Last Man Standing
With its competitors ailing, a very flush Cisco is attacking on all fronts
Barron's Cover Story
By ERIC J. SAVITZ
November 25th, 2002
Last week, Cisco Systems shareholders engaged in a stirring debate that nicely
outlines just how large a gap there is between the San Jose, Calif., networking
giant and its rivals. The subject: whether the company should dip into its $21
billion cash pile and start paying dividends. A shareholder proposal to that effect
lost in a landslide, as was widely reported. But the press coverage largely missed
what made that vote so remarkable.
Think about it: Silicon Valley is still
struggling to escape from the worst
technology downturn ever.
Corporate tech spending has
flat-lined. Phone companies
continue to slash budgets. Venture
funding for networking and telecom
equipment startups has all but dried
up. The IPO market is dead.
WorldCom is bankrupt. Global
Crossing is gone; Qwest
Communications is struggling to
stay solvent; Cisco rivals Lucent
Technologies and Nortel Networks
are in deep financial distress.
That paying a dividend is even a
topic of conversation in these dark
days is testament to Cisco
Systems's agility in dancing through the tech and telecom minefield. While the
company has certainly felt the effects of slower corporate and carrier spending --
quarterly revenue has flattened out at about $4.8 billion -- the company has
remained profitable through most of the downturn, including the last six quarters
in a row.
No restructuring issues here. Cisco remains debt-free. And it continues to
generate gobs of cash, providing funding for a substantial share repurchase plan.
In the October quarter alone, Cisco spent $1.1 billion buying its own shares.
Cisco has accomplished these feats in part by strengthening what was already a
commanding position in enterprise routers and switches. It's also been cozying up
to the suffering telcos, ready to soak up new business when a recovery finally
arrives. Built through scores of acquisition, Cisco continues to look for
technologies to add to its portfolio, though the pace of mergers and acquisitions
has slowed. It's also still spending liberally on research and development, 17% of
revenue in the latest quarter, with a particular focus on lucrative new markets
such as wireless, security, storage and Internet Protocol telephony.
That Cisco has stayed profitable also reflects a focus on controlling costs. Cisco
has trimmed inventories, reduced head count, re-engineered products to use
cheaper parts, reduced its list of suppliers and ruthlessly pressured them to cut
prices. It also has ramped up the use of contract manufacturing: Over the last
year, the percentage of Cisco boxes built by outsourcers has jumped to 90%,
from a little more than 60%, says Dennis Powell, the company's vice president for
finance.
The result of all that has been steady gross margin expansion, even as the
company reduces prices. In the latest quarter, Cisco's gross margin topped 69%,
up from 54% a year earlier and marking the highest level in the company's history
(see chart above).
In short, Cisco has endured the perfect storm, and come out stronger than ever.
No tech company is better prepared to take advantage of a tech turnaround when
it finally arrives. Roger McNamee, partner at Integral Capital Partners of Menlo
Park, Calif., which has about 3% of its assets in Cisco shares, points out that
Cisco's cash position is larger than the market value of any of its primary rivals.
And Cisco's market value, even after an 80%-plus slide, is more than twice that of
every major Cisco competitor combined.
"Their competitors are all dealing with immediate and pressing business issues,
beyond the difficult environment in the networking market," McNamee says.
"Cisco is doing classic market-leader things in this downturn. It is building market
share through every conceivable technique. If they find a customer that can't pay,
they do a deferred revenue transaction, taking advantage of their balance sheet.
It's impossible not to be impressed with what Cisco is doing right now."
Apparently, that sentiment is spreading. Cisco shares, which in early October
traded as low as $8.12, last week pushed past $15, a gain of roughly 75%, more
than twice the 30% Nasdaq rebound over the same span. The big move has left
some analysts nervous the stock may not have much more room to run in the near
term. At $15, the stock trades for about 28 times the Street consensus estimate
for Cisco's July 2003 fiscal year, or about 25 times the 61 cents projected for
fiscal 2004. Not an obvious bargain. And yet, there's reason to be bullish.
Last week, Standard & Poor's upgraded its rating on the stock to Buy, citing
continued market share gains in routers and switches, and setting a 12-month
target for the stock of $17.50. We think they're on the right track, and would
view any near-term pull back as an opportunity to jump in. If Cisco succeeds in
some of the new markets its targeting, and wrests business from its weakened
competition in telecom equipment, it isn't hard to imagine the stock moving into
the 20s and beyond.
And let's put this in historic perspective. Not that long ago, Cisco is the 20s would
have been a nightmare scenario. As the leading provider of routers and switches to
the corporate sector, Cisco rode the dot.com wave to astounding heights. In
March 2000, Cisco sneaked past $80 a share, pushing its market value to a
wondrous $550 billion, making it the world's most highly valued company. Now
the market value is down to about $100 billion. Ergo, $450 billion in shareholder
value went "Poof." That drop accounts for about 7% of the $6 trillion in value
erased in the bear market.
And let's be clear. The rough times aren't over yet. Corporate
information-technology spending isn't likely to grow much in 2003, and carrier
spending isn't likely to turn up before 2004 at the earliest. It's a hostile
environment, which poses clear challenges for Cisco: Maintain fat margins, even
as upstart competitors attempt to compete on price. Take advantage of the
weakness at Lucent and Nortel and win new business with the carriers even as
they continue to slash spending. And, not least, leverage router and switch
expertise to make inroads into related markets. As it happens, there is reason to
believe Cisco can succeed at each of these.
Cisco's main issue is that its biggest strength is also its most serious weakness.
The company so completely dominates the market for enterprise switches and
routers, which account for about 80% of Cisco's revenues and most of its profits,
that its ability to gain additional market share is limited. Dell'Oro Group, a
Redwood City, Calif., research firm, estimates Cisco has nearly 70% of the
Ethernet switch business, and close to 90% of the market for enterprise routers.
Incredibly, those numbers have been inching higher. As Chief Executive John
Chambers pointed out recently, Cisco's 9% year-over-year revenue gain in the
October quarter compares with an average 48% revenue slide for the company's
top 10 rivals. The problem is, you can't get more than 100% of the market for
anything. In enterprise networking, Cisco won't be able to grow much faster than
the overall market. And for now, that means almost no growth at all.
Meanwhile, some investors worry that new competitors could chip away at Cisco,
particularly at the lower end of the switch market. With an envious eye on Cisco's
gross margins, for instance, personal-computer giant Dell Computer has jumped
into the market, betting that switching will be commoditized. And Huawei, a
Chinese manufacturer which in 2001 had $3.1 billion in sales, is making inroads in
Asia.
Chambers doesn't seem worried. He contends that productivity gains, innovation
and software sells routers and switches -- not price. But isn't management
worried that both Dell and Huawei, which does business in the U.S. under the
name FutureWei, plan to move up the food chain into higher-complexity systems?
Not that worried.
"Brand-name competition is not a new thing," says Peter Alexander, vice president
for commercial marketing at Cisco, who repeats Chambers' observation that the
company is on its fifth generation of competition. "Hewlett-Packard had product.
Intel had product. We simply don't think that networking is being commoditized."
The telecommunications carrier market poses different challenges for Cisco. For
one thing, conditions are far, far worse in telecom than in the rest of the
technology world. Consider, for instance, the optical switching market. In the
third quarter, according to Dell'Oro, optical sales totaled $1.6 billion, down from
$3.9 billion in the 2001 third quarter, and $5.7 billion in the same quarter in 200O.
Now that's a downturn.
The good news is that Cisco to date hasn't been especially reliant on the telecom
sector. By most estimates, the company has no more than 3% of the overall
telecom-equipment market, accounting for 20% or less of its revenue. And while
overcapacity and debt service has crippled the carriers, telecom equipment
remains at least a $100 billion-plus global business annually. That leads to some
back-of-the-envelope math: If Cisco can double its market share to 6% from 3%
by selling optical and asynchronous transfer mode routers and switches and the
like to the regional Bells and long-distance companies, it would increase its $20
billion in annual revenue by 15%.
There are reasons to like Cisco's chances to boost its presence in the telecom
business. For one thing, most leading players in telecom equipment -- Nortel,
Lucent, Alcatel, Ericsson -- face huge financial challenges. While Cisco thrives,
those companies are struggling for survival. Giri Devulapally, an analyst with T.
Rowe Price in Baltimore, notes that Cisco need be in no hurry to see a telecom
recovery. A longer, deeper slide would further damage telco-centric equipment
makers Lucent and Nortel, perhaps beyond repair. That would mean easier access
to the market for a financially robust Cisco.
Meanwhile, Cisco has been developing products for a range of new markets. Fred
Hickey, editor of the High Tech Strategist newsletter based in Nashua, N.H.,
thinks the weakened condition of Cisco's competition and a tendency of tech
customers to gravitate toward companies that provide them with complete
systems could give the company a nearly unassailable position. "If they do things
right," he says, "they have the chance to be as important, as dominant, as IBM
was in the 1960s."
Speaking at Cisco's annual meeting last week, Chambers said the company was
making inroads into nine new areas, with others on the drawing board. For the
moment, four of those are getting the most attention: Internet telephony, storage,
security and wireless networks.
Cisco didn't choose those areas by accident. They are large sectors where
spending seems likely to increase in the years ahead -- and where Cisco has an
obvious entree. And they're responding to customer demand. In a research report
earlier this month based on a survey of 50 U.S. IT managers, Merrill Lynch listed
three hot areas in the data networking sector: 802.11-based wireless networks,
voice-over-IP (or Internet protocol) and security.
Of those markets, the one furthest along is voice-over-IP, which involves sending
telephone calls over data lines. The notion of Internet telephony isn't new.
Barron's published a cover story about it five years ago ("'Net Threat," Oct. 13,
1997). It's taken longer than many people thought, but the technology finally is
coming into the mainstream, as companies begin to replace their conventional PBX
phone-exchange equipment with IP telephony gear. Leveraging its strong position
in corporate networking, Cisco already has a commanding share of the IP
telephony market; Cisco figures it has 50% to 65% share. Cisco already has
shipped more than one million IP telephones to 5,600 customers. By switching to
IP telephony, companies can combine their voice and data networks, reducing
transmission and maintenance costs.
"We have technology ready, and telephony is a budget that is being spent by our
customers," Cisco's Alexander says. "They're shifting dollars" which would
otherwise have gone to PBXs from companies like Avaya and Nortel. Depending
how you count, Alexander says, PBXs are an $8 billion to $16 billion market.
"There's an IP telephony alternative to most of that," he says.
Security could be a big market for Cisco, too. While not known as a big player,
Cisco contends it actually has more revenue from security products than
companies such as NetScreen and Check Point Software Technologies that are
dedicated to the field. Like IP telephony, Cisco sees network-security products in
the form of intrusion detection, virtual private networks and firewalls as a natural
extension of the networking hardware it already provides corporate customers.
While declining to make its own estimate, Cisco points out that research firm
Infonetics puts the market for network security at $4.65 billion by 2005.
Cisco also thinks it can make a big dent in storage-area networks, or SANs, an
area now dominated by Brocade Communications and McData. Gartner Group
expects the market to reach $4.3 billion in 2006, from $1.2 billion this year. And
Thomas Weisel Partners analyst Hasan Imam expects Cisco to take 30% of the
market by 2005.
Right now, Cisco has zero market share in storage: Its first move into the sector
came in August, when the company agreed to acquire the 56% stake it didn't
already own in Andiamo Systems, a startup which had been housed and funded by
Cisco. The first Andiamo-based products should be on the market early in 2003.
Cisco also sees big potential growth in wireless networks. Market-research firm
Cahners expects the market to reach $4.5 billion by 2005. Cisco has been eyeing
this market for several years. Its core wireless LAN product stems from its 1999
acquisition of Aironet Communications, then a Cleveland-based startup. While
most of the buzz over networks based on the 802.11 wireless standard has
involved consumers, Cisco has focused on the corporate market, where it already
claims a leading market position.
Cisco eventually will start growing again, but not this quarter. The company has
forecast that current quarter revenue will be flat to down 4% from the prior
quarter; and the April quarter is always seasonally weak, which means no chance
for a real rebound until the middle of 2003. But the groundwork for a healthy
rebound has been laid.
In May 2000, just after the stock market peak, Barron's ran a story about Cisco,
declaring that while the company's management was excellent, its stock market
value was just way too high ("Cisco's Bids," May 8, 2000). It was considered
heresy. The company was then near the peak of its powers, growing revenue
more than 50% a year, and using its highflying shares to make a dizzying array of
acquisitions. The stock was then $67 and change, trading at close to 200 times
forward earnings. Now it's more than $50 lower, with a price-earnings ratio
nearly an order of magnitude lower.
Cisco's revenue seems unlikely to accelerate back to double-digit growth before
2004 or maybe later. Gartner recently projected Cisco in the "medium term" could
rebound to 15% to 20% growth. But there's reason to think the shares will do just
fine in the interim.
"This is an environment where uncertainty is as great in the stock market as it is in
the business environment," says Integral's McNamee. "It's when investors flee to
quality and scale, which favors Cisco as a stock. Every time the market has a
couple of bad days in a row, people retreat to whatever makes them comfortable.
That's helped Cisco. It's like a cash substitute for tech investors. And among the
really big technology companies, it has as interesting a long-term growth
opportunity as anybody."
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