Pessimism in the stock market is choking off

Cisco Systems'

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perpetual motion machine, the mergers-and-acquisition dynamo that it has driven to networking dominance.

Losing Steam
Cisco's down year

Discouraging words out of CEO John Chambers this weekend at Davos, regarding the developing slowdown in the U.S. economy, sparked a 6% selloff in Cisco shares Monday. The market's reaction to Chambers' comments, which are strikingly similar to

remarks he made three weeks ago at an investor conference, illustrates the queasiness investors increasingly feel about tech stocks. And with investors losing their faith in tech's blue-sky promises, Cisco investors face the prospect of the company's vital buying spree being curtailed.

Cisco took advantage of the 1990s' tech-stock mania like no other company, riding an exploding stock price to technological leadership and breakneck growth. The company made prescient bets on the direction of the fast-evolving communications industry, then used its shares to acquire start-ups whose know-how made Cisco equipment the foundation for the Internet revolution. Investors, wowed by booming profits, bid the stock ever higher, making deals cheaper and drawing the cream of the nation's engineering crop.

But after a staggering 40,000% rise over a decade, Cisco's stock finally tired last spring, just as the


peaked. Now, with the shares losing altitude over a sustained period for the first time ever, the pace of big-ticket acquisitions has slowed. Meanwhile, Cisco has begun paying a price once footed mostly by its competitors: talent flight. Several top engineers have defected in recent months as Cisco's once-precious options took on water, making rival offers far more attractive.

The bottom line, analysts and investors say: Cisco needs an appreciating stock to stoke the acquisition machine that has driven its growth. Without a strong stock currency, Cisco has fewer carrots to dangle before scarce engineering talent, just as competitive threats loom menacingly and telecom-industry capital spending slows. All this points to a deepening cycle in which the declining share price weakens a vigorous but widely challenged company, pushing the stock down further.

Off the Shelf

San Jose-based Cisco has championed the Silicon Valley practice of using mergers as a form of research and development. Instead of dedicating its own teams to develop products out of the lab, Cisco has in effect outsourced much of the heavy lifting by paying top dollar for teams of engineers that create products ready to feed the sales machine.

A recent example is Cisco's 1999 acquisition of optical networker


, for nearly $7 billion in stock. Though the company had minuscule revenue at the time of the merger, Cerent has ably filled a product hole for Cisco, and is expected to have contributed the better part of $1 billion to revenue in 2000. (Cisco is due to report 2000 results Feb. 6.) Cisco was clearly willing to risk overpaying for the optical gear maker on the eve of its IPO, and in the heyday of tech optimism, its shares didn't even break stride.

This buying strategy culminated in 94 acquisitions -- valued at some $36 billion, mostly in stock -- over eight years, according to

Thomson Financial Securities Data

. By Cisco's own count, the company did 23 deals in 2000.

But with Cisco's stock limping to a 28% loss in 2000 and sinking 55% below its 2000 peak, some investors contend that Cisco's vaunted growth-through-acquisition strategy is dead in the water. They point out that Cisco hasn't pulled off a major strategic deal since its stock began its descent last summer; its last big-ticket acquisition was last May's $5.7 billion

stock swap with Internet switching developer


. None of Cisco's subsequent 12 acquisitions exceeded $800 million in value. And while the company retains some $20 billion in cash, it hasn't shown an inclination to use that cash as currency in acquisitions, as cash deals could dilute earnings growth.

Not Bad
Cisco's 40,000% rise

A Cisco spokesman says the company will "continue to expand its technological expertise through innovations, partnerships and acquisitions," but declines to go further.

Reaching for the Stars

Observers say a down market makes acquisitions trickier, as both sellers and buyers are inclined to wait for their assets to be valued more appropriately -- at higher prices, that is.

"A lot of private companies probably have an inflated notion of their value, and it's going to take a while for them to come to terms with the new reality," says

Munder Funds'

Ken Smith, who reduced his Cisco holdings last fall. "They may still be thinking the public markets are going to come back and that they will be the next $6 billion takeout."

In a way, too, the market shakeout hasn't played to Cisco's strengths. Superior private companies, the type Cisco tends to buy, should be able to get financing to ride out a bad market until the big IPO payouts return, says

Pequot Capital's

Greg Rossmann, who before taking on venture capital work at the hedge fund spent 10 years as a telecom specialist with mergers-and-acquisitions boutique


. That reinforces the tendency on the part of start-up companies to look for a better deal.

"The market's been revalued," adds Rossmann. "Sellers are going to get less, and buyers are going to have to pay more of their equity, percentagewise, than they had to in the past.

"You could see sellers turning down an approach from Cisco," Rossman says.

CEO John Chambers sought to defuse these worries when he spoke to investors at a

Morgan Stanley Dean Witter

conference Jan. 10, saying acquisitions are more affordable in this market. Chambers added that he'd be surprised if Cisco couldn't maintain the brisk deal-making pace of last year.

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Running in Place?

Underlining Cisco's need to keep making deals to stay abreast of technological change,

CIBC World Markets'

Steve Kamman recently noted the risks of standing still as competitors desperately push forward. Kamman says Cisco

lost market share in its core router business last quarter because it missed a critical product cycle.


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beat Cisco to the market with a 10-gigabit interface for big routers, giving customers a way to open the bottlenecks in their networks.

If Cisco can't or won't make big deals to acquire those types of products, Cisco could miss more product cycles, frittering away market share. Kamman worries that Cisco's failure to meet the Juniper-Avici router challenge indicates the company is inclined to increasingly lean on internal research and development.

"If Cisco is in a deal-avoidance mode, that means in nine months or a year from now, or whenever growth picks up, they are not going to be there" at the leading edge of networking technology, Rossmann of Pequot Capital says. "The only way to get the share price back up there is growth -- growth in earnings and growth in revenues."

Ugliness Encroaching

Cisco faces these hurdles just as growth in its industry and the broader economy cool. Chambers told investors at the Morgan Stanley conference that with a federal tax cut and another easing of interest rates, the slowing U.S. economy could rebound in two quarters. But

seven weeks ago, Cisco wasn't aware of a downturn, so its prognosis might be a little suspect.

Closer to Cisco's home, the networking industry is facing its own

slowdown. Projections for telecom-equipment spending have been falling in recent months. Last month, a report from

Thomas Weisel's

ace researcher Hasan Imam

pegged spending growth by telephone and Internet service providers at 2.6% this year, a significant pullback from earlier estimates that called for more than 30% growth. On top of that, with corporate profitability on a slide, spending on office information technology and data communications systems is also showing signs of a chill.

Accordingly, as Cisco's quarters grow

more challenging and prospects for a rebound diminish, investors are bracing for continued turbulence. "This period is going to be difficult," says Munder's Smith. "Investors are going to have to come to grips with the fact Cisco isn't going to grow 60% every year. The valuation is starting to reflect that, but we think there is still a little risk there."

Indeed, Cisco's stock continues to trade at a hefty premium to the rest of the market, with fiscal 2002 earnings estimates putting its price-to-earnings ratio around 40. By the thinking of some growth investors, that means Cisco should be growing at least 40% a year, which is right smack in the middle of the range Chambers is projecting --assuming the continued healthy of the economy, which is far from a foregone conclusion.

Show Me the Money

The stock's fall also has taken a toll on Cisco's employees. While nearly all its rivals lean heavily on stock options to sweeten their employees' compensation programs, Cisco has taken the practice to an art. Cisco, which has around 7.2 billion shares outstanding, has 971 million stock options outstanding, according to company documents. That translates to an incredible 28,558 options per employee, more than seven times the levels at rivals







While that practice enriched countless Cisco employees during the stock's brilliant decade-long rally, it now risks deepening Cisco's struggles. With as many as half its employees holding options with a $63 strike price, Cisco could face substantial pressure to pay talented workers more. Repricing options tends to displease investors, who often see it as a way of rewarding insiders at the expense of most shareholders. Alternatively, issuing additional options or boosting cash compensation can get very expensive. If Cisco paid out cash covering the value of just 20% of its outstanding 2000 options, the cost would $224 million, which would reduce all-important earnings growth.

Meanwhile, the recent departure of two world-renowned router and optical networking experts underscores the prospect that Cisco's weak stock will lead to potentially damaging retention problems.

Last month, Hossein Eslambolchi, a one-time top network engineer at


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, took a newly created spot at Cisco to help develop its critical optical Internet strategy. Eslambolchi's specialty at AT&T was improving data network reliability, a key selling point for Cisco's attempts to crack the communications service provider market. But after a month, Eslambolchi quit, saying his heart was still with AT&T.

This month saw a coveted routing specialist, Yakov Rekhter, flee Cisco for archrival Juniper, bringing Juniper's tally of routing experts to nine, which is well over half the world's routing braintrust. According to an article in optical industry watchdog


, Rekhter is said to prefer challengers to champs. Rekhter was unavailable for comment, and Juniper declined to comment.

Chambers said at the Morgan Stanley presentation that as Cisco employees see rival start-ups founder, they can't help but note that the grass is browner elsewhere. To some ears, that almost sounds like faint praise coming from a man who until recently seemed destined to rule over an endless vista of plush green lawns.