Optical Keyhole Analyses Cisco's Current Position and Forthcoming 3rd Quarter Results.

Business Editors

LONDON--(BUSINESS WIRE)--May 6, 2002

Today's analysis on Optical Keyhole (http://www.opticalkeyhole.com), concerning Cisco Systems' (NASDAQ: CSCO) forthcoming results, is of the opinion that the market will probably react with mild relief, despite widely anticipated slow sales growth, to the third quarter numbers.

These are expected to show a decline in sales both from the $4.73bn it reported for the third quarter of 2001 and from the ca $4.8bn reported in the second quarter, but up to 10 cents EPS - a tripling of profitability year on year before special items. The company's forward forecast is expected to again suggest that sales for the current quarter will be at worst flat and at best up a little. Cash, based on minimal growth and modest profitability, is expected to rise by up to a $1bn.

Quite how the market reconciles a capitalization of around four times sales for a company which has a year of virtually flat sales behind it - and no real conviction that this is about to change - is hard to fathom, though the price has slowly trended closer to reality over the last 12 months. As usual, those same analysts who have misled the world for several years continue to try to push the stock up.

The fact that Cisco is a swan in the midst of a bunch of moorhens has tended to distract the market from noticing there is hardly any water in the pond. Certainly there seems a curious disconnect between the company's positive assertions about its own strength and its reasonably positive assertions about the market opportunity, when one compares this with its steady conversion of its hightech business into a bank. Investors might reasonably conclude from this, that in contra-distinction to what it was saying last year, Cisco actually expects the market to remain stalled at its present level for some time. One does not normally hang on to cash in this way if one considers the market is about to take off.

Admittedly if Cisco did start to grow again at the 30-50% pa level that it was still suggesting was feasible a year ago, a significant chunk of its ca $22bn of cash would be automatically sucked into working capital and it clearly needs to make sure that the sum would be available. However,in practice, if business conditions improved, Cisco would have minimal difficulty in raising any working capital it needed.

Despite continuous trial market propositions about Cisco taking over Nortel or Lucent, the company continues to insist it has no such intention and does not even appear to be meeting the kind of small company acquisition targets it has been proposing, ie of 1-2 small companies per month. This reluctance to use its cash hoard at a time when competitive assets are close to their lowest ever seems odd, and begs for an explanation. After all, the commercial rate of exchange for a Cisco dollar (and stock) over the last year has been breathtakingly good.

One obvious but slightly depressing interpretation might be that Cisco actually expects the market situation to still worsen, giving it an even better rate and opportunity in the future. Another interpretation is one we have given before, ie that the company was so badly burned by its spate of takeovers from 1999 onwards, that it now has a strong negative Pavlovian bias against acquisitions. An allied view is that, based on classic business teachings - ie that by far the majority of acquisitions are failures for shareholders - Cisco is now against acquisitions (particularly larger acquisitions in principle, which doesn't much square with history, but might well be its position now.

In any case whatever the historical statistics on failure rates, it seems obvious that even the most undesirable takeover can become desirable at some price, and several companies in the industry would appear to have dipped well below that price-point. It therefore remains puzzling that the company remains relatively untempted.

There seems to be another possibility, ie the purely pragmatic and inevitably embedded one, that the point of a business is not to be in a particular sector for conceptual reasons or out of habit, but to make money for shareholders. (James Crowe of Level 3 just seemed to illustrate this, by making what looks like a significant strategic shift in the company's business away from telecommunications - though it is possible this was just opportunistic financial engineering). Cisco therefore could be making its decisions and choosing its options sensibly, day by day, without much of a strategic preference other than making money. Indeed much has been made to date of Cisco's skill (or, more probably, luck) in having maintained a low dependency of only around 20% on the public telecommunications market, as opposed to the corporate business. The latter has been relatively more stable and it is expected to recover faster. The inverse of this statement of course is that the company's current strategy is not necessarily to become a full range mainstream telecommunications company, or, perhaps more correctly, to keep an open mind on the subject and if necessary take its time about it.

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