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Online Extra: Where Cisco Is Looking for Growth


When it comes to networking companies, Cisco Systems Inc. (CSCO) still looks like the best bet for customers and investors alike. Through the downturn, the San Jose (Calif.) giant tightened its grip on the corporate market for basic gear such as routers and switches. Its $3 billion annual research and development budget and $19.7 billion in cash and investments dwarf all of its top competitors combined.

And with a recovery just now starting, Cisco management has never been more confident. "We're in a great place at a great time," says Senior Vice-President Charlie Giancarlo, who says he recently decided not to pursue the opportunity to become CEO of chipmaker Broadcom (BRCM), to stay at Cisco.

If the mood is high, so are the expectations. To justify its $150 billion valuation, Cisco will have to post big growth numbers outside of that core networking business. Not just good -- but huge growth numbers. To hit analyst estimates of 12% growth, Cisco will need to grow 30% a year in new markets, says JMP Securities analyst Sam Wilson.

LOTS OF PROGRESS. It's off to a strong start. Part of the management strategy during the lean years was to focus on six new markets that had $1 billion potential. These include network security, Internet telephony, wireless networks for homes and corporations, storage networking, and optical switches for big phone carriers. With the exception of storage networking, the news is all good. In security, Cisco now leads with roughly 30% share in the third quarter, up from 20% three years ago, says Synergy Research Group.

For years, Cisco has been the driving force in the market for voice-over-Internet-protocol (or, VOIP) phones that run over corporate data networks rather than the phone company's lines. Now, that market is starting to take off as corporations look to trim their phone bills -- and Cisco leads the way. It's also on a roll in wireless networking, where it leads in both the home market, thanks to its acquisition of Linksys earlier this year, and in the corporate market.

Keeping this momentum won't be easy, however. Cisco hasn't been able to land knock-out blows against competitors across the range of these businesses. Now, those rivals -- from scrappy small-fry such as NetScreen and Airespace, to resurgent behemoths such as Nortel (NT) and Alcatel (ALA) -- have made it through their darkest days and are also poised for a rebound.

"THE NEW GUYS." Take Internet telephony. After Cisco spent years of working the bugs out of its phone networks, customers seem willing to buy again. Unfortunately, its gear is all-digital. That means companies basically need to scrap their existing PBXs and other gear to move to Cisco's approach. At the same time, traditional phone-equipment providers such as Nortel and Avaya (AV) have fielded products that can work with companies' existing gear, and both have gained big chunks of share.

"We're seeing major corporations coming back to the suppliers they believe really understand the voice market," says Malcolm Collins, president of Nortel's Enterprise Networks group "When it comes to large customers looking to do IP telephony, my strongest competition doesn't come from the new guys like Cisco."

Cisco's rivals say they relish the fight, even when it offers to cut prices or even throw products in for next to nothing along with its other gear. Netscreen CEO Robert Thomas claims his fast-growing company beats Cisco in 80% of deals it gets to bid on. It's a pittance of the opportunities that Cisco's army of 10,000 salespeople drum up, but it's Netscreen's core business. "It's almost impossible for them to win based on technology," Thomas boasts.

DEAL-BY-DEAL DISCOUNTS? Executives in other areas also insist they still win more than they lose against Cisco, despite the company's dominance and aggressive marketing tactics. One rival CEO says on three recent occasions, Cisco not only offered to give its product away but also offered to buy his company's products from the customer to boot. Yet, none of the customers gave Cisco a chance, he says. "We did more damage to ourselves preparing to compete with Cisco, than actually competing with them," says one CEO that invested in products, branding campaigns, and even golf tournaments for CIOs out of fear of Cisco's entry into the market.

Cisco says it doesn't give products away for free. "That's something Cisco is never accused of -- giving products away," jokes Giancarlo, referring to its reputation for premium prices. He says it discounts only on a deal-by-deal basis, for a critical account.

Cisco has expended the most energy in getting phone companies to use its gear in the "converged" networks they're building to handle not only voice but also video and data services. In the 1990s, Cisco failed to crack this $64 billion market. The reasons: Buyers complained its products weren't reliable enough, and Cisco had all but declared war on traditional phone carriers by joining forces with new Net-style carriers with names like Covad (COVD), Global Crossing, and WorldCom. When many of those companies went bust, Cisco's telecom-related sales plummeted from $6 billion to $1.5 billion in a matter of months.

CONNECTING CUSTOMERS. Since then, Cisco has changed its attitude, its strategy, and its technology to win over the telecom giants. Rather than tell these carriers to throw out decades worth of phone equipment, the new plan calls for gear based on Internet technology that would work with their old-style networks.

Also, Cisco created groups whose sole job was to work with carriers to develop new services -- particularly those it knew its corporate customers would want to buy. And, say insiders and one large customer, Cisco then offered to use its sway with these corporate buyers to get them to buy those services.

One large customer confirms that its contract with Cisco says that it intends to deliver a dollar of service revenue to the carrier for every dollar the carrier spends on Cisco gear -- an attractive deal that convinced him "I'd rather be in the market with them than against them," if Cisco can make the gear work. Also, a former Cisco sales executive says that its salespeople got extra commissions if their customers bought services offered by these telecom partners.

FAR FEWER PROBLEMS. Cisco isn't just relying on dealmaking. It's also making substantive progress in increasing the reliability of its products. That's critical. Unlike Cisco's corporate buyers, carriers can't just take down the network on Sunday nights for maintenance, unless they want to draw the ire of regulators and millions of consumers.

For example, when Cisco finally got BellSouth (BLS) to consider one of its high-end optical switches, BellSouth Chief Information Officer Bill Smith handed Cisco a list of 158 problems that would preclude a deal. Two years later, Cisco has worked that list down to less than 15, and BellSouth plans to deploy the device early next year.

Also, Cisco is solving a problem that has held up progress with carriers. Since it was founded in 1984, it has had the same basic software called IOS, a 30 million-line monstrosity that can be buggy, hard to manage, and which has far more features than any class of customer really needs.

FALLING MARGINS. To ensure reliability, carriers have been calling for a simpler version of IOS for years. Former Cisco executives say it has invested hundreds of millions of dollars on the problem in recent years. Now, a Cisco vice-president says it has streamlined and "modularized" the code and will release its new IOS 12.2SP in coming months.

Cisco has momentum. It has signed deals with BellSouth, SBC (SBC), and Verizon (VZ) this year. And sales of its optical gear have grown more than 20% in each of the past two quarters. In his most recent quarterly conference call, Chambers said it wasn't clear yet whether this was due to an overall increase in carrier spending or an indication of Cisco market share gains. But "none of our peers in ths market signaled [an upturn in carrier spending]," he said.

The irony is that Cisco's overall profit margins will likely fall as it gains share in many of these new markets -- simply because they're not as profitable as Cisco's near-monopoly in corporate networking. And despite its success, rivals aren't laying down. In fact, some are getting off the mat and grinning. By Peter Burrows in San Mateo


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