What's wrong with Cisco?
Nothing, really. Sales are strong and profit margins are fat. But the network giant is no longer the one tech stock you have to own. Here's why.
By Adam Lashinsky

(FORTUNE Magazine) – bell·weth·er

One who takes the lead or initiative; leader. Also: an indicator of trends.

THERE WAS A TIME, NOT SO LONG AGO, WHEN CISCO Systems appeared to be a plausible proxy for the technology industry. The company was wired in to virtually every aspect of the emerging Internet economy, so the stock, naturally, was seen as the ultimate tech bellwether. Of course, when Cisco began its sickening plunge, from around $80 in early 2000 to $8 in 2002, it was still a bellwether. And the trend line was positively awful.

A half-decade later a curious thing has happened. Tech survivors have solidified their finances, and tech stocks--including Cisco (CSCO, $18)--have recovered, if not to anywhere near their peak. But despite stellar financial performance and continued market leadership in its core markets for computer network routers and switches purchased by big corporations, Cisco's shares have lagged the rest of the tech market. The stock is up 6.7% since September 2001, for instance, compared with a 15.6% return for the Nasdaq composite index.

What's the reason for the underachievement? Basically, say investment pros, Cisco has gotten so big and its primary markets so mature that its once white-hot growth has cooled to merely smoldering. "Show me the corporation that's replacing all its routers," says Glen Kacher, who runs money for tech-oriented Integral Capital Partners. "Cisco is without a doubt one of the most important companies in the tech sector, but it now looks a lot more like Intel and Microsoft. It's going to be hard for them to put up growth numbers like they have in the past."

The comparison to the titans of Wintel is apt. Intel and Microsoft make most of their profits on their slow-growing but cash-gushing PC-related franchises. Similarly, Cisco generated about $1.6 billion in cash flow in the quarter that ended in January on revenues of just over $6 billion, but most of the cash comes from its market-leading products. Cisco's routers and switches account for 62% of the company's revenues, but in its most recent quarter the combined product line grew only 7% from the previous year. What's more, as Cisco ramps up newer technologies, its profitability is taking a hit. Nikos Theodosopoulos, an analyst with UBS, estimates that Cisco's gross margins, at a still stratospheric level of 67%, will decline by up to one percentage point a year for the foreseeable future.

Make no mistake: Cisco remains a leader, albeit in a segment of tech that's lost some of its pizzazz. "If Cisco has a big hiccup, the companies that supply the switching industry for components are going to miss their quarter too," says Douglas Whitman, a tech-focused hedge fund manager. What's more, Cisco has a plan for growth centered on new business lines like security, storage, voice-over-Internet calling, and its recently acquired Linksys home-networking division. "We believe that we are a growth company with a strategy for growth," says CFO Dennis Powell. He predicts earnings growth of 10% to 15% for the next four to five years, adding, with some of the old Cisco spirit, "Our expectation internally is that we'll be at the higher end of that range."

Wall Street sees things differently, which explains why the stock has fallen to what would once have been seen as a shockingly low price/earnings multiple of 20 times forecasted 2005 earnings. (The Nasdaq composite trades for about 22 times current-year estimates.) UBS expects Cisco's per-share earnings growth rate to decline from 28.8% in fiscal 2004 to 11.1% in fiscal 2006. The revenue picture is grimmer: 16.4% growth in 2004 should fizzle to 9.3% growth in 2006. So while Cisco's profitability remains solid--earnings and revenues have approximately doubled in the past five years--Wall Street's expectations have plummeted.

The irony is that Cisco is positioned extremely well for the day that voice and video networks begin sending oodles of traffic over the public Internet. But that time, long heralded, simply hasn't arrived. "Whether they like it or not, now they're a bellwether of telecom spending," says Andy Kessler, a former hedge fund manager. That is true. However, Cisco's challenge is to win significant business from the telephone companies, which didn't throw much business its way even when they were still spending heavily on hardware. "If you squint hard enough, you can see Cisco growing again," says Kessler. "You just don't know when."

One way for Cisco to juice its growth would be a major acquisition. Rumors have swirled that Cisco might purchase a Network Appliance (market cap: $11 billion) or EMC ($31 billion), two competitors in the storage business. The problem is that mega-M&A isn't Cisco's style. It prefers to buy companies with a bunch of engineers and nascent products that can be fed into its well-oiled sales machine. "We don't need to do a large acquisition," says Dan Scheinman, Cisco's M&A chief. "At least we haven't seen one yet where one plus one equals three."

The fact that CEO John Chambers and his team are unlikely to waste capital chasing growth should be reassuring to shareholders. But their slow-and-steady plan underscores that the company is far from the hottest thing in tech these days.

If Cisco isn't the tech trendsetter it once was, what is? Investors and strategists we talked to suggested a handful of companies worth watching in areas where money is flowing freely.

With a boom in contract manufacturing, hedge fund manager Whitman suggests Flextronics International (FLEX, $13), a company that assembles products across the tech spectrum for major customers like Dell, Microsoft, and Siemens. According to Vadim Zlotnikov, chief investment strategist for Bernstein Research and a former technology analyst, another powerful driver in technology spending is the need for customized software to help corporations comply with Sarbanes-Oxley and other regulatory requirements. That's an area in which Infosys (INFY, $76) excels. "Infosys may end up being as much of an indicator of strong demand as Cisco," says Zlotnikov. He also singles out German software giant SAP (SAP, $41) because of the growing trend toward integration of disparate tech systems, its specialty. And finally, there is the increasingly potent X-factor of consumer spending on tech. Apple (AAPL, $42) is hands down the hottest company in that category. Though if Apple is the new bellwether, investors may want to proceed with caution. Its stock is up more than 200% over the past year alone. And that's a pretty steep trend line.

Tech trendsetters to keep an eye on

These four companies are leading players in businesses where money is flowing freely.