was able to more or less shake off the effect of two analyst downgrades -- despite mounting evidence that the company's problems aren't going away any time soon. UBS Warburg analyst Nikos Theodosopoulos downgraded seven telecom equipment makers, among them Cisco, Nortel, and Juniper Networks, arguing that drastically reduced capital expenditures among telecom carriers would keep the stocks from rebounding in any significant, lasting way. While he argued that "most of the 'bad news' already is in the stocks", he suggested the networkers would be dead money "for the next two quarters and perhaps longer." Theodosopoulos now rates Cisco a "hold." First Union Securities downgraded Cisco from a "strong buy" (ha!) to a mere "buy." (Don't make much of the difference in ratings -- both might as well be calls to sell.)

In a column a few weeks ago, I worried about how Cisco might get out of this mess. For those who missed it, I think it's worth going through all the problems Cisco faces.

First and foremost, the tech slowdown CEO John Chambers calls a "100-year flood" has left the company swamped in inventory. With capital spending on networking equipment grinding to a halt, Cisco finds itself stuck with a lot of excess stuff -- and in the tech world, stuff on the shelves gets old faster than overripe bananas. Last week, we learned that the current inventory problem is worse than even the most pessimistic analysts had feared. Indeed, the company will write down a startling $2.5 billion in inventory this quarter.

And it may have to write off some of its customers as well: Some cash-strapped telecom companies may go bankrupt before paying their bills -- some of which were partially financed with help from Cisco in the first place. Chambers now says he doesn't expect telecom carriers to resume the free-spending ways of yore for at least three quarters.

Moreover, Cisco has lost one of its key strategic advantages. In happier times, the company made aggressive use of its high-priced stock to make acquisitions that kept it on the cutting edge. With the stock price considerably deflated, it will be harder than ever for the aging tech giant to compete against nimble competitors like Juniper Networks, which has managed to grab a giant chunk of the router business in only a few short years.

Cisco's shrinking stock price also means that many of the stock options handed out so liberally in its glory days are now worthless. That's not only bad for employees, it's also bad news for the company since -- as Cisco bashers never tire of pointing out -- it will lose literally billions of dollars of tax benefits that come with the exercising of options. (Because of a quirk of the tax code, Cisco has been able to deduct employee's gains from stock options as if they were wages paid to them.) Without this boost to the bottom line, Cisco will find it increasingly hard to deliver the earnings growth investors have come to expect -- and this in turn will keep a lid on the stock price.

Cisco is down, way down, from its highs. But with a P/E ratio, based on forecasted earnings, of more than 30, the stock is still no bargain. (Plus, who can count on those forecasts? Assuming earnings estimates will come down further, the P/E is even higher than it looks.) I think Cisco's current woes, and its cloudy future outlook, could push the stock down further before it finally bottoms out for good. And it will be hard for the stock to sustain any significant rally until we can see evidence of an imminent pickup in demand. All evidence suggest we're not going to see that for some time.

http://www.money.com/money/depts/techinvestor/archive/010425.html

-- Carl Jenkins (somewherepress@aol.com), April 26, 2001