Even as Rivals Began to Stumble, Cisco Believed Itself to Be Immune
By SCOTT THURM
Staff Reporter of THE WALL STREET JOURNAL
Last summer, with its order book overflowing but its assembly lines sputtering because of a lack of parts, Cisco Systems Inc. decided to crank up its supply line. It made commitments to buy components months before they were needed. And it lent the manufacturers that build most of its Internet-switching gear $600 million interest-free to buy parts on Cisco's behalf.
As it turns out, Cisco made a bad bet. On Monday, with both its sales and the value of its surplus components shrinking, Cisco said it would write off $2.5 billion of its bloated inventory.
Chief Executive John Chambers says his company was the victim of a sudden, unanticipated economic chill. As recently as November, Cisco's orders were growing at a 70% annual clip; these days, they are running below year-ago levels. "I don't know anybody that can adjust to that," Mr. Chambers says.
But some of Cisco's wounds were self-inflicted. Mr. Chambers and other Cisco executives ignored or misread crucial warning signs that their sales forecasts were too ambitious. They overestimated Cisco's backlog, because of misleading information supplied by Cisco's ballyhooed internal order network. And they continued to expand aggressively even after business slowed at some Cisco divisions.
As a result, when Cisco hit the wall in mid-December, its was running fast, making the collision all the more damaging. Now, Cisco, whose meteoric growth made it the shining star of the New Economy, is laying off a total of 8,500 full-time and temporary employees, after hiring 5,000 between November and March. And it is sharply curbing purchases from some of the same suppliers it had been courting.
In the end Cisco, hugely confident after years of extraordinary growth, worried more about turning away orders than about whether they would materialize. "Cisco always had a bit of trouble finding the brakes," says Alex Mendez, an ex-Cisco executive who left in November to become a venture capitalist. Even Cisco Chairman John Morgridge concedes that elements of the slowdown were "foreseeable."
By contrast, some Old Economy standbys reacted much more quickly. Major auto makers, for example, quickly pared production as sales slowed in the fall, averting huge inventory buildups. Some of them now are considering restarting assembly lines they idled just a few months ago.
A 30% Decline
To be sure, Cisco is facing a steeper dropoff in business than the auto makers, whose fourth-quarter sales were down 7% from the previous quarter. Cisco says sales will plunge roughly 30% to $4.75 billion in the current quarter. Just six months ago, they were growing at a 66% annual rate.
Like other high-tech names, Cisco was caught unaware by the one-two punch of the broader slowdown and the retrenchment in the telecommunications sector. But the magnitude of Cisco's fall is unique. For a while last spring, Cisco had the highest market capitalization of any company in the world. Since then, its shares have fallen 80%, erasing more than $400 billion in market value. That plunge imperils two cornerstones of the company's success: luring talented employees with stock options and using its coveted shares to buy promising start-ups.
Cisco's ills are far from fatal. To stay ahead in quickly changing markets, technology companies frequently have to make big gambles. "The day we stop taking risks as a company is the day I would sell the stock," says Mr. Chambers.
The company still has a chokehold on the computer networks of virtually every major U.S. corporation and a growing presence inside local and global telecom networks. It has $17 billion in cash and investments, no debt and says it will still eke out a small operating profit for the third quarter ending April 30, its worst quarter ever.
Back in May, when 600 top Cisco managers gathered for their annual retreat in Monterey, Calif., the company's outlook was particularly bright. Cisco had just chalked up its 11th consecutive quarter of accelerating revenue growth, and Mr. Chambers told his troops to plan on revenue increasing by 60% in the fiscal year that was to begin July 30.
There was one cloud on the horizon. Components for some Cisco products, particularly switches used in corporate computer networks, were in critically short supply. As a result, Cisco customers had to wait as long as 15 weeks for their orders, compared with the normal one to three weeks. Mr. Chambers says the long waits cut Cisco's sales by 10% for much of last year, as frustrated customers bought from rivals. He worried that the defections might outlive Cisco's short-term supply woes.
In midsummer, he and top aides devised a two-fold strategy to revitalize Cisco's supply chains: help contract manufacturers accumulate parts and commit to buying specific quantities of components from key suppliers.
Contract manufacturers, the outsider companies that make the vast majority of Cisco's products, worried that Cisco and its rivals were setting overly aggressive expansion plans. As long ago as last summer, executives at Solectron Corp., one of Cisco's biggest contract manufacturers, had warned Cisco and other telecom-gear makers that they appeared to be ordering more parts than needed, a Solectron spokesman say. Cisco says that despite that warning, its overall business was still growing strongly.
Meanwhile, the high-tech landscape was changing. The Nasdaq Composite Index peaked in March 2000 and then headed south. Soon, dot-coms began to fail. While dot-coms had accounted for less than 5% of Cisco's sales, Cisco was projecting that its sales to dot-coms would nearly double in the fiscal year ahead. That forecast looked less likely by the day. Still, Mr. Chambers says dot-coms "had money and they were buying" in May and June, as Cisco planned its next fiscal year. "To not plan to meet that growth," he says, "is the quickest way to lose customers."
More ominously, investors were souring on telecommunications companies, amid signs that they had massively overbuilt the nation with new high-speed long distance lines. Cisco, which had been making big strides in selling its Internet gear to telecoms, was projecting that its sales to that sector would double in the new fiscal year, say several current and former Cisco managers. Before long, however, upstarts challenging the Baby Bells couldn't raise money to finish their networks. Giants such as AT&T Corp. and WorldCom Inc. began retrenching, halting or scaling back their equipment purchases.
From January through August, telecoms raised an average of $5.6 billion a month by selling stocks and bonds. In September, the total plunged to $1.2 billion. And it kept dropping, to $900 million in October and $700 million in November.
Seeing those signs, others in the telecom food chain began lowering their sights. Chip maker Xilinx Inc., an important Cisco supplier, trimmed its forecast for fourth-quarter sales growth to 10%, down from a record 20% in the third quarter.
It isn't clear how closely Cisco managers were watching the numbers. "I'm not sure we were doing that analysis, looking at the overall financial markets or the cash positions" of the carriers, says one former executive. Other Cisco officials say they noticed the telecom downtrend, but concluded it was the start of a shakeout that would leave behind fewer but stronger carriers to buy Cisco's gear. "We planned for consolidation," rather than "evisceration," one of them says.
At the time, it hardly seemed to matter. Cisco continued to accelerate. Revenue for the fourth quarter ended July 29 soared 61% from a year earlier. Orders grew even faster. By October, Cisco's internal "stretch" goal -- which Cisco had met or exceeded in the past -- had ballooned to 70% growth for the current fiscal year.
Even as rivals such as Nortel Networks Corp. began to stumble, Cisco executives believed themselves immune. In late October, Nortel stock fell by 33% in one two-day period after the company reported slower-than-expected sales of its industry-leading fiber-optic products.
Management 'Exuberance'
Soon after, Cisco Chief Strategy Officer Michelangelo Volpi said Nortel had fallen prey to management "exuberance." Was Cisco in danger of falling into the same trap? "I don't think so. We try to very precisely set expectations," he replied.
Today, Mr. Chambers says he had no reason to be shaken by Nortel's news. Nortel executives still were forecasting revenue growth of 30% to 35% for this year, and Cisco had been growing 10 to 20 percentage points a year faster than Nortel. Cisco could meet Wall Street expectations, even if both companies' growth slowed, he says.
However, parts of Cisco's business had already begun to lose steam. In the October quarter, sales to telecoms grew less than 10% from the previous quarter, slower than other parts of Cisco's business. The growth engine was becoming the caboose. Sales to upstart carriers, which used Cisco gear more extensively than traditional telecoms, didn't grow at all. Some upstarts, including several that had borrowed money from Cisco to build their networks, failed. ICG Communications Inc., Englewood, Colo., sought bankruptcy-court protection on Nov. 14, owing Cisco $32 million.
In October, at least two Cisco suppliers began warning Cisco that shipments were slowing, or not meeting forecasts, say people familiar with the talks. Cisco confirms the warnings but says they weren't unusual, because suppliers might feed only one or two of its product lines. "The overall picture continued to be one of incredible strength," says a Cisco spokesman.
By November, Mr. Chambers says orders were "comfortably" more than 70% ahead of the previous year. And Cisco officials thought they had some built-in buffers. The company had an order backlog of $3.8 billion as of Sept. 25, equivalent to more than seven weeks of sales. Telecom purchases were slowing, but sales to businesses were going "gangbusters," Mr. Volpi says. And overseas sales surged, even as U.S. sales slowed.
Challenging Wall Street
In early November, Chief Financial Officer Larry Carter urged Wall Street analysts to boost their revenue and profit estimates, saying that Cisco now expected revenues to grow by as much as 60% this fiscal year. Mr. Chambers continued hiring aggressively, though he cautioned analysts that expenses could be a problem if orders didn't arrive.
The strategy had worked before. When sales of computer-networking gear slowed slightly in 1994 and 1997, rivals paused, or rushed into ill-conceived mergers. Cisco succeeded by plowing ahead. During the 1997-98 Asian financial crisis, for example, Cisco substantially increased its presence in the region, picking up market share.
In late November, Mr. Chambers started to describe the latest downturn as an opportunity for Cisco to "break away" from rivals such as Nortel and Lucent Technologies Inc. "Cisco is actually better off if the stock market stays tough for the next 12 to 18 months," he told 500 investors and Wall Street analysts on Dec. 4. He added that with Cisco's sophisticated information system it could be nimbler than its rivals and could control its own fate.
Stephen Kamman, an analyst at CIBC World Markets, could hardly believe his ears. Mr. Kamman, who had been covering telecoms, had recently been reassigned to cover Internet-gear makers such as Cisco. He knew the telecoms were in trouble. And he says he was surprised that "nobody got up and acknowledged that" some of Cisco's clients were going bankrupt.
When Mr. Chambers returned home that night, he checked Cisco's order volume on the online system that tracks the company's business. He was a little surprised to find them roughly 10% below expectations. When the trend persisted all week, he began to worry.
Mr. Chambers called top executives of Cisco customers, who told him that their own businesses had slowed suddenly, forcing them to re-evaluate spending plans. On Dec. 15, Mr. Chambers gathered his top lieutenants at Cisco's San Jose headquarters. "What happens if we're off by a billion or a billion and a half" in quarterly sales, he asked.
Going 'Soft'
Mr. Chambers says the other executives were less worried than he, but together they agreed to go "soft" on hiring and stockpiling inventory for 45 to 60 days. Word was slow to filter down to the ranks, however: Cisco extended more job offers in December than any other month last year.
Cisco's business continued to erode. Sales to upstart telecom carriers fell 40% in the January quarter, to $300 million. Businesses trimmed spending on high-tech gear. And instead of doubling, as projected, Cisco's sales to dot-coms fell by half. Scarcely used Cisco equipment from failed Internet businesses came on the market at steep discounts.
The speed of the sales decline surprised Cisco executives. As it happens, they may have been misled by their own internal information system, which they tout as a model for others. Facing two- and three-month waits for some popular Cisco products, some customers had been double- and triple-ordering, once from Cisco and then again from Cisco distributors. Once the product was shipped, customers canceled the duplicate orders. And after Cisco's production lead times began to shrink in the fall, customers could afford to delay new orders. Cisco's backlog was vanishing fast.
"We knew there were multiple orders. We just didn't know the magnitude," says Cisco's Mr. Volpi. Without the misleading information, he says, "we might have seen better and made better decisions."
Mr. Chambers plays down the importance of the multiple orders, saying Cisco doesn't rely exclusively on data from its internal network. "Do our systems do a great job of telling us where we are today? Yes," he says. "But they don't tell the future."
Stuck at 18 Cents
On Jan. 28, as he waited to make a speech to the World Economic Forum in Davos, Switzerland, Mr. Chambers fielded a call from Mr. Carter, his CFO. Analysts had expected Cisco to post earnings of 19 cents a share. "We couldn't get the last $100 million off the floor. We're at 18 cents," Mr. Chambers says Mr. Carter told him. For the first time in more than six years, Cisco had failed to meet Wall Street targets.
On March 9, Cisco reversed course, saying it would lay off as many as 5,000 employees and 2,500 to 3,000 temporary workers, and restructure parts of its business. On Monday, Cisco increased the number of full-time layoffs to 6,000. Final decisions on the cuts are due at the end of the month, but Cisco already has announced a few big steps. On April 4, it said it would discontinue a fiber-optic switch business it bought for $500 million 18 months ago.
Mr. Chambers concedes that he probably could have avoided layoffs this spring with a hiring freeze last fall. But he says that the move would have cost Cisco sales and market share and angered customers by making them wait longer for Cisco products. "We will always err on the side of meeting customer expectations," he says. More important, Mr. Chambers says that if he had paused at every sales hiccup in the past 10 years, Cisco never would have grown to a $19 billion-a-year titan.
Mr. Chambers says he's managing the company more conservatively today, emphasizing profits over growth and market share. For example, Cisco has sharply cut back on lending to upstart telecoms. And analysts expect it to shed more of its acquisitions. But Mr. Chambers continues to believe that in a healthy economy, Cisco's sales can grow 30% to 50% a year.
In the meantime, the parts that Cisco so desperately needed last summer are piling up. Even after its write-off, Cisco says it will still report inventories of $1.6 billion, up 33% from July.
Mr. Volpi says it's too soon to judge how well Cisco will perform in a downturn. "We will tell the tale in six to nine months," he says. "Anytime you have a company that has been growing for 14 or 16 years, it's not the easiest thing to turn it on a dime."
Write to Scott Thurm at scott.thurm@wsj.com |
