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The Cisco Effect -- R. Scott Raynovich

Column
Column
Column
5/11/2000

Everybody's favorite game this week seems to be "name Cisco's real value," and the results do not look good for the world's second-most valuable company.

Cisco Systems Inc. http://www.cisco.com shares continued to fall throughout the week, even after a solid earnings report. The slide started on Friday, after Cisco announced its $5.7 billion acquisition of ArrowPoint Communications http://www.arrowpoint.com. Over the weekend, an article in Barron's http://www.barrons.com, the eminent bear of the financial press, grabbed headlines by pointing out the high price of Cisco's stock.

Cisco stock is trading at an exorbitant price/earnings ratio? What a surprise! The company has been on an acquisition spree that's dilutive to its share value? You don't say!

These tidbits of insight are about as fresh as the fruit cocktail on a Las Vegas buffet table.

Just six months ago high valuation ratios would not have worried technology investors, but times have changed. We are now in a technology bear market that is likely to last well through the summer. Investors have become more realistic in the past month, and they are no longer willing to pay 170 times earnings for a company that is valued at $435 billion on the public markets. And, as all earnings releases do, Cisco's quarterly report, announced Tuesday night, cast some realism on its share price.

The company, in the most optimistic scenario, will grow at a 50 percent rate over the next two years. That means the roughly $20 billion in annual revenue for this year could grow to $45 billion or so over two years. And earnings per share, now on track for about $.60 per share over the next year, could double to $1.20 or so. If we imagine that Cisco's share price stayed in the $60 range, and then plugged in this optimistic scenario for growth, you would find that Cisco stock would be trading at a price-to-earnings ratio of 60 and a sales-to-price ratio of about 10 to 1 in the year 2002. Those would be reasonable valuations, today. But these are valuations based on estimated earnings for the year 2002, based on today's share price.

Judging from an informal survey here at the NetWorld+Interop tradeshow, various players in the networking industry seem to be thinking such thoughts.

"Cisco is definitely overvalued," says Hardeep Luthra, president of Soft Connexions Inc. http://www.softcone.com. Luthra worked at Cisco for five years, so he knows the company well. It's a great company, he says, but how fast can it possibly grow? "120 times earnings, that's ridiculous," says Luthra. Cisco shares were, in fact, trading closer to the vicinity of 170 times actual earnings.

"I would agree that Cisco is overvalued," says Jean-Yves Lagarde, a principal with Boston Millennia Partners http://www.milleniapartners.com, a venture capital firm. "You can't continue growth like that forever. There's going to be a lot of competition coming up around them."

Indeed, the competitive scenario does not bode well for Cisco. Networking startups are being funded at a phenomenal pace. That means that Cisco will have to scramble even faster to snap up the acquisitions it needs to compete--and it will have to pay higher prices for the companies. If its stock price slides further, Cisco would have to give up more of its shares and further dilute shareholder value.

Ironically enough, Cisco itself has been responsible for driving up the prices of the companies it's acquiring. The landmark Cerent acquisition, ringing in at $7 billion last fall, had reverberations throughout the industry. It started a bidding war for smaller networking companies--especially optical networking companies--and ratcheted up the valuations of private companies. Where companies such as ArrowPoint Communications once would have settled for an acquisition in the $500 million range before going public, they saw more upside in an IPO that would grant them a multi-billion dollar valuation. Cisco ended up paying $5.7 billion for a company that only a year ago should have been snapped up for under $1 billion.

The effect has been enormous, and nearly everybody seems conscious of it.

"Most of these companies seem overvalued," says Luthra. "Juniper is overvalued, Sycamore is overvalued. I would not buy any of these stocks."

"I think Sycamore is totally overvalued," says Lagarde.

So Cisco seems to be caught in an interesting Catch-22. As the largest player in the industry, its high-priced acquisitions will drive up prices of all the players in the networking business--making their potential future acquisitions more costly. This, in turn, benefits the younger competition--companies such as Sycamore and Juniper--by driving up their share prices, giving them the currency to make their own deals. If Cisco wanted to stop the "company inflation," it would have to stop acquiring companies at a premium to market rates. But to slow down its pace of acquisition is to slow its expansion and risk falling behind other monsters in the field such as Nortel Networks http://www.nortel.com and Lucent Technologies http://www.lucent.com.

With investors recently voting with their pocketbooks, it seems as if the market is making that decision for Cisco. Investors are now looking for better bargains in stock prices. Because the "Cisco Effect" has such a powerful effect on the networking market at large, the action in Cisco's stock price is likely to be the single largest factor in the technology markets over the next few months.

--R. Scott Raynovich, Executive Editor of Light Reading http://www.lightreading.com

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