| | This Weeks BARRON'S Cover Story..."Cisco's Bundles of Joy"...
Getting the World Wired
By BILL ALPERT
IN RECENT YEARS, Cisco Systems Chief Executive John Chambers has had trouble persuading investors that data-networking still is a growth business.
The company's routers and other networking gear lie at the heart of the Internet and most of the world's large organizations. But does all that electronic plumbing ever need upgrading? After all, a notebook computer cracks when you drop it, but network switches rarely wear out.
As 2006 began, Cisco's sales were rising by less than 10%. With its annual revenue around $30 billion, the San Jose, Calif.-based company needed to find new sources of growth, and in very large increments.
Apparently, it has. At a meeting with Wall Street analysts last month, Cisco said that several markets look ripe enough to nourish its next growth spurt: oil-rich nations looking to wire their people; telephone and cable providers locked in an arms race for Internet gear; corporations bundling e-mail and voice messaging on their networks and a coming flood of Internet video traffic. Anyone of these new markets could be worth $10 billion in annual sales to Cisco within five years.
Cisco CEO John Chambers says even he is surprised by the company's early success in these new ventures. "We are winning almost all the new jump balls," he says. "We will become the leading company as the network enables all forms of communication."
In appreciation of these prospects, analysts have been raising their sales growth forecasts for Cisco from the low teens to 15% or more per year. As for profits-which totaled $6.8 billion, or $1.10 a share in the fiscal year ended July 2006-the Street sees $1.27 a share in fiscal "07, and $1.47 in fiscal "08. Cisco, like most technology companies, reports earnings before option expenses.
Investors seem to have marked up their opinions of Cisco, as well. Since early August, the company's shares (ticker: CSCO) have risen almost 40%, to a recent 23.90. Yet, at 18.8 times next year's estimated earnings, the stock sports a lower price/earnings multiple than most other networking shares. As sales and profits begin to flow from new customers and new markets, like Internet video, Wall Street is likely to raise its stock-price targets. A number of analysts think the shares easily could tack on another 15%.
CISCO DIDN'T INVENT the Internet, but few other companies did as much to help it come of age. In the 1990s, as the dot-com bubble was inflating, Cisco's sales in some years grew more than 50%. Revenue growth since has slackened to a comfortable low-to-mid-teens pace. Fiscal "06 sales rose 15%, bolstered by the February acquisition of Scientific-Atlanta, a supplier of cable-television equipment.
Today almost 40% of Cisco's revenue comes from the sale of switches, the basic movers of data packets through electronic networks. Routers-the brainy parts of a network, which control and direct traffic- chip in a bit more than 20%. Around 20% comes from new technologies like Internet telephony and video, on which the company is pinning much of its hopes for future growth. Services account for the remaining 15%. Total revenue topped $28 billion in fiscal "06 and is expected to rise to $33 billion in the current fiscal year.
A few years back, Cisco's router sales flattened when Juniper Networks (JNPR) seized the high end of the market with powerful routers designed for the core networks of telephone-service providers like Verizon Communications (VZ). The competition forced Cisco to spend $500 million to develop a new router, the CSR-1, which could carry 100 times more traffic than Juniper's. Since its launch in 2004, the CSR-1 has stormed the market, forming the core of new networks at Sprint (S), Comcast (CMCSA), British Telecom (BT) and Japan's Softbank BB, while Juniper has struggled to come up with a response. According to the Dell'Oro market-research group, in Redwood City, Calif., Cisco now enjoys about a 60% share of the router market for such customers.
The development of the CSR-1 helped place Cisco once more on the ground floor of a revolution, this one involving the delivery of multiple services over a single network. Until now, telephone, cable and satellite television each has been delivered via a different network technology. Now, companies in all three industries are gearing up to offer customers a "triple play" of voice, highspeed Internet and television service-and, before long, wireless and wireless TV-over a single network that uses the Internet Protocol technology that is Cisco's forte.
Similar efforts are unfolding abroad, where upstarts like France's Neuf and Italy's Fastweb are challenging their countries' former telecom monopolies. CEO Chambers says Cisco designed products like the CSR-1 with a vision of the coming convergence. "We did not build the CSR-1 to do a billion phone calls," he says. "We built it to do 100 million videos."
Suppliers of traditional telecommunications equipment, such as Lucent Technologies (LU) and Nortel Networks (NT), have seen flat or falling demand from their phone-service customers in recent years. But spending on Internet equipment by phone and cable operators is growing by 17% a year, says Mike Volpi, who runs Cisco's router and service-provider businesses. Volpi views his business unit as the arms merchant in a war of competing communications companies. But unlike the network spending of the 1990s, which was financed by stock sales, today's outlays are funded by these companies' copious cash flow.
The spending is likely to increase. When Verizon began installing its FiOS fiber-optic network in Massachusetts last year, Comcast countered by boosting the download speed of its cable-modem service. That required the cable company to upgrade its routers.
Volpi is encouraged by Cisco's win rate so far. "When we do a good job as a vendor, we get 80% of the business and the second source gets 20%," he says. "When we don't do a good job, it's 50/50."
IN THE TRIPLE-PLAY race so far, cable companies have had great success selling telephone service. They can charge a low fixed price because they run calls over Internet style routers, most provided by Cisco. Within about six months, Volpi says, Cisco routers also will incorporate digital-video technologies. Internet Protocol-based television, or IPTV, is the delivery technology of choice for new providers of TV service like AT&T, Verizon and Italy's Fastweb.
The technology also will enable Cisco to bring the home-alarm industry into the digital age. Indeed, the company thinks it could create a billion-dollar market for gear that transmits video from your baby's crib to your cell phone, or from a break-in to the local police station.
Best of all, the "data packets" carrying video are bigger than other kinds of network traffic, and would require networks to upgrade their switches and routers. High-definition video conferencing, for instance, might use 10 times the network bandwidth of other network traffic. "The more bits, the better for Cisco," Volpi says.
To beguile enterprise customers with the virtues of video, Cisco soon will unveil a sophisticated high-def video-conferencing system. Companies such as Polycom (PLCM), Radvision (RVSN) and Norway's Tandberg have been selling videoconferencing products for years, but Cisco could quickly become the market leader. Bob Hagerty, CEO of Pleasanton, Calif.- based Polycom, guesses there have been around a million video-conferencing systems installed around the world, about half sold by his company. In May Polycom introduced its latest $250,000 video-conferencing set-up. In coming months it will upgrade its product to high-definition.
Competing with a high-def product of its own will be Fair Lawn, N.J.-based Radvision, whose video-conferencing gear has been sold under the Cisco label. Video transmission over Internet-protocol networks means video calls no longer need be a luxury for CEOs only, says Radvision's chief executive, Boaz Raviv. His company created a consumer video-calling product for Fastweb that uses the living-room television as the conference-call's video monitor. With Cisco and Northrup Grumman (NOC), Radvision is building the world's largest video-conferencing network, by linking 1,500 meeting locations for the U.S. Defense Department.
Cisco's Chambers has used current- generation video-conferencing products to confer with other executives, such as IBM's Sam Palmisano. Chambers says he can barely tell who's who on the TV screen, and that he'd never use it to talk to customers. But next-generation products are another story, capable of delivering a "telepresence."
"It's video conferencing and data conferencing and IP telephony conferencing," says Chambers. "You can play Texas Hold'em with three other groups at the same time in different locations, as if you were all at the same table."
Time permitting, you could also get some work done, and Chambers believes collaborators would work 20% to 30% more productively. He's got a credible record in productivity improvement; Cisco pulls in more than $700,000 in revenue for each employee, triple its nearest competitor. Cisco will roll out its telepresence product to its 70 sales offices next year, and estimates it will break even on the investment in less than nine months. It expects to save an annualized $100 million in travel expenses by year-end 2007.
CISCO'S VIDEO PLANS are but a piece of a larger ambition to lead in all forms of communication. In the same way that a phone company can run all communications over a single Internet-Protocol network, a large business now can use one IP network to unify its various systems for e-mail, instant- messaging, project collaboration, physical security and PBX phones. Cisco believes the annual market for "unified communications" solutions will reach $10 billion within three to five years.
The company's first communications products have been successful. In just a few years, Cisco grabbed the lead in the market for PBX [private branch exchange] internal phone switches, winning a 23% market share with its Voice-over-Internet- Internet- Protocol systems, according to figures from Synergy Research Group. In the July 2006 quarter, Cisco shipped more than a million VoIP telephones. For a branch office or a medium-sized business, getting a PBX can be as simple as adding a card to Cisco's Integrated Services Router, a Swiss Army knife-style product that also can become a network firewall and a Wi-Fi network base station, also by inserting new cards. Video surveillance soon will become another add-in feature.
Cisco sells tens of thousands of ISR routers every quarter; the ISR ramped to a $1 billion annual sales rate within its first year, faster than any other Cisco product.
Table: Leader of the PackVoice-over-Internet-Protocol solutions have dominated the PBX market with surprising speed, forcing incumbent vendors like Avaya (AV) to revamp their product lines. In 2002, VoIP products were about 15% of all PBX phone lines sold, says Avaya CEO Lou D'Ambrosio. This year, he expects IP products will be 60% of PBX industry sales. The computer-like IP-PBX systems save companies money by letting them use cheap Internet links, instead of expensive trunk lines. They also allow third-party software writers to invent clever new applications. At the Wynn Las Vegas resort, for example, an Avaya IP phone lets guests use many of the casino's services from their night tables.
D'Ambrosio concedes that Cisco enjoys an advantage in selling IP products, as most large organizations own Cisco switches and routers. So PBX incumbents like Avaya and Nortel strive to compete on the quality of their software applications. Many customers want their mission-critical phone systems to remain separate from their networks, says Avaya's CEO.
The University Hospitals Health System in Cleveland, Ohio, is not one, however. The hospital complex has hired Cisco to replace its existing PBX, cable TV and computer networks with a grand, unified network, in an 18-month project costing tens of millions of dollars. The hospitals' phone center will feature triple-redundant systems, says the system's chief information officer Ed Marx. Medical records will be accessible instantly to authorized people anywhere. Intercom announcements of the "Code Blue, Unit 5700" variety will be a thing of the past as the network wirelessly summons the required doctors and nurses.
The Cleveland system did not solicit a network vendor other than Cisco, satisfied with the company's promise of a certain level of network performance, with financial penalties if the service fell short.
Indeed, many Cisco customers make just that one call, instead of soliciting competitive bids. In a survey of 500 information- technology buyers conducted in March by SG Cowen, 35% of respondents indicated they planned to move more of their network spending to Cisco, while only 4% expected to shift more to competitors. Customer satisfaction is one reason why strong challengers, such as China's Huawei, have yet to crimp Cisco's 67% gross profit margins.
IF CISCO IS leaving most of its traditional networking rivals in the dust, there's a new competitor looming: Microsoft. The Redmond, Wash., software behemoth (MSFT) has its sights set on the same unified-communications market that Cisco is targeting. In June Microsoft announced several products planned for late 2007 that would handle VoIP phone calling, instant messaging and video conferencing. Microsoft plans to take advantage of its huge installed base by bundling some of the new communications features into its ubiquitous suite of PC applications, Microsoft Office, while adding other features to its popular e-mail-server software, Microsoft Exchange. There are more than 400 million users of Microsoft Office and over 100 million workers with mailboxes on an Exchange server.
Communications is a natural next step for Microsoft, says Anoop Gupta, a vice president of the company's unified communications group, "What are the key pain points that information workers have?" he asks. "Twenty years ago, it was creating documents and spreadsheets. Today, it's how worldwide partners can collaborate."
Growth Engine: While Cisco's other businesses are growing at a measured pace, sales of advanced technology have rocketed its recent quarters on demand for Internet video, telephony and conferencing.
At the June announcement, Microsoft demonstrated how a worker on the road could phone into the Exchange e-mail server and tell it to read aloud from the text of freshly arrived e-mail messages. A writer could click on a person's name where it appears in a Word document, and instantly be able to phone or e-mail that person. A videoconference demo featured a tabletop gadget with a 360-degree camera at the top of a six-inch stalk. This "Roundtable" video-conferencing device sends a panoramic view of everyone assembled, and can zoom in on any speaker.
But apart from devices like the Roundtable camera, the Microsoft unified communications solution is all software-with software's attendant economies. "In our approach, there is no PBX," says Gurdeep Singh Pall, another Microsoft VP. "It's a totally distributed architecture."
If Microsoft sees communications going from computer to computer, Cisco foresees communications functions running on its network gear. One Cisco advantage is its head start; it has been selling communications products for a few years, and can deliver solutions that work out of the box. Microsoft plans to start selling its software around the middle of 2007, and its third party hardware and software partners may need more time to get everything working. Microsoft and Cisco products may compete with each other, but at least they'll be able to talk to each other; the two companies say they'll work to ensure compatibility. Gupta says it's a huge market they're both chasing: perhaps as large as $40 billion in annual sales.
While these new technologies are giving Cisco's current customers reason to upgrade, Cisco also is seeing growth of nearly 50% a year in its sale of networking systems in emerging markets like Saudi Arabia. That growth results from sales investments Cisco made in the past couple of years, just as it had done previously in India and China. A large sales force of Cisco representatives is now making the case for oil-rich nations to invest in networks as a way to improve health care in those countries and create high-value jobs. Today such countries represent 10% of Cisco's sales, but Chambers thinks they will contribute 30% to 50% of future growth.
If Cisco revs up its sales growth with products for unified business communications or consumer quadruple plays, its gross margins should remain in a range of 64% to 66%, says Dennis Powell, the company's chief financial officer. That's because the value added, in most Cisco products, is software, whether it's embedded in computer chips or part of the company's network operating system.
Cisco generated free cash flow of $7 billion in its July 2006 fiscal year. Financial chief Powell says the company wants to give shareholders the cash it isn't investing in new ventures or acquisitions. Since September 2001 Cisco has shrunk its shares outstanding by about 25% through $35.4 billion in stock buybacks. It still has $4.6 billion of firepower left under its share-buyback authorization. Sooner or later, Powell expects Cisco will start paying a dividend, but there has been no ground swell of shareholder demand yet. When Cisco does initiate a dividend, Powell would like it to be more meaningful than the token 1.5% yield paid by Microsoft (not including its special dividends).
Investors probably will be happy to continue betting on John Chambers and his team. "We were $1 billion in sales when I took over, ten years ago," he says." We now move into new markets and do $1 billion in each of them. No company in the history of IT has ever done that in more than a couple of products, and we're doing it repeatedly. We're in the right spot at the right time, and we're trying not to mess that up."
Chances are, it won't.
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