FOOL GLOBAL WIRE
Jeff Fischer (MF BudFox)

(derived from the 2/4/97 Fool Portfolio recap, with many significant additions, updates and links)

ALEXANDRIA, VA., February 5, 1997/FOOLWIRE/ -- Many networking stocks were hit in the head by bricks early this year and have been stumbling about ever since. In the movies, often a note is attached to the brick by a rubber-band. The note on these bricks reads: "Slowing growth? Decreasing margins? More competition?" Pow!

Ouch. Busted nose. We'll see if we can't straighten that out a bit by looking at 3COM, CISCO SYSTEMS, ASCEND, and others.

The stock of 3COM <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COMS)") else Response.Write("(Nasdaq: COMS)") end if %> has fallen 33% in one month. During the final week of January some analysts cut estimates by pennies here and there after 3Com said December sales were slower than expected, but hinted that January was making up for it. Otherwise, only good news has continued to roll out of Santa Clara, only healthy press releases; but the stock continues to fall.

February 4th, 3Com fell as another analyst, this one at Deutsche Morgan Grenfell, cut his quarterly earnings estimate from $0.63 to $0.58 per share, and lowered his fiscal year estimate from $2.41 per share to $2.34. He sliced estimated revenues for next quarter from $875mm to $850mm. That day the shares fell $3 1/4 on volume of 25 million shares, making it Nasdaq's most-active stock. Over-reaction? The analyst lowered his estimated revenues for the fiscal year to $3.31 billion from $3.36 billion -- not a very notable amount -- in fact, perhaps even less than the room often granted for margin of error with such estimates.

There wasn't mention of any new reasoning behind the analyst's statement aside from the old news that 3Com experienced a slowdown in indirect sales channels during December, which was described as a "one-time anomaly." Meanwhile, the analyst reiterated his "buy" rating on the stock.

Other analysts have been reiterating their "buy" ratings on the stock as well, while a Bear Stearns analyst stated business is actually improving, which supports the "one-time anomaly" argument. But while re-stating buy ratings, several analysts have trimmed estimates, though few agree on the final numbers. In fact, at least one analyst actually raised estimates, while the current consensus for fiscal year 1997 (ending in May) now appears to rest around $2.33 per share. It was priorly $2.40 per share. Still, the analysts' numbers are all over the place, and it's obvious there's plenty of uncertainty, which causes nervousness and declining stocks.

The uncertainty is caused by, well, uncertainty. Prices are coming down on some networking products as competition heats up. Networking leaders have often enjoyed gross margins above 60%, and CISCO SYSTEMS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %> in the last quarter had gross margins above 65%, actually up a tad from the prior quarter. Such impressive margins can't last forever, though, and as the still nascent but maturing industry becomes more competitive, and more strong companies enter the mix, prices will probably slip some.

Add to that the fact that leaders Cisco and 3Com have grown over the past five years from only a few hundred million dollars in annual sales to multi-billion dollar companies, and now Wall Street is complaining that growth is slowing. Of course it's slowing somewhat. A company's sequential growth is bound to slow-down after rocketing nowhere but up for several years. Cisco's sales in the latest quarter still rose 73% year-over-year, to an impressive $1.6 billion, though sequential growth slowed for the fourth consecutive quarter. That is probably more a sign of competition in networking and the girth that particular company has reached, rather than a slow-down in the entire sector. Investor's Business Daily reported, though, incorrectly in my mind, that Cisco's earnings prove the fear of a slow-down in networking.

Networking: if you look at a chart of the industry's growth over the past decade you see a dream of a sector in which to invest. But has it peaked or is it notably slowing? You tell me. A leading company like AMERICA ONLINE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AOL)") else Response.Write("(NYSE: AOL)") end if %> has daily member usage double to only 32 minutes per day and the company's network falls apart. More than half the people can't get online, and when they can, the network is often slow. AOL needs to build out its network to not only meet current demand, but that of future demand, too. But that's just one company.

Ironically, as networking stocks are falling, IDC Research released strong 1996 year-end summaries for key networking products. Growth is the theme. The big theme. The reports can be seen on IDC's Web site, and are a fine reference for those studying the industry and its many parts, from routers, to switching, to hubs to ATM products.

One general related headline stands out: "Unprecedented Growth in Global Internet and World Wide Web Usage." The article states:

** The number of devices accessing the Web will grow from 12.6 million worldwide at yearend 1995 to 233.3 million at yearend 2000.

** The number of users accessing the Web will grow from 16.1 million at yearend 1995 to 163.0 million at yearend 2000.

The Internet reaches about 10% of homes in the U.S., while Europe and the rest of the world lags well behind. Meanwhile, Intranets are a new world. A scant percentage of corporate America has them in place, but the business is estimated to grow from $2 billion last year to around $14 billion by 1999. That's a conservative estimate.

Networking is the column supporting the build-up of a technology which is arguably in the position to replace the television, as computers can replicate television -- while offering so much more. ''The Internet and intranet are the most significant events in computing since the invention of the Personal Computer,'' stated an executive at Intel Corp. last year. Down the road, if you're not networked, you're going to be out of the loop, isolated. And being "networked" promises to become a much "smaller" -- and so increasingly omnipresent -- way of life, as Bill Gates foresees the Internet in your pocket.

We'll become so well-networked in the next few decades that you'll be able to reach into your pocket, pull out a contraption, log onto a network and see your mom's face smiling at you from five thousand miles away, while on the split screen you're surfing the Web for a recipe to send to her through a fax button. Simultaneously, CNN on the Web is playing on the other side of the screen, and your flight confirmation number is sitting at the bottom of the screen, along with a proposal just sent to you from your Asian business partner, with a live line set up for you to talk to him or her immediately. Just click that icon. Seven things at once.

Despite the future, 3Com and others in the networking sector have taken a bath. In a mere month, from January 6th to February 5th, this has happened with some industry stocks:

Ascend Comm    <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ASND)") else Response.Write("(Nasdaq: ASND)") end if %>  Flat  
Cisco Systems  <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %>  Down 10%
3Com Corp      <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COMS)") else Response.Write("(Nasdaq: COMS)") end if %>  Down 33%
Cabletron      <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CS)") else Response.Write("(NYSE: CS)") end if %>      Down 6%
Cascade        <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCC)") else Response.Write("(Nasdaq: CSCC)") end if %>  Down 36%
Shiva          <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SHVA)") else Response.Write("(Nasdaq: SHVA)") end if %>  Down 52%
US Robotics    <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: USRX)") else Response.Write("(Nasdaq: USRX)") end if %>  Down 13%
Bay Networks   <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAY)") else Response.Write("(NYSE: BAY)") end if %>     Flat

3Com is one of the more bruised stocks, though not the hardest hit. Cascade Communications was slammed after reporting earnings which many companies would be proud to achieve. The fear was slowing sequential growth, and Cascade and Shiva spooked the networking sector as a whole. 3Com appears to be the stock hit hardest for the least reason, though. "Loss" to "Reason For Loss" appears out of whack with 3Com. Anyway, is this good old-fashioned panic finally hitting the stocks? If so, those people selling are selling directly against the tide of one of the most important and largest advances in technology to come in decades. They're got to be selling the future of networking at a cheap price.

On February 5th, Cisco Systems reported confidence that the networking sector will continue to grow at a brisk 30 to 50 percent clip in 1997 and into the foreseeable future; as usual, Cisco's goal is to outperform that market growth. Of the companies already achieving that, Cisco, 3Com and Ascend appear most promising to continue outperformance -- being the market leaders.

Let's look at some of the numbers behind networking names:

Ascend Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ASND)") else Response.Write("(Nasdaq: ASND)") end if %> ($65)
Trailing Sales: $548 million 
Five year est. annual growth rate: 45% 
Far earnings estimate (max. 2 fisc.years out): $2.01/share
P/E on estimate: 32.3 
Return on Equity (ROE): 16%
Net margins: 23%

Cisco Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %> ($64)
Trailing Sales: $5.4 billion
Five year est. annual growth rate: 35%
Far earnings estimate: $2.75
P/E on far estimate: 23
ROE: 44%
Net margins: 21%  

3Com <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COMS)") else Response.Write("(Nasdaq: COMS)") end if %> ($55)
Trailing Sales: $2.8 billion
Five year est. annual growth rate: 29%
Far earnings estimate: $3.13
P/E on estimate: 17.5
ROE: 35%
Net margins: 12% last quarter, 8% year before.

Cabletron Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CS)") else Response.Write("(NYSE: CS)") end if %> ($32)
Trailing Sales: $1.29 billion 
Five year est. annual growth rate: 25%
Far earnings estimate: $2.20 
P/E on estimate: 14
ROE: 32%
Net margins: 15%

Cascade <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCC)") else Response.Write("(Nasdaq: CSCC)") end if %> ($37)
Trailing Sales: $340 million
Five year est. annual growth rate: 50%
Far earnings estimate: $1.64
P/E on estimate: 22.5
ROE: 37%
Net margins: 19%

Shiva <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SHVA)") else Response.Write("(Nasdaq: SHVA)") end if %> ($17)
Trailing Sales: $199 million
Five year est. annual growth rate: 37%
Far earnings estimate: $1.07
P/E on estimate: 16 
ROE: 10%
Net margins: 8%

US Robotics <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: USRX)") else Response.Write("(Nasdaq: USRX)") end if %> ($64)
Trailing Sales: $2.25 billion 
Five year est. annual growth rate: 32%
Far earnings estimate: $4.40
P/E on est: 15
ROE: 29%
Net margins: 8.8%

Bay Networks <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BAY)") else Response.Write("(NYSE: BAY)") end if %> ($21)
Trailing Sales: $2.0 billion
Five year est. annual growth rate: 28%
Far earnings estimate: $1.01
P/E on est: 21
ROE: 27%
Net margins: 10% (year prior)

Analysts expect the industry to grow an average 23% per year over the next five years. Only in technology do you often see such high annual growth rates, most notably in networking and in computer software. Meanwhile, 3Com is perhaps the number two company in the networking world (behind Cisco Systems), but trades at a lesser forward multiple than many peers. 3Com's gross margins and net margins are less than some peers, but were expanding last quarter, and that trend was expected to continue.

But what about the threat of Intel? Compaq, IBM, and Intel all sell networking products. Some fear INTEL CORP <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %> will eliminate 3Com's healthy NIC market by offering the product on motherboards. A significant portion of 3Com's revenues derive from these high margin products, but Intel enjoys strong margins on the product, too, and if they kill that market they put a bullet in their own foot. Will they? Well, on February 5th Intel Corp. announced up to 40% price cuts in Fast Ethernet adapter cards. 3COM's stock got hit on the news. Intel is the number two leader in NIC sales, while 3Com is the leader. It appears Intel isn't afraid to start a price war to gain market-share, though the company states the drop in price is attributable to expertise in design and volume production.

In the past years companies such as COMPAQ <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CPQ)") else Response.Write("(NYSE: CPQ)") end if %> have announced significantly less expensive lines of networking products, and the leaders, fat and happy Cisco and 3Com, saw their stocks decline sharply on the news. The stocks eventually recovered, though, as the fears were over-done. Will that happen this time? Or is this time different? Intel appears that it wants to play hard-ball -- and play hard-ball with products that make up about 40% of 3Com's current revenues.

The day before Intel's news, CISCO SYSTEMS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %> announced earnings a penny above expectations, as sales increased an impressive 73% to $1.6 billion. The conference call was regarded as very positive, and the company, again, was confident with the coming growth in the sector and with its gross margins remaining strong, though Cisco stated about gross margins, "There will be a few quarters up, but I think most will be down, hopefully just slightly." Fears also cropped up after Cisco's report that the book-to-bill ratio for the company was only 1-for-1, meaning for every dollar of product shipped, only one new dollar of product was ordered. Usually the company's book-to-bill ratio is higher, and as networking is entering a seasonally slow quarter, this was cause for more nervousness -- but this is a short-term concern, of course. Seasonality is a fact of life in many sectors.

Still, some analysts are calling the networking sector a "sitting duck," as competition becomes more fierce and margins are pressured (which goes against what 3Com reported last quarter, of increasing margins). But looking at the leaders, none of the stocks trade at earnings multiples even close to their estimated five-year growth rates looking less than two years out. In fact, the leaders look very attractive on the current estimates listed above, and even on estimates 10% below those numbers, should those estimates prove too high for any number of reasons.

CISCO SYSTEMS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %> sports an estimated annual five-year growth rate of 35%. Multiplying that growth rate by fiscal year 1998 earnings estimates of $2.75 per share, the YPEG fair value on the stock comes to $96.25. If you account for any weakness by dropping that earnings estimate a full 10%, the stock still has a YPEG fair value of $86.80, 36% above the current $64 stock price. (This is calculated on the basis that over the five-year period the annual estimated growth rate is met -- overall. If you drop that growth rate over the time-period the YPEG gives a lower fair valuation for the stock based on the fiscal 1998 earnings estimate -- the original estimate or the 10% lowered estimate -- though it makes a significant difference only if the annual growth rate varies significantly from what was expected).

3COM <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COMS)") else Response.Write("(Nasdaq: COMS)") end if %> has an estimated annual five-year growth rate of 29%, and earnings estimates of $3.13 for the fiscal year ending six quarters away. The YPEG fair value comes to $90.77. Drop the earnings 10% and the YPEG fair value is $81.75, still a full 48.6% above the current price of $55.

ASCEND COMMUNICATIONS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ASND)") else Response.Write("(Nasdaq: ASND)") end if %> sports an estimated annual five-year growth rate of 45%, with earnings estimates of $2.01 eight quarters away. The YPEG fair value comes to $90.45. Drop Ascend's earnings 10% from that estimate, to $1.80, and the stock's YPEG value is $81, or 27% above the current $64 price. Meanwhile, Ascend has been handily beating estimates, even in the transitional last quarter, during which it beat estimates by a penny instead of the usual many pennies.

All told, the three largest ghosts spooking networking are increased competition and decreased margins, haunted by slowing sequential growth. That slowing growth is in part a result of the size of the industry and the leading companies now, not that the industry growth or outlook is actually depreciating. Nothing shows that it is. Either way, yes, competition looms in the headlights more prominently than before, but the companies with leading technologies will still sport impressive market-beating growth rates and very healthy margins.

The networking industry is one of the most dynamic and promising when looking five to ten years out, especially for leaders such as 3Com, Cisco, and Ascend -- if they can stay in the lead, as they have been. Slowing sequential growth? Hard to avoid when an industry becomes so large so quickly, and the companies within it as well.

But networking is growing quickly enough that leaders should continue to show market-beating performances, despite the occasional respites. As Fools only care about 3-to-5 year time spans, at the minimum, THAT is the picture you need to look at, and there, good Fool, networking looks like a great place to invest for long-term growth.

--Jeff Fischer (MF BudFox), February 5th, 1997

* This Foolwire represents the opinion of one Fool and in no way should be taken as the opinion of either The Motley Fool, Inc., the companies in question or representative of anyone or anything else other than that specific Fool's thoughts.

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