Sagging Cisco Tempers Hope on Wall Street

Some investors think the selloff reflects a more realistic view of communications-gear demand.
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Wednesday's

Cisco

(CSCO) - Get Report

rout quieted talk of a roaring recovery, at least for a day.

Presenting earnings on Tuesday, the San Jose, Calif. computer-networking colossus failed to clear the high bar set by Net gear peers

Juniper

(JNPR) - Get Report

and

Nortel

(NT)

. While Cisco's performance was solid, with 6% sequential revenue growth and record profit margins, tech investors evidently wanted much, much more.

The disappointment was widespread Wednesday, with the Nasdaq sagging more than 2%. Networking gearmakers like

Extreme

(EXTR) - Get Report

,

Sonus

(SONS)

and

JDS Uniphase

(JDSU)

all dropped 5% or more. The sad procession was led by Cisco, which dropped $2.28, or 9%, to $24.13.

"I think the reaction in the sector is basically a realization that the end market isn't as healthy as people had thought," says American Technology Research analyst Albert Lin. "Before Cisco reported, it was thought that we were going to see an incredibly strong recovery." Lin has no rating on Cisco and a buy on Nortel.

Expectations started

edging up last month after Juniper delivered a whopping 26% sequential sales increase, and only jumped higher after retooled Nortel

turned in half a billion in profit last quarter. But when Cisco said Tuesday that 3% sequential growth was the best investors could expect this quarter, even with an extra week to book sales, investors took flight.

"It's definitely a reasonable reaction," said a Connecticut hedge fund manager. "The fact that so much was priced in, Cisco needed seriously good numbers to stay up there."

But not everyone took the latest quarter's performance as a wild miss.

"I think the bigger thing out of this is that they achieved revenue growth even though they weren't firing on all cylinders," says Parker/Hunter analyst Tim Slevin, who rates Cisco a buy.

Even so, Cisco's message about continued sluggish spending among business managers was a surprise, says Slevin. That probably caused people to question some of the "valuations that had gotten pretty rich across some of these names."

Businesses buying gear to wire their internal networks account for somewhere between 50% and 60% of Cisco's sales, which helps explain why Nortel and Juniper had altogether different financial tallies in the recent quarter. Phone companies are Nortel and Juniper's biggest customers, and both companies have a hot hand in the type of next-generation Internet gear that telcos have been buying.

But analyst Lin says that doesn't fully explain the disparity. Lin says Cisco probably realized it could hit its 6% sales goal last quarter and took its foot off the gas rather than fight on price for more orders.

"Cisco was willing to give up market share to protect margins," says Lin.

Next time around, if spending hasn't caught on, Lin says he expects Cisco try to push for top-line growth and take back market share. A lesson learned one quarter too late, perhaps.