Cisco Hits the Brakes on Buyouts


By Sam Jaffe When most companies hit a rough patch, they order a hiring freeze. But when high-tech star Cisco Systems (CSCO) runs into trouble, it stops buying other companies. While Cisco insists there's no grand design in place, the fact remains that it didn't make a single purchase during the first two months of 2001.

While that might not sound very dramatic, it's a seismic shift for the networking-equipment giant. This is the company, after all, that has made 68 acquisitions since 1993 -- 39 of them in the past two years alone. And it is probably a sign of things to come.

HARSHER REALITY. If Cisco is indeed shutting down its acquisition machine, the move could have enormous ramifications for the company and all of Silicon Valley. Cisco lacks a sizable research and development arm, which means that its ability to develop new products depends, in large part, on acquiring other companies.

Meanwhile, hundreds of startup technology companies that just a few months ago shared the dream of being purchased by Cisco must now adapt to a harsher reality. As for the the other large companies that have followed Cisco's acquisitions strategy -- IBM and Hewlett-Packard, for example -- they could decide to follow suit and slow the pace of their own buyouts.

There are many reasons why Cisco would want to put the brakes on its buyout spree. First and foremost: the severe drop in its shares. Since hitting a 52-week high of $82 in March, 2000, Cisco has dropped 71%, closing at $24.50 on Mar. 1. This once-sizzling stock is now about as hot as an Eskimo Pie.

CASH IS KING. The upshot is that Cisco can no longer buy other companies with its own shares. "Cisco's stock became a very valuable weapon. It was like money with a forward value," says Frank Dzubeck, president of consulting group Communications Network Architects. "But now cash is king."

Oh, it's not that Cisco doesn't have cash. As of the end of its second quarter, the company claimed cash reserves of $4.8 billion. And it's pretty much in the same boat with the rest of the high-tech sector: Most tech valuations are down sharply, and many are worse than Cisco's.

Yes, companies with the technology that Cisco covets are cheaper now than ever before. But don't expect it to spend its cash hoard, especially in the light of other obligations. Cisco has committed $2 billion for loans to customers having a hard time finding other types of financing, and it must still cover the huge costs involved in completing the mergers of the 21 outfits it bought last year.

HARD TO SWALLOW. That's another reason why the acquisition stream has been dammed: Cisco has a very bad case of indigestion. Although it is reputed to have the Midas touch in mergers, acquisitions have been creating more lead than gold of late. True, the early purchases of Crescendo and Kalpana dramatically spurred Cisco's growth. But as the number of acquisitions soared, not every buy was a smashing success.

Many of Cisco's optical products, too, have seen less than spectacular sales. A few years ago, CEO John Chambers preached about the coming optical networks and how the machinery to run them would come from Cisco. Instead, upstarts like Corvis (CORV) and Ciena (CIEN) have taken leading positions in that market.

Nowadays, you don't hear Cisco execs talking up the optical space. "The buzz is that they've become disenchanted with the carrier-optics market," says Robertson Stephens analyst Paul Johnson. "I don't expect to see them make any more purchases in that area."

CAN'T PLEASE EVERYBODY. Here's the problem: Although Cisco prides itself on its comprehensive software, what it has to offer holds only limited appeal to providers of optical machinery. To understand why, turn back the clock to the early '90s, when Cisco created a software-management system called IOS (Internet Operating System).

IOS is one of the main reasons why Cisco was able to turn its acquisitions' technologies very quickly into profits. Because IOS was so modular and easy to program, a new product could be ported to it in a matter of weeks. By comparison, it took years before 3Com (COMS) finally had a unified software structure that oversaw the products of its disastrous acquisition, US Robotics.

But IOS loses its value when those products are used on a network in conjunction with competitors' technology. Cisco's primary customer base is the so-called enterprise community, better known as large corporations. When building a network, these clients like to deal with one vendor and, as a general rule, will be glad to buy all the pieces from one supplier like Cisco.

"CREAKING WITH AGE." Telecom companies, on the other hand, want to assemble their networks component-by-component, and they have no interest in overseeing a voice-and-data system that serves, say, a million people with another company's proprietary software. "IOS is creaking with age," says Johnson. "It works in the enterprise space and nowhere else."

Without its valuable stock price or its software edge, it's understandable that Cisco would slow down spending on acquisitions. But company spokesperson Tom Galvin denies that's what's going on. "Our acquisition strategy is unchanged," he says. He also scoffs at the notion that Cisco has a quota of companies it wants to buy this year, insisting that each potential purchase is weighed on its own merits and not as part of an overall strategy.

A simpler way of looking at the slowdown is this: Maybe Cisco's acquisition "spree" wasn't one at all. One of the philosophical foundations of Cisco's buyout strategy has long been that it is the means by which the company comes up with new products. Rather than develop a new router or switch in-house, it lets a startup's ambitious and overworked engineers build it. Then Cisco offers the innovators big stock-option packages, along with the benefits of one of the world's best sales forces, to bring the product under its wings.

DIFFERENT MOTIVE. That was true in the early days, says Johnson of Robertson Stephens, but now there seems to be a different motive. "Most of the recent acquisitions have been nothing more than mass recruiting," he says. "When there's a field that Cisco doesn't have expertise in and wants to enter, it goes out and buys the company that has the best engineers in that area."

Indeed, a close look at the 39 acquisitions of the past two years shows that only two of them, Cerent and Arrowpoint, created important new products that were significant revenue producers. Of the rest, most were startups that were still in the pre-product-development stage.

If that's the case, then it makes sense that Cisco would stop buying. For such a high-growth enterprise, an acquisition freeze is the equivalent of a hiring freeze. And once the current inventory buildups are worked through, the buying -- like hiring in another company -- can begin again. Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column

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