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Can Cisco Settle For Less Than Sizzling?


Just a couple of years ago, Cisco Systems Inc. (CSCO) seemed like an unstoppable force in the tech industry. Every trend pointed toward the rise of the Internet technology that was the company's specialty. Telephone companies, cable-TV providers, and cellular companies all were planning to replace their aging networks with cheaper, more powerful Net technologies. Ask a Cisco executive why the company didn't buy its way into telecom by acquiring the beleaguered equipment makers Lucent Technologies Inc. (LU) or Nortel Networks Ltd. (NI) two years ago, and the answer was predictable: As Executive Vice-President Michelangelo Volpi put it in 2003, "What would we get out of it? Their technologies are not relevant to what customers want." The world, it seemed, was moving Cisco's way.

But it hasn't been that simple. While the migration to Net technology is proceeding apace, the opportunities for Cisco are turning out to be more elusive than it first seemed. Since plunging into one new market after another, Cisco finds itself in a multifront war against a range of surprisingly feisty rivals. Little-known competitors like Brocade Communications Systems Inc. (BRCD) and F5 Networks Inc. (FFIV) go toe to toe with Cisco in some markets, while the recovering Lucent and Nortel are waging fierce battle in others. Even in corporate networking gear, its traditional stronghold, Cisco is facing its most serious competition in a decade from China's Huawei Technologies, Silicon Valley's Juniper Networks (JNPR), and others.

All of this is starting to take its toll on the San Jose (Calif.) giant. The company had stellar results in 2004: Sales surged 17%, to $22 billion, while net income rose 24%, to $5.3 billion. But Cisco's struggles in so many of its new markets raise questions about whether this is the end of its heyday. On Feb. 8, it reported that sales for its most recent quarter increased 12%, to $6.1 billion, slightly short of Wall Street estimates. Many analysts think that may be the first step in a marked slowdown in both revenue and profit growth, possibly to 10% over the next two years. The company's stock has dropped 39%, to $18, since the beginning of 2004.

"PAINTED INTO A CORNER"

Cisco, it seems, is stuck in a strategic box. It can pursue either growth or profits, but not both. Although Chief Executive John T. Chambers recently laid out a plan to boost revenues as much as 15% per year until 2008, it now looks as if Cisco may fall short of that mark unless it takes drastic action. It can target new markets and slash prices in several markets to grab market share and boost the top line. But that would wreak havoc on Cisco's rich margins, which averaged 68% last year. With $16.5 billion in cash, it could also pursue more and larger acquisitions. But again, that's likely to come at the cost of the company's profits. "Cisco is a phenomenally well-managed company, but I think they've painted themselves into a corner," says David J. Eiswart, who manages networking investments for T. Rowe Price Group Inc. (TROW) "Having 68% margins means you're in the high-tech equivalent of the diamond business, and there are only so many diamond mines out there."

One possibility: Give up the hunt for the next mine. Cisco could let go of the notion that it's a hot-growth company and start acting like its big-cap brethren. Some analysts and investors think Chambers & Co. should accept lower revenue growth and lure investors with steady cash flow and even -- gasp! -- dividends. "There's nothing wrong with being the market leader and making a ton of money," says analyst Samuel C. Wilson of JMP Securities LLC.

REVENUE QUEST

This is simply heresy to Chambers and his lieutenants. The CEO contends that Cisco can thread the needle, balancing speedy growth with healthy profits. At a December analysts' conference, Chambers and his top brass walked through a detailed explanation of how Cisco could grow 12% to 15% a year through 2008, while maintaining 65% gross margins. The plan calls for reigniting growth in its core markets, selling corporate routers and switches, and then marketing those products with a broad swath of related technologies, from $79 wireless routers for the home to consulting services for companies. "We believe we are not only well-positioned to compete, but to lead," Chambers said at the conference.

Still, the math doesn't look as if it adds up. To reach the 15% annual growth target, the number investors are really looking for, Cisco would have to increase revenues from $22 billion last year to $38.5 billion in 2008. Cisco predicts that sales to its core markets will rise about 11% annually, but some industry analysts say the more likely figure is just 9%. That means Cisco will have to come up with roughly $7.5 billion in incremental sales from its emerging businesses.

Is that figure attainable? Chambers may have to take the gloves off. Consider the market for the equipment that corporations use for Internet telephony. Cisco helped pioneer the field and held a 40% share just two years ago. But since then, little Avaya Inc. has surpassed Cisco as the market leader, swiping a 25% share and pushing Cisco down to 23%. CEO Donald K. Peterson says he's lucky to have Cisco as a competitor because it refuses to undercut him on price. "It's not because they are nice people," he says, "but because their market value requires them to hold their margins."

LOUD GROANS

As it competes in so many markets, Cisco has struggled to stay on the front edge of innovation in all of them. One example: wireless networks for corporations. Cisco leads the market, but upstart Airespace Inc. has gained loads of share over the past year because its products are easier to use and install. The result: In January, Cisco agreed to pay $450 million for Airespace, which was on track to do $85 million in sales in 2005, say insiders. That prompted groans from some investors who believe that Cisco should be getting more of an edge from the $3 billion it spends on research and development. "It's kind of pathetic," says a portfolio manager at one of the company's largest shareholders. "It seems like something is broken at Cisco."

Cisco has had a number of successes in the new markets it has targeted. It became the market leader in home networking products after acquiring Linksys Inc. in early 2003. It also has become a leading provider of network security products. Sales of its advanced technology products surged 40% in the most recent quarter.

And Cisco vows to keep diving into new markets. Chambers told analysts in December that Cisco would soon unveil four more initiatives that it thinks could eventually become $1 billion businesses. BusinessWeek has learned that these will include network management software to help companies make more efficient use of their computers and storage gear, and applications for Internet telephony, such as videoconferencing. Goldman, Sachs & Co. (GS) analyst Brantley Thompson said in a report that a third new line will be video-on-demand systems for cable and phone companies.

Even if Cisco gains share in these businesses, the real trick is gaining enough to make a difference for a $22 billion company. Take the market for storage networking, specialized switches that direct the data flowing between storage systems and servers. When Cisco entered the $1.3 billion market in 2003, most analysts figured it would quickly swamp smaller incumbents such as Brocade Communications. Brocade was so concerned that it hired a platoon of high-priced execs and even hosted a $100,000 golf tournament to buff up its brand. It could have saved its money. Despite investing more than $500 million, Cisco has sold just $200 million of its storage switches, dubbed Andiamo. That gives it 17% of the market, compared with Brocade's 47%. The reason: Most customers are loath to risk their data if their current technology is working. "Cisco is a formidable competitor, but you can't underestimate the value of a happy customer," says Brocade CEO Michael Klayko.

The most disappointing performance has been in the market with the most potential: telecom. Phone companies spend about $70 billion a year on capital investments, and a rising percentage of that money is going towards Internet technology that will help telecom companies offer voice, data, and video services to their customers. Yet Cisco has nabbed a modest 5% of the market -- far short of the 15% goal Chambers set a few years ago. One big reason is that fast-rising Juniper Networks is making off with a chunk of the business. Cisco expects to start regaining some share in the market for the largest routers. During its Feb. 8 earnings call, it said it had 12 paying customers for its recently introduced, $500,000 CRS-1 and another 12 are evaluating it.

Even so, Cisco may find rising competition from traditional phone company suppliers. Lucent and Nortel were teetering on the edge of bankruptcy a few years ago, but they've since regained their footing and have developed their own efficient equipment based on Internet technology. They're also willing to accept lower margins than Cisco. Alcatel (ALA), for example, is the industry leader in selling digital subscriber line match spacing (DSL) equipment -- broadband gear that typically carries gross margins of less than 50%.

Many investors believe Chambers needs to take more decisive action to reestablish Cisco's hot-growth credentials. One possibility: a big acquisition. Cisco says it isn't interested in big deals and will stick to buying hot startups. Yet with a market cap of $130 billion and that $16 billion in cash, it could afford almost any company. Potential targets range from Avaya to all or part of Nortel.

The problem with most acquisitions, however, is Cisco's margins. If it buys another company that gets less profit per dollar of revenues, the combined margins will fall and many investors would punish Cisco's stock. Asked if he thought Cisco would knock on his door, Avaya CEO Peterson says he isn't holding his breath. "Our corporate gross margin is 48%, and theirs is 68%. The arithmetic does not work," he says. "That's why I don't think they can do a big play without resetting their earnings expectations."

There's one oft-whispered target that's an exception to the margin problem: Network Appliance Inc. (NTAP). A fast-rising star in the surging storage market, the Sunnyvale (Calif.) company is growing more than 30% a year and had 68% gross margins in its most recent quarter. But NetApp's success presents a separate problem. Cisco's price-earnings ratio has dropped to 24, compared with 67 for NetApp. That means that NetApp's market value, which is now $11 billion, would only be worth $4 billion if investors started valuing its earnings at Cisco's p-e. NetApp CEO Daniel J. Warmenhoven says there have been no discussions with Cisco.

During the Feb. 8 earnings call, one analyst asked Chambers why it is that he believes Cisco will be able to avoid the law of large numbers, which has meant slowing revenue growth at every other company as it grows in size. Chambers gave an expansive explanation, suggesting that Cisco may be different because the networking products it sells increase in value as more and more customers have them. "This may evolve into an industry where it isn't as simple as the law of large numbers," he said. "Let me give you the opportunity ...to challenge our thought process on this." What's one more challenge in the months to come?

By Peter Burrows in San Jose, Calif.


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