Cisco Bull's Rebuttal
by Chris Rugaber ([email protected])

Congrats Paul, you took a good shot at the Cisco Kid, but focusing on valuation isn't going to cut it. Cisco is not perfect, but its valuation is not necessarily the Achilles' Heel you suggest.

First, let's deal with the general question of valuation. While a P/E of approximately 80 is certainly daunting, what about last year, when its highest P/E was 53? Doesn't that also "seem" high? If so, you might have passed on Cisco, and the share price has since more than doubled. As is the case with any good company, there are plenty of times it will seem expensive, and then become even more so. Waiting for it to "dip" can frequently cost money.

Secondly, Paul argues that Cisco is "maturing." Perhaps it won't be able to continue 55% earnings growth, but Cisco may have some of its best years ahead of it, and calling it a mature company may be - sorry -- premature.

According to a recent Fortune article, Cisco has more than 40% of the $20 billion "data networking equipment" market. This is the market that will grow exponentially as Internet traffic doubles -- how often? -- every hundred days or so. As companies large and small, governments, universities, and non-profits continue to build internal and external networks, Cisco will provide much of the hardware and software, and their market share could increase while the market itself grows larger, giving Cisco quite a bit of growing room. Visit Cisco's website for its press releases, and read about what it's selling to corporate America. For example, it's going to provide Kaiser-Permanente, the world's largest HMO, with "integration of [its] nationwide facilities," and "network management, security and infrastructure solutions." Click around and you'll see plenty of other brand names and large companies continuing to develop their networks, as well as telecom and Internet Service Providers upgrading their capabilities. It's a good snapshot of the growth of the Internet.

But wait, there's more! Cisco is aiming for the voice/video/data networks of the future. What will this mean? Check out this excerpt from a press release from Sprint, announcing its version of integrated service:

"A household or business will be able to conduct multiple phone calls, receive faxes, run new advanced applications and use the Internet at speeds up to 100 times faster than today's conventional modems -- all simultaneously through a single connection. The need for multiple phone lines will be eliminated, and applications such as high-speed online interactive services, video calls and telecommuting will be readily accessible and less costly. Use of the Internet will be so fast that typical pages on the World Wide Web will pop up almost instantaneously."

Who thinks this sounds pretty cool? I do!

The kicker is that telephone companies around the world that want to provide this holy grail of networking are going to need different technologies. Currently, most telephone lines are "dedicated circuit" lines, which provide direct connections for voice transmission. The Internet uses "packet-switching" technologies, wherein e-mail and web pages (and any other data) are broken into digital packets that travel over several different routes and are then reassembled at the receiving end. Therefore, integrated voice/video/data networks will require new telecom equipment.

Like many other analysts, Paul argues that companies like Lucent and Nortel Networks are "much more experienced and familiar" with the telecom equipment market than Cisco. It's true that in addition to being much bigger, those companies do work in the scalable, reliable telephone industry that allegedly makes the 'Net look creaky. Some questions arise regarding whether packet-switching networks could handle Mother's Day, for example, when call volumes are highest.

This is a legitimate point, though stories of the Internet breaking down under heavy traffic -- such as during the 1996 Olympics -- are a lot rarer than they used to be. But even if Lucent and Nortel have built reliable networks, those were of the old circuit-switching kind. Packet-switching is cheaper and more efficient, and that's where the future lies. And packet-switching technology is what Cisco makes, while Lucent and Nortel Networks are just beginning to do so. In fact, Cisco has already won a contract to provide much of the hardware for Sprint's integrated network described above.

And there's a lot more where that came from. Fortune estimates that the telecom equipment market is about $250 billion a year. Even a smaller share of that market, compared to Cisco's 40% of the $20 billion data networking equipment market, will mean big growth for Cisco.

Finally, let's not forget e-commerce, which is projected to go from $13 billion in 1998 -- 1% of the US retail market -- to as much as $3.2 trillion by 2003, which would still be only 5% of worldwide sales. All that selling will require lots of networking hardware and software, much of which will be provided by Cisco. This is why comparisons to the overall market don't really cut it. How many other companies are in this kind of industry?

Sorry, pardner, you've lost this shoot-out. Worrying about a high P/E for a company whose markets may grow by ten-fold or more isn't enough to make me bearish on this stock. As the Cisco Kid rides into the sunset, it's got lots of high-margin earnings growth ahead of it.

Next: The Bear Responds