Tech firms thought they could elude laws of gravity
BY CHRIS O'BRIEN /Mercury News /Saturday, March 17, 2001
In a world where Internet service providers come and go, the decision by Fastpoint Communications of Los Angeles to file for bankruptcy last December hardly merited a headline. It was so insignificant that the 300 workers who were laid off last week at a Jabil Circuit factory in Florida probably have no idea how it was connected to their fate.
What none of them probably fully understood was just how closely their fortunes were linked through Cisco Systems.
The San Jose networking company sits at the heart of an intricate web of high-tech companies that include its customers, suppliers and partners. Follow the strands that radiate from Cisco to find a range of customers that include buttoned-down Fortune 500 companies and ultra-hip dot-coms, stodgy old phone companies and swaggering new Internet service providers. Trace the web back through Cisco and it leads to an array of suppliers who build semiconductors, write software, and assemble and distribute products.
For the last several years, Cisco has led this collection of believers along the path of the Internet revolution. Their ambitions were fueled by eager investors who supplied billions of dollars in capital and credit. Caught in the rapture of an economic boom that seemed to have no end, this collective mistakenly believed it had re-written the rules of business and could defy economic gravity.
Even as this illusion crumbled along with the market for high-tech stocks last year, it seemed like Cisco would sidestep trouble. In retrospect, it was inevitable that problems affecting Cisco customers like Fastpoint would eventually ripple across this web to first humble Cisco and then companies like Jabil which assembles many of the San Jose company's products.
The close connections that once assured that many of these companies would prosper together are now also contributing to the velocity of the economic downturn that is now spreading in Silicon Valley and beyond.
``It's tough when your customers stop buying from you,'' said John Coons, a market research analyst at Gartner in San Jose. ``And there's not a lot you can do about that.''
Founded in September 1998, Fastpoint sold high-speed Internet access called ``digital subscriber line'' or DSL which promised connections more than 50 times faster than dial-up modems.
This was good timing for Cisco which had made its name selling networking equipment to Fortune 500 companies like General Electric. Fastpoint was just the type of New Economy telecommunications company that Cisco was counting on to fuel its ambitious growth. And Cisco wasn't alone.
PC manufacturers like IBM and Compaq hoped DSL would fuel computers sales; Microsoft hoped faster connections would drive software sales; chip makers like Intel hoped they would sell more chips; and dot-coms hoped broadband would make streaming music and video a big hit.
Over the course of its short life, Fastpoint would raise and spend about $5 million from private investors -- a tiny sum measured against Cisco's revenue of $18 billion in 2000. Fastpoint also used the money to buy servers from Sun Microsystems. It hired about 100 employees. It launched service in 22 cities. And it bought large Cisco routers and other equipment to build its network.
This equipment connected Fastpoint to a high-speed network built by Covad Communications of Santa Clara. Covad, which was founded by former Intel employees and backed by Intel, spent almost a billion dollars building a high-speed DSL network that connected ISPs like Fastpoint to the Internet. Along with NorthPoint Communications of San Francisco and Rhythms NetConnections of Colorado, Covad provided another type of new customer for Cisco.
All these new companies posed a challenge to traditional phone companies like SBC Communications, the parent company of Pacific Bell. So in 1999, SBC announced ``Project Pronto'' -- a plan to spend $6 billion to roll out its own DSL services across its territory. Six months later, Cisco was selected to be SBC's main partner in building its new Internet services.
Investors, venture capitalists and bankers were all too happy to fund this massive capital spending. Stock prices of many of these companies soared. The message was clear: Nobody cared about profits, only the number of customers being signed up.
For Fastpoint, that meant grabbing customers at any cost. It spent money on advertising. It cut the price of its service. It offered free installation, which usually cost $225. It offered free equipment, which usually cost another $200.
``We had a rather promiscuous business strategy,'' said Kate Greenberg, Fastpoint's chief financial officer. ``If it breathes, we wanted to sell it a DSL line.''
In February 2000, Fastpoint hired Greenberg and several other executives to put the company on a path to eventually go public.
``We never even got close to filing for an IPO,'' Greenberg said.
Last March, as the Nasdaq broke the 5,000 barrier, companies like Cisco and Intel were having inventory problems, according to analysts. Demand for their products was growing so fast, they couldn't keep up. They began increasing orders so they would have the products on hand to meet demand.
But at the same time, investors lost faith in the dot-com revolution. The Nasdaq began to plummet. Investors and venture capitalists demanded to know when companies would become profitable.
Cisco's customers discovered that the rules of the games had changed.
``Everyone in the DSL space was looking at a situation where they would lose money for four years,'' said Dave Burstein, editor of the DSL Prime newsletter. ``A year ago, they could get more money when they needed it. But when the money disappeared, business was dead for these guys.''
Fastpoint was in the middle of trying to raise more money last summmer when its bankers stopped it because the company's credit rating had dropped. Fastpoint executives began cutting expenses like advertising but had trouble paying bills to Covad which was having its own problems.
Covad's stock price fell to the single digits by October. Its CEO was ousted in November. It began demanding payments from its network of ISPs, such as Fastpoint. And Covad announced it would stop the geographic expansion of its network and focus on signing up more customers for its existing network. In 2000, the company spent almost $600 million on new equipment. In 2001, it plans to spend only 40 percent of that.
``The market moved from rewarding growth to saying we need to see a path to profitability,'' said Abhi Ingle, Covad's vice president for product development and marketing. ``Somebody slammed the door shut.''
The pain spread quickly. Covad said 19 of its ISP customers couldn't pay it and four of them -- including Fastpoint -- filed for bankruptcy. Covad's competitor, NorthPoint, filed for bankruptcy in January.
With the competition for DSL buckling and Wall Street demanding more profits, SBC slowed its own rollout. SBC had only signed up 767,000 customers nationwide for DSL by the end of 2000 -- short of the 1 million it had projected. It also said it would reduce its capital spending from $3 billion in 2000 to just $1.8 billion in 2001.
The result for Cisco and its competitors was a sharp reduction in orders, a pattern being repeated across their spectrum of customers. Between July 2000 and January 2001, Cisco saw the size of its inventory of products more than double, according to documents it filed with the U.S. Securities and Exchange Commission. Cisco's biggest competitors -- Nortel Networks and Lucent Technologies -- were facing similar problems.
As recently as Dec. 4, Cisco CEO John Chambers said he saw no reason to worry. But just a couple weeks later, he warned that the quarter was proving to be ``challenging'' as he saw orders slow.
On Feb. 6, Cisco missed Wall Street's financial targets for the first time in six years and warned a slowdown could continue for at least the next two quarters. A month later, Cisco announced it would cut up to 8,000 jobs.
To see the dilemma facing the networking giant, go to eBay and search under Cisco's name. It will return a list of almost 40 pages worth of Cisco products being auctioned off by companies that are scaling back.
In the SEC documents, Cisco also warned that it was spending more to finance the inventory, which could in turn narrow its profit margins even further. And Cisco said its networking equipment could be rendered obsolete by advances in networking technologies.
With unsold products piling up, Cisco slowed its own orders.
The shock waves were felt almost immediately.
Altera, a San Jose company which makes many of the chips that companies like Cisco, Nortel and Lucent use in telecommunications equipment, said its orders began to slow last fall. It expects demand to continue falling the first half of this year.
``It's clear to me that all the businesses we're talking about will see increased demand in the future,'' said Erik Cleage, Atlera's senior vice president of marketing. ``We just got ahead of that in the short term.''
When Altera's chips are ready, they are handed off to distributors such as Arrow Electronics of New York, which assembles components needed in manufacturing. Arrow has announced that it expects earnings to be down the first nine months of this year from its high last year.
Companies like Arrow take those components to contract manufacturers such as Solectron of San Jose and Jabil. Cisco outsources the building of most of its products to these companies.
Solectron will report its earnings on Monday. But it has already announced that it will be laying off an unspecified number of employees. The company builds products for several major communications companies, with Cisco accounting for about 13 percent of its business.
As for Jabil, the St. Petersburg, Fla. company said on March 5 it would cut about 300 jobs from its plant near St. Petersburg. The company cited a slowdown in orders from major customers, which include Cisco. |
