Linking Stocks and Profits

For much of this decade, it was hard not to make money in stocks of networking-equipment companies--firms that provide the technology for moving and routing information at blinding speeds among business computers, automated teller machines, Internet sites and so on.

As demand for those networks exploded, sales of networking gear soared more than 30% annually, and the networking stocks seemed to go virtually straight up.

Until this year.

The stocks got clobbered this spring after some networking players reported disappointing first-quarter results, and it didn’t help that Wall Street had gone cold on technology stocks in general during that period. 3Com Corp. (ticker symbol: COMS), for instance, saw its stock price plunge 60% between January and April.

“The marketplace got nervous that the fundamental growth rate of the networking sector had slowed,” said William Rabin, analyst at J.P. Morgan Securities Inc.

But in early May, industry leader Cisco Systems Inc. (CSCO) reported fiscal third-quarter profit that matched Wall Street’s forecasts. That calmed the market’s fears and triggered a new rally in the sector.

An index of 19 networking-related stocks compiled by J.P. Morgan has surged 42% since May 1, compared with a 12% gain for the Standard & Poor’s 500. But because of the networking stocks’ blood bath in the spring, Morgan’s index is about flat for the entire year to date.

And despite the rally, Wall Street is still quick to punish any networking company that shows weakness. Early this month, for instance, a third of Cabletron Systems Inc.’s (CS) stock price was wiped out in a single session after the company said its failure to quickly get enough new products on the market would hurt its upcoming earnings.

Likewise, the stock of Ascend Communications Inc. (ASND) tumbled as much as 10% on June 10 after the company said snags in certain of its networking products might cause the company to miss its financial targets for the second quarter.

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Overall, though, the networking industry’s growth is not slowing down, and sales are still expected to leap at an astonishing 30% to 50% a year for the next five years, executives and analysts said.

But not every networking company is going to enjoy that rate of growth, because the field is quickly being divided between players that are expected to be healthy, long-term contenders and those that are in for a struggle.

“The stocks have tended to move in a group” up or down, Rabin said. “But the market hasn’t understood yet that this is a rapidly consolidating, competitive environment” and that the networking industry is still due for a major shakeout, he said.

So Rabin’s top picks are Cisco and Ascend because they have the best fundamentals he tracks: a large base of existing customers, new products, global distribution channels and strong management.

It’s hard to find an analyst who isn’t recommending Cisco, which is a testament to the company’s remarkable growth and ability to stay well ahead of the pack. After all, this is a stock that has multiplied in price more than a hundredfold since going public in 1990; it currently trades at about $70.50 a share.

Clearly, the company’s giant presence in the industry gives it advantages. Customers increasingly like having a single big vendor that can provide a range of equipment to suit them, whether it involves routing or delivering data, video, multimedia or audio, and whether it’s for business-to-business transactions, the Internet or telecommunications.

In addition, Cisco has no long-term debt. That and its enormous earning power (profit for the nine months ended April 26 soared another 62%, excluding one-time items) give it the financial muscle to win any price wars and buy more competitors as the industry shakes out. It has already made a number of acquisitions to expand its product line.

In an interview last week, Cisco President John Chambers said the industry--Cisco included--will experience more “spikes up and down” in quarterly growth rates than before, as customers get more selective about networking vendors and the companies launch new products against one another at a faster pace.

“But we’ll still grow about 10% to 15% faster than the industry,” he predicted.

Not everyone can make that claim. Cabletron, for instance, on Monday fulfilled earlier forecasts and reported disappointing results for its fiscal first quarter ended May 31, with sales up 12% from a year earlier but operating profit slipping 1%. Among its other problems: European sales “substantially below target.”

That’s a big reason why Cabletron, currently at $31.50 a share, still is down 11% since May 1 despite the overall rally in networking stocks. Some analysts said the company, which had enjoyed a long string of consecutive quarters with rising sales and earnings, will get back on track, but several are neutral on the stock until that happens.

Bay Networks Inc. (BAY) is another networking company trying to turn things around. The product of the 1994 merger of Wellfleet Communications and SynOptics, Bay struggled to come out of the marriage with a well-executed strategy, and the stock--despite a 24% gain so far this year--is still trading at about half its late-1995 price of nearly $50 a share.

“The outlook is getting better,” said Luke Szymczak of Prudential Securities Inc., who has a “buy” recommendation on the stock. “There’s a new management team in place [and] in a very short time frame they’ve stabilized the situation. Hopefully, we should see more improvement in the fall.”

Bay also keeps working to fill out its product line. Last week, it agreed to buy smaller RapidCity Communications, which is developing even faster methods of routing data on computer networks, for $155 million in stock.

Ascend also gets bullish reviews overall, but the company’s current product snags--combined with its plans to buy rival Cascade Communications--prompted analyst Nikos Theodosopoulos of UBS Securities in New York to downgrade his recommendation recently to “hold” from “buy.”

“Typically you like to do these [merger] integrations when your core business is running smoothly,” he said. “Now management’s attention is being stretched over several challenges.”

3Com, at $50.50 a share, faces the same problem with its recent $9-billion purchase of U.S. Robotics Corp., the giant maker of computer modems whose technology is expected to give 3Com a major leg up in delivering advanced networking systems.

“Their business continues to grow, but they have a major [merger] execution problem on their hands right now,” said Prudential’s Szymczak in explaining his “hold” recommendation. “So we’re staying on the sidelines here.”

Times staff writer James F. Peltz can be reached at [email protected]

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Network Volatility

Shares of computer-networking firms plunged in the spring, then mostly roared back. But picking winners now gets a lot more tricky, analysts say. Here are some of the big players:

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Ticker Recent % Change % Change Stock symbol price from May 1 from Jan. 1 3Com* COMS $50.50 +63% -31% Ascend Communications** ASND 41.75 -11 -33 Bay Networks BAY 26.00 +41 +24 Cabletron Systems CS 31.50 -11 -5 Cisco Systems CSCO 70.50 +32 +11 Xylan XYLN 15.25 - 8 -46 J.P. Morgan Network Index +42% + 1% Standard & Poor’s 500 +12 +21

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* Acquired U.S. Robotics on June 12.

**Plans to acquire Cascade Communication

Sources: Bloomberg News, J.P. Morgan Securities