Ethernet switching companies, Extreme Networks Inc. (Nasdaq: EXTR) and Enterasys Networks Inc. (NYSE: ETS), formerly Cabletron, watched their share prices tumble after Morgan Stanley Dean Witter & Co. analyst Christopher Stix issued two separate notes downgrading both stocks.

Stix downgraded Extreme and Enterasys to Neutral from Outperform. Extreme’s stock finished the day at $16.50 a share, down 5.95 (26.50%), and Enterasys finished at 9.19, down 3.86 (29.58%).

“Stix has a lot of respect in the industry,” says one analyst who didn’t want his name used. “He can move a stock up or down just by sneezing.”

In both reports issued today he cited overall weakness in the Layer 3 switching area with increased pricing pressure from competitor Cisco Systems Inc. (Nasdaq: CSCO).

“We believe that pricing could be an issue over the next year, likely driven by an attempt by Cisco to gain market share,” writes Stix in his report on Extreme.

Citing market research from the Dell'Oro Group, Stix said that combined Layer 2 and Layer 3 switch prices have declined an average of 23 percent annually since 1994. (Layer 2 10/100-Mbit/s switch port prices alone declined 30 percent annually). Based on historical data, Stix contends that growth rate forecasts for the Layer 3 switch business have been overstated by 10 points or more and that reasonable growth for Layer 3 switching should be in percentages in the high-teens to mid-twenties. Factoring in Cisco’s aggressive pricing, he expects growth rates to fall to the mid to upper teens.

Stix lists several key factors that indicate Cisco is about to launch a pricing war. He says that a recent channel check suggests that at one large distributor about 65 percent of Cisco’s major LAN deals are being done on “special” pricing. Also, he expects Cisco to try to increase its 38 percent market share in Layer 3 switching, which is expected to generate $4 billion in 2001, according to Dell'Oro. What’s more, Cisco’s Layer 3, 100-Mbit/s ports are priced about 60 percent above the competition, says the report. If it cuts its prices by 30 to 35 percent, it would put pressure on the businesses of Enterasys, Extreme, and Foundry Networks Inc. (Nasdaq: FDRY).

Stix believes Extreme will end its quarter on target, with the company still expected to hit his target of $0.02 EPS and $116.0 million in sales for fiscal Q1 2002. He also maintains his fiscal 2002 estimate of $0.18 a share but is cutting his revenue forecast to $518.8 from $540.1 million.

“We would emphasize that our cautious stance on Extreme is purely a macro call on the long term Layer 3 switching growth rate,” he writes.

But in his note on Enterasys he warns that the company, which is exclusively focused on switching sales to enterprises, has seen inventory buildups increase to 19 weeks. Even though Stix expects Enterasys to meet or exceed its expectations this quarter, as it works to push out inventory through aggressive pricing, he believes that this could lead to problems further down the road.

“We recognize that we just recently initiated with an Outperform-V rating on August 15, 2001,” he writes. “However, this new channel information gathered over the past several days has caused us to get more cautious on the stock.”

Other Layer 3 networking stocks were also affected (see Riverstone Upstaged by Downgrades). Riverstone Networks Inc. (Nasdaq: RSTN) closed at 11.30 down 1.01 (8.20%), Foundry ended at 14.30, down 0.96 (6.29%), while Cisco actually ended on a positive note. Its final price was 16.90, up 0.29 (1.75%).

- Marguerite Reardon, Senior Editor, Light Reading
http://www.lightreading.com