Spending Haunts Cisco's Q1: Page 2 of 3

• Declining gross margins. Cisco has a plan in place to take advantage of new technologies, but those won't have margins as high as the company's traditional routers and switches. The analysts also predict Cisco will show a sequential decline in inventory in the quarter, due to weaker orders and the reduced guidance by many of its semiconductor suppliers and contract manufacturers over the past two months. Lower inventories should help gross margins a little.
• Increased operating expenses. Cisco says its operating expenses will increase between 2 percent and 4 percent in 2005 due to a higher headcount from direct hiring and acquisitions. The companys headcount at the end of the fourth quarter of fiscal 2004 was 34,371, up from 34,307 during the prior quarter. The company says it plans to add an additional 1,000 employees by the end of the calendar year.
• More spending to fuel new market growth. The analysts note that more than a year ago Cisco identified six markets that would eventually become billion-dollar industries for the company: security, IP PBX, storage, wireless, home networking, and optical. Since that time, the company has made some acquisitions of note in the home networking space and in security. But UBS expects that Cisco will take more action to drive growth in these new areas. The analysts say RFID, WiMax, next-gen IP access infrastructure, and IP video equipment are all areas of interest for Cisco.
• More competition. Low-cost competitors are continually coming into Cisco's traditional LAN switch and enterprise router space. Competitors such as Dell Inc. (Nasdaq: DELL) and Hewlett-Packard Co. (NYSE: HPQ) in LAN switching and 3Com Corp./Huawei and Adtran Inc. (Nasdaq: ADTN) in enterprise routing could put a strain on Cisco’s dominance if they aggressively use price as a means to compete, the analysts write.

The UBS report maintained a Neutral rating on Cisco’s stock, but lowered its price target to $19 from $20.