Carnegie Consulting

Carnegie ConsultingStrategic Solutions for Business

Capturing Market Share Duringan Industry Slump

Prepared for:

______________________________________________________________________________Carnegie Consulting

425 N. College Ave. s Claremont, CA 91711- 1 -

!

Table of Contents

Executive Summary..............................................................................2

Company History ..................................................................................2

Internal Rivalry......................................................................................7

Substitutes and Complements........................................................... 13

Entry .................................................................................................. 14

Buyer and Supplier Power................................................................. 15

Strengths, Weaknesses, Opportunities and Threats......................... 16

Financials........................................................................................... 19

Strategic Analysis: Capturing Market Share During an Industry Slump

........................................................................................................... 21



Executive Summary

In this strategic analysis, Carnegie Consulting analyzes Cisco by means of a five forcesanalysis and SWOT analysis. The following table gives a summary of our findings.

Five ForcesForce Threat to ProfitsInternal Rivalry HighSubstitutes & Complements WeakBuyer Power WeakSupplier Power WeakEntry Weak to Medium

After carefully assessing Cisco’s past and current position, Carnegie Consulting recommendsto management a three-part plan. The first arm of our plan is focused on increasing researchand development in two key areas: optical networking and router software. The secondcomponent involves resuming Cisco’s acquisition program. In an effort to eliminate some ofCisco’s macroeconomic risk, we recommend that Cisco acquire a customer premises, ormodem, maker. Additionally, we believe that Cisco must continue to acquire small opticalnetworking firms. Third, we believe that Cisco must prudently use more of its resources toprevent another inventory crisis.

Company History

Cisco Systems was created by two Stanford University computer network managersin 1984; the company literally started in a garage. Although both of the networkmanagers had email, they could not email each other because they were in differentdepartments with incompatible Hewlett-Packard computer networks. Realizing thatthey were not the only people facing this frustrating inefficiency, they joined withthree engineers to eliminate the barriers between different servers. The networkmanagers were on to something. At the time, engineers around the world weretrying to improve the Internet and were confronted by the same problem, which wasa major hurdle to the Internet’s growth.

A team of engineers at Stanford created a device that could translate network trafficfrom one network to another. This “router” allowed the separate computer networksat Stanford to interoperate, and hence allowed the network managers tocommunicate by email. As other universities heard about the new device, theywanted routers for their own computer networks. The two network managers leftStanford and started Cisco Systems in their nearby home; they bought a usedmainframe computer to take orders over the Internet.

At the time, most of Cisco’s customers were educational institutions and technologyenthusiasts, not business pragmatists. Often times Cisco’s customers found Cisco,not the other way around. Eventually corporations began taking a chance on Cisco,one of the first of which was Boeing. Demand for Cisco’s networking solutions wasbuilt by word-of-mouth, not by a sophisticated marketing program.



On April 20, 1990, Cisco became a public corporation with a market capitalization ofapproximately $300 million. At that point, Cisco dominated the market with morethan 85% market share.i Cisco’s only other competitor was WellfleetCommunications, which would eventually merge with SynOptics to become BayNetworks.

Cisco benefited greatly from its first-mover advantage. When routerscommunicated with other routers, they would typically use a proprietary protocol.Moreover, Cisco and Wellfleet used different network management, which mademanaging a multivendor network unnecessarily difficult. Because of these highswitching costs, once a company or industry began buying from one vendor, thechance that they would even consider a different provider was small. The routermarket was growing at a blazing pace; the annual growth rate was over 180%during the fourth quarter of 1990.ii

While Cisco was focused on the router market, the other half of the future BayNetworks, SynOptics, was pioneering a technology called intelligent hubs. Intelligenthubs were a solution to the in-line structure of computer networking. The problemwith in-line networking was that when one computer anywhere on the line wentdown, so did the whole network, like a string of Christmas tree lights. Xerox haddeveloped a better way to wire computers using a hub-and-spokes architecture.This way if one box became disruptive it could be detected and shut off from the restof the network. The device at the center of this architecture was the intelligent hub.

Because intelligent hubs gave new power to network administrators, the operatingcost of the computer network decreased considerably. Although hubs were new,they were much easier to connect to existing infrastructure than were routers. Theyrequired little new wiring and just a few tweaks to network cards located in theindividual computers on the network. Hubs ran into scaling problems, however, andat some point, hubs must plug into routers. Moreover, network-to-networkconnections over a Wide Area Network (WAN), could only be provided by a router.Essentially, routers and intelligent hubs became strong complements.

An analysis of the intelligent hub market reveals that the hub market was quitedifferent from the router market. First, the two major players in this category,SynOptics and Cabletron, each had a significant chunk of the market in 1990,approximately two-thirds and one-third of the market, respectively. More important,however, was the fact that the critical interface was “set by an industry standard –the Ethernet protocol – and not by the hub device or its maker.”iii Hence, while thetechnology inside the box may differ significantly, all hubs can talk to the networkusing the same language, and thus, there are much lower switching costs.

While Cisco did not enter the market for hubs, the success of the hub marketcontributed to Cisco’s dominance in the router market. When companies build acomputer network, they build from the bottom up: first PC’s, then hubs, and last,routers. Cisco capitalized on this decision making process by making marketingagreements with the three intelligent hub manufacturers that comprised the wholemarket: SynOptics, Cabletron, and Chipcom. In fact, at one point, SynOptics and



Cisco considered merging, but ultimately, it would be SynOptics and Wellfleet thatwould merge to create Bay Networks.

As the networking industry experienced tremendous growth, bandwidth, or lack of it,became a serious problem. Hubs did nothing for bandwidth, they just increasedmanageability. While routers increased bandwidth, they were expensive, not veryfast, and the complexity of their management grew exponentially. Networksrequired a new device that had the simplicity of the hub, but the brains of a router.The product that would meet this need was called a Local Area Network (LAN)switch. In ethernet networks, every packet of information shares the bandwidth withall other packets. With a LAN switch, network managers could relieve the congestedwires by giving high-volume users their own share of the bandwidth and leaving therest for less frequent users to share. The best place to place switches was rightbehind the hubs. It would turn out that switches could replace hubs completely.

In September 1993, Cisco acquired Crescendo Communications, one of the manyprivately held LAN switch vendors. The deal was important for two reasons. First, itwas an endorsement of the switch market, which was relatively small compared tothe router market, and would catapult the switch beyond the intelligent hub.Secondly, it was Cisco’s first acquisition and represented Cisco’s willingness toleverage its strong equity valuation. Cisco would go on to buy Kalpana and GrandJunction, securing its place as the dominant LAN switch provider.

As networking began to replace mainframe computers, the Internet and emailbecame an increasingly important resource for businesspeople. Having access tothese services was vital for professionals, even when traveling. While corporatenetworks may have direct lines to the Internet, everyone else, including executiveson the road, need a remote access device to get online. Remote access devicesallow computers to communicate with one another over the Internet. The mostcommon example of a remote access device is a modem.

Managing answering of the growing number of a modems became highlyproblematic. Engineers at Ascend Communications and U.S. Robotics createdremote access concentrators to manage the huge number of individual modems byintegrating them into one device. Cisco entered the access market in 1996 when itbought Telebit, a small player in the access market. Cisco went on to acquire ArdentCommunications in 1997, and Fibex Systems and Sentient Networks in 1999.

In 1996, Cisco bought StrataCom, a leading maker of high speed asynchronoustransfer mode (ATM) and Frame Relay switching technologies. This acquisitionenabled it to provide end-to-end networking solutions for public, private, and hybridnetworks.

Cisco’s most recent major market move was into optical networking. As usual, it didso with strategic acquisitions. In 1999, Cisco acquired Cerent and MontereyNetworks, entering it into the market for optical routers and switches. By doing so,Cisco was taking on telecommunication providers such as Lucent and Nortel.



In early 2000, Cisco purchased Pirelli Optical Systems. The acquisition was Cisco'sfirst entry into the dense wave division multiplexing (DWDM) market. DWDM is aninnovative technology that substitutes different color light waves for electronicpulses to dramatically increase the capacity of broadband networks carrying acombination of phone, Internet, and video traffic.

At that time, the network equipment industry was experiencing a tremendous boom.In its October 2000 quarter, Cisco reported year-to-year revenue growth of 66%. Itwould go on to have revenue growth of 55% in its next quarter. The beginning ofthe new millennium, however, brought with it decreased spending on networkingequipment. Cisco’s revenues fell 4%, then 25% and were down a full third by itsOctober 2001 quarter.

Along the way, Cisco would take the largest inventory write-down ever: $2.2 billionin May 2001. The write-down was due to ordered components that the companycould not use. The event was especially embarrassing because of Cisco’s pastpublicity of its extensive real-time information system. The company claimed itssystems were so responsive that it could close its books in a given 24 hour timeframe. Essentially the system got locked in a loop. Cisco management made largecomponent orders during the boom. The orders were based on forecasts from thesales force; what the company didn’t notice was that those projections wereartificially inflated. Because the demand for equipment was so high, many of Cisco’scustomers would order network gear from more than one provider with no intentionof making more than one purchase. The tighter the market got, the more Cisco’scustomers double and triple-ordered and the more inflated the sales forecastsbecame. The bubble was destined to burst.

Cisco’s acquisition program peaked with its revenues in 2000, during which itacquired twenty-three companies. Since then, Cisco’s acquisition program hasslowed dramatically. The company made just two acquisitions in 2001, and has yetto announce an acquisition this year.

Peaking along with its acquisitions and revenue was Cisco’s market capitalization.The company reached a market capitalization of more than $400 billion in 2000. Asthat year ended, Cisco’s market cap began its slide from which it has not recovered.Today the company is valued at roughly a third of its former valuation.

The force behind this wild cycle was telecommunication service providers. Theirequipment spending grew by 81% in 1999 and 70% in 2000 to more than $17billion. iv The service provider market was considerably weaker in 2001. “As theeconomy weakened, carriers’ access to capital dried up, and expenditures onnetworking gear dropped sharply.”v

Sales to the other core group of networking equipment customers, corporations,experienced less volatile fluctuations. Sales to the sector grew at a rate in the mid-teens during the last few years of the decade, only to slow in 2001 because of theweak economy. Cisco has remained true to its beginnings, still doing a largemajority, 80%, of its business over the Internet.vi



In response to tougher economic conditions, network equipment providers have hadto restructure. Cisco laid-off approximately 8,500 people in May 2001. Additionally,the company restructured its engineering department around technology groupsrather than line of business.

All told, Cisco is positioned as an industry leader in an industry experiencing its worstdecline yet. While signs of an improving economy are becoming more abundant, themost optimistic forecasts predict growth rates only a fraction past rates.



Internal Rivalry

Industry

Cisco Systems is the worldwide leader in networking for the Internet. Cisco providesInternet Protocol-based solutions that are the backbone of the Internet and mostnetworks, be they corporate, education, or government. The company offers thebroadest line of solutions for transporting information, whether it is data, voice, orvideo, allowing people to access or transfer information without regard to differencesin time, place, or type of computer system. Over the past decade, the Internet andcomputer networking have become a vital part of business, learning, communicationand entertainment. Demand for Cisco’s products is driven by the adoption of theInternet and web-based applications in an effort to increase productivity. Practicallyall data passing over the Internet goes through a piece of Cisco equipment.

The networking equipment industry is made up of four sectors: LAN switches,routers, access, and Wide Area Network (WAN) equipment. LAN switches make upnearly a quarter of the industry’s revenues. Routers include both data and data andvoice routers and account for approximately one-eighth of industry revenues.Access equipment includes access concentrators supporting ISDN, cable and digitalsubscriber line access multiplexors and customer premises equipment, or cable andDSL modems, and provide 16.5% of the industry’s revenues. WAN equipment is abroad category including WAN switches and WAN routers, and loug-haul equipment;the category comprises nearly half of the networking equipment industry. The belowtable gives a brief summary of the market.

Worldwide Networking Equipment Market4th quarter 2000 3rd quarter 2001

Product Revenue (Mil.) Mkt. Share Revenue (Mil.) Mkt. ShareLAN switches $3,812.2 22.5% $2,529.6 24.3%Routers $1,885.7 11.2% $1,254.7 12.0%Access $2,750.9 16.3% $1,716.6 16.5%WAN $8,457.4 50.0% $4,920.5 47.2%Total $16,906.2 100% $10,421.4 100%Source: Dell’Oro Group.

This report will focus on Cisco, but will analyze other companies to the extent thatthey impact the strategy of Cisco Systems.

Product

The principal activities of Cisco Systems are to design, develop, manufacture andprovide technical support of networking products and services. The companyprovides end-to-end networking solutions for customers. Its products includerouters, LAN and ATM Switches, dial up access servers and network managementsoftware. Cisco provides a broad line of solutions for transporting data, voice, andvideo within buildings, across campuses, or around the world. The company’s



solutions allow networks, both public and private, to operate with flexibility, security,and performance. The primary customers of Cisco include corporations, governmentagencies, utilities, educational institutions, a growing number of medium sizedbusinesses and other consumers. Switches accounted for 42% of fiscal 2001revenues; routers, 34%; service, 11%; access, 9%; and other, 4%.

Routers are responsible for transporting information from one network to anotherand are considered intelligent devices. They serve as the Internet’s post offices andthe traffic managers of private networks run by telecommunication companies.Cisco’s routers include the Cisco 12000, 10000, 7600, 7400, and 7300 SeriesInternet Routers and the Cisco 3600, 2600, 2500,1700,1600, and 800 SeriesInternet Routers.

Switches are boxes that filter and forward data packets between local area networks(LANs) and wide area networks (WANs). Cisco’s switches support a number oftechnologies including Ethernet, Gigabit Ethernet, Token Ring, and asynchronous andthen transfer mode (ATM). Cisco’s line of LAN switching products is called theCatalyst Family. The Cisco IGX, Cisco BPZ, and Cisco MGX Families are its lines ofWAN switches.

Cisco provides installation and consulting services on all of its products through itsInternet Business Solutions Group (IBSG).

Cisco also manufactures a number of access products. They allow network providersto offer high-speed data and voice services to residential and home office markets.Products in this area include the AS5000 family of access servers, the Cisco 3800,3600, and 2600 access routers, digital subscriber line multiplexors (DSLAMs), andthe Cisco uBR7200 Series Universal Broadband Router cable head-end equipment.

Cisco also creates software for its hardware products. Its Internetwork OperatingSystem (IOS) provides a common platform across networks. Since the software issold with the hardware, it is not possible to disaggregate the sales numbers.

Geography

Cisco has operations mainly in the United States, Japan, Europe, the Middle East,Africa and Asia. During fiscal year 2001, 60% of sales were in the Americas, 25%were in Europe, the Middle East and Africa, 9% were to Asia Pacific and 6% were toJapan.

Rival Firms

Cisco is involved in a number of different markets and dominates nearly all of them.Its market share, however, depends on how one slices the market. We will dividemarket into switches, routers, access and Wide Area Network (WAN) equipment.



Ethernet switches represent approximately a quarter of the entire networkingequipment industry. Cisco is dominant in this market with a more than 60% share,representing its largest source of revenue.

Market Share in Ethernet Switch MarketCompany 4th Quarter 2001Cisco Systems 60.2%Nortel Networks 7.3%Enterasys 5.0%3Com 4.6%Extreme 3.9%Source: Dell’Oro Group. http://www.delloro.com/PRESS/PressReleases/ES021502.shtml

Predictions for the ethernet switch market expect meager revenue growth of 2.4%.vii

While sales of switches are expected to grow in the low double digits, aggressiveprice competition is expected to limit revenue growth. Growth in this market isexpected to stem from the acceleration in the migration from fast ethernet (10/100Mbps) to gigabit ethernet, new ten-gigabit ethernet switches, and a broaderacceptance of Layer 4-7 switching, technologies used to balance server loads.

Cisco’s second largest source of revenue is routers. The router market and Cisco,almost synonymous due to Cisco’s dominant share, experienced a slight recovery inrevenues with growth of 5.2% over the previous quarter during the third quarter of2001.

Market Share in RoutersCompany 3rd Quarter 2001Cisco Systems 91.0%Juniper Networks 4.0%Nortel Networks 1.6%Unisphere 1.1%Others 2.2%Source: Dell’Oro Group.

The recession in the U.S. economy and product transitions are the two factorsresponsible for the overall slowdown. The rebound in the third quarter of 2001 isdue to strength in enterprise class routers, which rose at a double digit rate.viii

Forecasts for the router market expect revenues to fall to $7.5 billion in 2002 from$7.8 billion in 2001.ix

The one market in which Cisco is not dominant, in fact not number one, is the accessgear market. Cisco comes in second behind Alcatel with an 11% market share.Cisco’s position represents a steep fall from its 17.4% market share in the thirdquarter of 2001. Revenues in the sector fell 21% during the third quarter of 2001 to$1.7 billion.x

Market Share in AccessCompany 3rd Quarter 2001



Alcatel 18.6%Cisco 11.0%Siemens 10.8%Lucent 7.2%Sumitomo 6.0%Motorola 5.2%Samsung 5.2%Terayon 3.7%3Com 3.3%Orckit 2.0%Others 26.9%Source: Dell’Oro Group

The outlook for access equipment varies among devices. Direct subscriber line (DSL)access concentrators are expected to fall from revenues of $3.6 billion in 2001 to$3.0 billion in 2002. The forecast for dial modems is consistent with its continualdecline in 2001: revenues to decline 30% from $1.0 billion in 2001 to $700 million in2002. Last, cable access concentrators are expected to experience rapid growthfrom $300 million in 2001 to $500 million in 2002. xi As a whole, the access gearmarket should experience robust growth over the longterm as the number of endusers seeking high-speed Internet access continues to grow.

In the market for WAN equipment, Cisco remained the leader, despite its loss inmarket share.

WAN Equipment (Routers & Switches) Market ShareCompany 4th quarter 2000 3rd quarter 2001Cisco Systems 35% 32.0%Nortel Networks 21% 19.0%Lucent Technologies 15% 16.1%Juniper Networks 12% 12.4%Alcatel 7% 11.4%Source: Dell’Oro Group.

Cisco’s strength in this market is due in part to its commanding, although weakened,position of the market for long-haul routers, in which it has a nearly 70% share.xii

Weakness in the WAN switch and router market was due to general economicweakness and product transitions. The weakness broadened, though, because ofsubstantial investments in the past few years resulting in overcapacity. The size ofthe market fell nearly a third on a year-over-year basis to $1.4 billion. Analystspredict WAN switch revenues to fall to $3.5 billion in full-year 2002 from $4.0 billionin 2001.xiii

Herfindahl Index

Using the data above, we estimate the Herfindahl indices in the markets as definedabove. These numbers suggest highly concentrated markets in LAN switches,



routers and WAN equipment. The exception is the access market, which wecharacterize as relatively unconcentrated.

Sector Herfindahl IndicesSector Herfindal Index

LAN Switches 3700Routers 8300Access 754WAN equipment 1906

Although many of the sectors are concentrated, the threat of a new product or newtechnology keeps each highly competitive.

Product Differentiation

Cisco’s differentiation originates from the breadth of its product offerings. This is acritical advantage as customers will always prefer complete end-to-end networkingover hiring several firms to do it piecewise.

Strategies

Cisco’s strategy has always been to make its equipment versatile enough to workwith any networking protocol, while still enabling it to be optimized for Internettraffic. As Chris Lawler, a vice president of Unisphere, said, “Cisco was verysuccessful at supporting every protocol known to man”.xiv

During the late 1990’s Cisco started extending credit to many telecommunicationsstart-ups. The motivation behind the financing was driven by fear. Cisco, and manyother equipment providers, reasoned that if they didn’t extend generous financingterms, someone else would, and that would cost the company the “relationships withthe likely purchasers of the equipment vendors’ next-generation offerings”.xv Ciscohas an estimated $2.4 billion in loans outstanding, a substantial fraction of whichmay not be recoverable, given the financial woes of many of these companies today.

Cisco has always been focused on enterprise sales. Cisco’s biggest rival, JuniperNetworks has focused on telecom-service providers, a strategy which has hurtJuniper given the current slump in telecom spending. Evidence can be found inCisco’s second quarter results: while orders were “relatively flat” from businesses,orders from telecommunications companies fell by roughly 15% during the secondfiscal quarter of 2002.xvi

Cisco has long been an active acquirer in an effort to add key technologies. Thisstrategy has proved useful as Cisco has expanded from primarily being a routermanufacturer to also being a player in switches, optical networking, and a number ofnewer technology markets including wireless.

In fact, Cisco sees its growth coming from these new markets. Although Cisco’srouters and switches lie at the heart of the Internet and many corporate networks,



the company has not yet come to dominate the optical telecom space. Cisco has hadmore success selling through telecom service providers than to them (seeStrengths). Nonetheless, Cisco is convinced that the “next generation oftelecommunications networks will move to its specialty, Internet Protocol.”xvii Itscompetitors in this space, Lucent and Nortel, which control the market, employ atechnology called asynchronous transfer mode (ATM).

With the slowdown in the economy, Cisco’s bottom line has felt the pressure. Ciscohas undertaken a variety of cost cutting measures. Besides laying off workers, thecompany has cut research and development spending by approximately 20%.Additionally, Cisco has essentially ceased its acquisition program.

What truly differentiates Cisco’s strategy from that of most manufacturers, however,is its network business model. By “network” here, we do not mean Cisco’s products,but rather the idea that “companies go far beyond outsourcing and actuallycollaborate in the delivery of products and services to customers.”xviii Cisco is what iscalled a “network orchestrator,” in that Cisco is the maestro, or overseer, of thenetwork. The idea is essentially that by owning fewer assets and leveraging theresources of its network partners, Cisco will “require less capital and return higherrevenue per employee than do conventionally run companies, and [will be] betterable to weather the damage usually inflicted by market volatility.”xix While Cisco’sstrategy is different than most manufacturers, it is not unique. Other networkorchestrators include Charles Schwab, CNET Networks, eBay, Palm and Qualcomm.The strategy allows Cisco to concentrate on product development and marketing andexempts it from much of hassle of maintaining inventory.



Substitutes and Complements

Essentially, there are no close substitutes for networking equipment. Sincenetworking enables communication and data transfer, the closest substitute is a faxmachine or a phone and the mail system. These substitutes are poor, however,because they cannot offer the unique feature of a network: the ability to access ortransfer information without regard to differences in time, place, or type of computersystem.

The primary complement to networking equipment is the personal computer (PC)itself. Without the PC, there would be no need to network. To that extent, fastercomputers with larger hard drives and more memory complement networks, becauseeach makes the other more effective. Advances in PC hardware and software resultin demand for more bandwidth, which requires new networking equipment. Fasternetworks can best be taken advantage of by faster PCs, and hence the cyclecontinues. The switch from earlier computer systems in which many users wereconnected to a large host computer, to client/server based computing is largelyresponsible for creating the networking equipment market.

The other obvious complement to networking equipment is the Internet. As theInternet becomes a more important part of everyday lives, more Cisco networkingsolutions are required to direct information over wires. Analysts estimate that thenumber of people using the Internet will double from 500 million to one billion by2005.xx

Other technologies also complement networking equipment. Intranets, or privateinternal networks based on Internet programming standards, require networkequipment, just as does the larger scale and public Internet. Client/serverapplications are another example, as they would not be possible without a network.Peripherals also complement a network, as the need for more than one PC to attachto a peripheral creates the need for a network.



Entry

In the current environment, entry into the networking industry is not an issuebecause of depressed profits. Nevertheless, when dealing with technology, makingany statement with certainty is a display of hubris. Additionally there are few formalbarriers to entry in the networking equipment market. On the other hand, webelieve, that with the exception of a completely new technology, entry is unlikely. Wewill limit our focus to analyzing the factors that will prevent entry.

The networking equipment industry has significant economies of scale. That is, thereare extensive diminishing marginal costs in the industry. To produce one unit, acompany must develop a successful technology, and in the process manyunsuccessful technologies, which requires a large capital investment. Once they havethis technology, however, the cost of producing individual boxes is minimal incomparison. In this sense, the networking equipment industry is analogous to thepharmaceutical industry.

There are also economies of scope in the networking equipment industry. That is, itis much easier to have one equipment maker provide a complete solution than doingit piecewise because of the various communications that must take place between thedifferent components. This is more true when there is proprietary technologyinvolved, for example in the router market. Cisco gained the ability to offer end-to-end networking solutions when it acquired StrataCom. Because there are economiesof scope, even if an entrant creates a better product than Cisco, it at least will have towork with Cisco equipment, but more likely will have to offer better products in anumber of different markets

Along these lines, Cisco’s past, an essential part of which is its first mover advantage,gives it an advantage over new network equipment providers since buyers want to beassured that the company will be around to service and install updated equipment.



Buyer and Supplier Power

Buyer Power

Since the economic slowdown, there has been a consolidation of buying power. Withmany upstart telecommunications companies, formerly Cisco’s biggest customers,now in bankruptcy proceedings, Cisco now must market to more conservativepurchasers such as the Baby Bells. The equipment industry was unprepared for thissudden concentration of buying power. In December 2000, Cisco told analysts thatthe top 50 companies in the world now control 80% of capital spending.xxi Thesenew customers value product reliability and a router’s ability to work with olderequipment, for example equipment in a phone network. These buyers are also mostinterested in a technique called clustering, already used by the old class-5 telephoneswitches in their networks. This change gives an edge to Juniper Networks (seeThreats).

While buyers have consolidated, the networking equipment industry is much closerto a monopoly than a monopsony. Raw evidence of the concentration in networkingequipment providers can be seen in the Herfindahl indices above. As there are fewsubstitutes to Cisco’s products, we expect Buyer power to remain a non-issue.

Supplier Power

Suppliers to Cisco Systems are suffering from the economic and technologyinvestment slowdown as much as Cisco is. The markets that Cisco buys equipmentfrom tend to be fairly competitive, limiting supplier power.

One example is Jabil Circuit Inc., a contract manufacturer, whose earnings fell morethan 90% during its fiscal second quarter.xxii Jabil has been hurt by the slowdownand the fact that many of its customers, including Cisco, had excess Jabil inventoryon hand.xxiii

In summary, we do not feel that suppliers will be able to extract rents from Cisco;that is, supplier power is weak.



Strengths, Weaknesses, Opportunities andThreats

Strengths

Cisco’s main strength is its market dominance. Cisco dominates nearly every marketit has entered. From this success comes Cisco’s other strengths, such asrelationships with customers and strategic alliances.

One such relationship was created by Cisco in December when it formed a broadalliance with Sprint. The pair were just hired by Case Western Reserve University todeliver a wireless Internet network that will encompass 94 buildings by next year.xxiv

Another of Cisco’s strengths is its sales force. Its heavy use of e-learning applicationsmakes the cost of training almost half of instructor-led training. In fact, Sales &Marketing Management magazine rated as having the “best-trained sales force”across all industries in the U. S.

An intrinsic strength of Cisco is its humility. Despite its dominance over thenetworking space, it “is willing to recognize that it can’t out-innovate the market.”xxv

This humility has led to a legendary acquisition program through which Cisco hasmade more than sixty acquisitions over the past five years. Chief among them wereits 1996 acquisition of StrataCom, a leading maker of high speed ATM and FrameRelay switching technologies. Cisco has also made acquisitions in an effort tointegrate become a larger player in the optical networking market. Late in 1999,Cisco bought Cerent Corp. and Monterey Networks, entering it into the opticalnetworking market. Its acquisition of Pirelli Optical Systems in early 2000 is anotherexample.

Weaknesses

One weakness of Cisco is also one of its sources of strength. With the networking-equipment market switching over to a new customer base, Cisco’s size means that itmay lose a quickness advantage to smaller and more nimble competitors.

As Cisco has become the world leader in networking, its product line has becomecomplicated with a virtual cornucopia of features and releases. This mess hasconstrained the company’s ability to “update code, provide new services, and reactas quickly as smaller competitors.”xxvi In effect, Cisco’s technologies are becomingconvoluted.

A key vulnerability is Cisco’s software that serves as a traffic cop, guidinginformation to the appropriate destination as it travels along Cisco’s hardwarenetworks. Although Cisco is known for its router hardware, analysts say that Cisco islagging its competitors in creating software that “serves as the brain for thatequipment.”xxvii Hillary Mine, a vice president at Probe Research, believes the issue



is “a very tough challenge.”xxviii “It’s not only a key to Cisco’s turnaround, but if theydon’t get their house in order, they’ll be left behind.”xxix

Cisco’s smaller competitors have been effectively exploiting this weakness byoffering their own comprehensive technologies. As a Juniper spokesperson said, “Alot of our wins are based on software.”xxx

This problem is thought to have caused some defection in the company’smanagement team. Near the end of the last decade, Cisco became over-focused onsales and lacked a coherent equipment strategy. Former Chief Technology OfficerJudy Estrin pioneered an effort to simplify the company’s code, but was ultimatelyfrustrated by delays.

Cisco’s strategy of compatibility with any and all networking protocols has come backto stab the company in the back, creating a catch-22. While Cisco tried to make itsproducts appeal to anyone in need of a network, its smaller competitors have beendeveloping technologies that are optimal for certain businesses. One such exampleis at the edge of networks, often where a service provider intersects with its businesscustomers. In this subspace, Unisphere has quickly become a viable alternative toCisco. Market researcher Dell’Oro Group reports that the company has captured10% of this market.xxxi More importantly, Juniper has claimed 30% of the high-endrouter market that Cisco used to control almost exclusively.xxxii

Cisco would like to become a bigger player in optical networking. Unfortunately,telecom providers are expected to cut spending on equipment by anywhere from10%xxxiii to 30%xxxiv this year. Says William Nuti, a Cisco senior vice president, “Anytime there’s that kind of upheaval, you’re going to be giving up opportunities withcustomers.”xxxv Although forecasts for the economy have grown rosier, analystsexpect the telecommunications industry to be hurting for a long time. Some believethe trouble is so deep, it will hamper the overall economic recovery from last year’srecession.xxxvi

As mentioned above, one of Cisco’s strategies in the late 1990’s was to financestartup telecommunications companies in hopes of developing a profitablerelationship. That strategy, however, turned out to be less than rewarding. Many ofthose startups are now near bankruptcy. One such example is Velocita Corp. Ciscoloaned the company $285 million to purchase Cisco equipment and took a $200million equity stake in the firm.xxxvii Velocita has laid off 75% of its work force in arestructuring.

Opportunities

While telecom capital spending is expected to fall up to 30% this year, the high endrouter market should remain moderately attractive.xxxviii Although data traffic is notgrowing at the multiples at which it used to, it is expected to grow 80% to 100%yearly.xxxix Hence, communications carriers such as the Baby Bells will need newequipment to grow and replace older and slower boxes.



While the industry is clearly in a slump, Cisco’s financial position remains relativelyhealthy. This is detailed more extensively below.

Threats

One threat to Cisco is Juniper Networks’ new router, the M320. The router is fasterthan Cisco’s current competitor, the GSR 12416, and is expected to hit the marketthis month. Cisco has not yet gone public with its response to the new router.Juniper hopes the new router will give it an advantage in light of the change in thecustomer base of network-equipment providers (see Buyer Power). The new routercomes with a unique clustered arrangement, what analysts call a hub-and-spokelayout. While the router has been testing for the past several months, the clusteringtechnology is still under development. Juniper’s advance in this area has spurredother competitors to challenge the new technology. Joseph Kennedy, the CEO ofPluris, touting his company’s clustering technology says the hub-and spoke design isflawed.xl Because all traffic must travel through the hub, the system is susceptible tofailure for the same reason as airlines with hubs in Rocky Mountain locations in thewinter. If the central hub goes down, the system goes with it.

Regardless of which technology is better, both companies appear to be ahead ofCisco. Cisco has had episodic development efforts, presently calling a confidentialproject “Q.”xli Cisco says it is continuing to work on multichassis designs, in whichmultiple-router chassis are linked together, but has publicly doubted that few if anynetworks are large enough to require such a design.xlii

We feel that Cisco’s skepticism could leave it flat-footed in the race for the newtechnology. David Siegel, a director of IP engineering at Global Crossing Ltd. believescompanies are in a “never-ending search for the low cost, highly availablenetwork.”xliii

The success of Cisco’s strategy should be apparent in late spring. That month, manylarge telecoms are expected to place orders for networking equipment, showingwhether or not Cisco has lost share to its smaller competitors.

Another threat to Cisco is French equipment maker Alcatel. The company isappealing to customers’ desire to repeal Cisco’s market dominance. Says OlivierHoussin, president of Alcatel’s eBusiness group, “Everybody is afraid of an arrogant,dominant, Cisco… Customers are begging for a strong alternative.”xliv



Financials

Cisco has one of the strongest balance sheets of any company in the world, sittingon a hoard of cash amounting to roughly $21 billion. Despite this, the equity marketshave been undecided on Cisco stock, given its mixed results for the trailing twelvemonths. Cisco has a beta of 2.00, which can be seen by the heavy fluctuations in thechart below:

Indeed, Cisco has been stuck in the mid-teens for the most part for the ttm. For thefiscal second quarter, Cisco announced earnings of $660 million, far exceedingprevious projections. However, this was viewed negatively by the market as theoutlook for the fiscal year was downgraded. The $660 million profit was a 24%decrease from the same quarter for last year.

Cisco’s market capitalization has plummeted from its high of over $400 billion, andcurrently stands at $119 billion. Briefly, Cisco was the most valuable company in theworld, displacing Microsoft, but those days are gone.

Accounting worries have recently weighed negatively on Cisco stock as well. Thecompany is known for its “aggressive” accounting methods, and has come underclose scrutiny in the post-Enron era.

As mentioned above, the company has a very strong balance sheet and is highlyliquid. The company carries no debt and has a current ratio of 1.64. Its quick ratio, ameasure of very short-term financial health, is a strong 1.44. For the most recentquarter, Cisco generated an impressive $1.69 billion in free cash flow, meaning thatthe market expects growth to average about 17% annually in perpetuity.xlv

Company executives have claimed that growth of 30% per annum is expected forsome time still, but many feel these numbers are unreasonable. It is worth



mentioning that these numbers are based on pro-forma numbers, which do notreflect extraordinary items, etc.

Cisco’s financial health suggests that a significant cash acquisition could be pulled offrather easily. The company’s recent lack of acquisition activity is likely attributable toits depressed stock, as the trend for tech companies is to acquire companies withovervalued equity rather than cash. However, Cisco is unique in its financial position,and we feel that targets should be considered with cash.

Valuations of Cisco are slightly above industry averages, but this is probablyreasonable for a company of Cisco’s health. It is selling for approximately 17x FreeCash Flow, and 7.6x sales. Earnings for the ttm are negative, so the earningsmultiple is not meaningful.

Again, we feel that Cisco’s strong balance sheet warrants possible acquisitionactivity.



Strategic Analysis: Capturing Market ShareDuring an Industry Slump

Summary of Current Position

As it stands now, Cisco’s stock price is depressed for a number of reasons, one ofwhich is its alleged aggressive accounting practices. There are also questionsregarding Cisco’s exposure to financing various telecommunication start-ups. Thestock has not recovered since Cisco announced its $2.2 billion inventory write-off inMay 2000. Cisco’s acquisition program has slowed sharply, and the company issitting on approximately $20 billion in cash. Cisco sees its growth coming from theoptical networking sector, which is severely depressed. While Cisco has been largelysuccessful in the enterprise market, 3Com’s recent exit is evidence, it has been lesssuccessful marketing to telecom providers. A number of Cisco’s competitors aresuffering because of the slump in telecom spending, which is not likely to recoveranytime soon. As Cisco’s results in recent quarters have been lackluster, thecompany has felt pressure to cut costs, which Cisco has done a number of ways,including cutting R&D. A look at the bigger picture reveals that Cisco’s success isvery sensitive to the overall domestic economy.

We propose to management an three plan. The first component of our plan isfocused on increasing research and development in two key areas: opticalnetworking and router software. The second component involves resuming Cisco’sacquisition program. In an effort to eliminate some of Cisco’s macroeconomic risk,we recommend that Cisco acquire a customer premises, or modem, maker.Additionally, we believe that Cisco must continue to acquire small optical networkingfirms. Last, we believe that Cisco must prudently use more of its resources toprevent another inventory crisis.

Strategy going Forward

We feel that Cisco is overemphasizing short term results at the cost of greater longterm profits. This is evident in Cisco’s strategic decisions. The company has cutR&D while its sits on nearly $20 billion in cash. Additionally, the company has notcontinued its successful acquisition program, despite earlier statements that it would.Essentially, we feel that Cisco is being too passive in number of areas. We believethat Cisco ought to lever its current dominance by being more aggressive in makingacquisitions, acquiring new technologies, and spending money on its own research.The third and final prong of our plan confronts inventories.

Research and Development

Cisco should not be cutting research and development funds. While the company’srecent financial performance has been far from stellar, Cisco is in a strong positionrelative to its competitors. Although investments in R&D now will diminish Cisco’scurrent bottom line, they will maximize shareholder value. Cisco is playing passive atthe precise time that it needs to invest heavily to gain share in critical markets.



One such market is the market for optical networking. Cisco’s main competitors inthis area, Lucent and Nortel, are suffering much more than is Cisco from theeconomic downturn. Cisco must position itself well for eventual turnaround in theindustry. Given that Cisco’s competitors have supplied this industry for many moreyears than has Cisco, Cisco will need to compete on non-price characteristics. Thatis, we believe Cisco will have to offer a better product to gain share. Given Cisco’sstrong financial position, we believe that in-house investment is a viable way for it toimprove its offerings in this sector.

The other critical market that Cisco must focus on is router software. Routers areCisco’s original core competency. Cisco started ceding share, however, to JuniperNetworks in 2000. Cisco was caught off guard as Juniper offered a faster new high-end router at the precise time the service provider market transitioned to higherspeed networks. Juniper now claims approximately 30% of this market. While Ciscohas had some success recently in regaining share, we believe the Juniper storyshould serve as a cautionary tale to Cisco. If Cisco is to continue its dominance as anetwork provider, it must be at the leading edge of new technologies. Increasedspending on R&D during an industry downturn is a many times proven successfulmethod of capturing market share.

In sum, we believe large investments in R&D now will pay off in the future in theform of new technologies and greater market share.

Acquisitions

We believe that Cisco must restart its acquisition program. Although it can no longerleverage a generous stock price, it can spend cash to buy companies that aresimilarly suffering from a sharp decrease in valuation. In other words, Cisco is notthe only company suffering from a much lower valuation, and it should capitalize onthe depressed valuations of acquisition targets. Cisco’s acquisition program hasbeen very successful in the past, and we see no reason why it cannot continue to besuccessful even though valuations are much lower. In fact, management has statedin the past that it would like to complete between eight and twelve acquisitions in2002, but the company has yet to close a single deal.

In making acquisitions, we believe there are a few specific areas that Cisco shouldspend extensive time analyzing to decide who to acquire. The current recession isCisco’s first since it has become one of the world’s largest companies. Clearly,Cisco’s valuation is heavily dependent on capital investment, which is highlycorrelated to the macroeconomic environment. In other words, Cisco is sensitive tomacroeconomic conditions. We believe that Cisco’s share price could benefit fromacquisitions in which the end-user is consumers and not large companies. That is,diversifying away macroeconomic risk should play a key role in Cisco’s acquisitionstrategy.

While ideally we would like Cisco to sell something whose sales are negativelycorrelated with sales of its network solutions, we realize that this is unreasonable.Let us make clear that we are not suggesting Cisco buy a company strictly fordiversification; synergies must be present to make the acquisitions successful. On



the other hand, Cisco could focus on subsectors that are less cyclical; we believe theaccess market is one example. In this sector, we believe Cisco should stronglyconsider acquiring a customer premises equipment maker. While naming potentialtargets is beyond the scope of this paper, we believe that acquiring a modem ornetwork interface card maker has two benefits. First, such an acquisition willdiversify away some of Cisco’s macroeconomic risk. Spending on modems, in whichthe price to the end user is under $200, is much less sensitive to the macroeconomicenvironment than is spending on routers, in which the price to the end user can be inthe hundreds of thousands of dollars. Second, such an acquisition will help Ciscogain share in the access market, one of the few markets it does not alreadydominate.

One theme of the networking equipment industry in the future will be convergence ofdata networks and voice networks. Eventually, voice, video, and data will all becarried on the same network. In an effort to stay competitive, many traditionaltelecom equipment providers have already acquired traditional data networkers;Northern Telecom acquired Bay Networks to form Nortel in 1998 and Lucent acquiredAscend Communications in 1999. While Cisco has made a number of keyacquisitions to gain voice networking technology, most notably Cerent, Monterreyand Pirelli, the convergence of these technologies has created new competitors forCisco. Given that Cisco’s current success stems from acquisitions it made intoswitching technology in the early 1990’s, we believe that Cisco must continue toacquire optical networking companies.

Inventory

Another major part of Cisco’s strategy needs to address inventory. Given whathappened in May 2000, Cisco’s share price cannot recover until Cisco convincesinvestors that their inventory problem is under control. Cisco’s solution to theproblem is found in eHub, a technology to be run by supply-chain integration firmViacore. The system is supposed to eliminate almost all human interaction. Thisreminds us of a facetious mathematical maxim “if brute force doesn’t work, thenyou’re not trying hard enough.” Essentially, we feel that while technology can helpCisco with its supply-chain, complete reliance upon a computer system is not ideal.After all, it is this mindset that put Cisco in the hurt locker that it is in now.

We believe that a system that uses technology, but that is tempered by humansentiments would serve Cisco better, given its past troubles. That is, we believeCisco must spend more human resources on managing its inventory. Although, thecost may seem unnecessary now, the benefits of eliminating the chance of anotherMay 2000 are invaluable.

Summary

In summary, we feel that Cisco is in a strong position relative to itscompetitors, although considerably weakened from the recent past, but that itscurrent strategy does not take advantage of this position. While the currenteconomy is not friendly to capital investment in networking solutions, Cisco can do anumber of things now to temper the downturn and enable it to capitalize on available



opportunities when the economy strengthens. By prudently investing in strategicareas, acquiring new technologies, and allocating more resources to inventoryissues, we believe that Cisco will enable itself to not only continue its dominance, butto strengthen its strategic position as the global leader in worldwide networkingsolutions.



i Moore, Geoffrey A, et.al. The Gorilla Game. Pg 210.ii Ibid. Pg 212.iii Ibid. Pg 216.iv Synergy Research Groupv Industry Surveys Computers: Networking. Standard & Poor’s. February 28, 2002.vi Hacki, Remo, and Lighton, Julian. “The Future of the Networked Company.” TheMcKinsey Quarterly. 2001, Quarter 3.vii International Data Corp.viii Industry Surveys Computers: Networking. Standard & Poor’s. February 28, 2002.ix Ibid.x Ibid.xi Dell’Oro Groupxii Dell’Oro Groupxiii Dell’Oro Group. http://news.com.com/2100-1033-837743.htmlxiv Heskett, Ben. “Crack’s in Cisco’s Empire.” CNET News.com. March 7, 2002.xv Buehler, Kevin S., et al. ‘‘Caveat Vendor.’’ The McKinsey Quarterly. 2001 Quarter3.xvi Thurm, Scott. “Cisco Tops Forecast With $660 Million in Profit.” The Wall StreetJournal. February 7, 2002.xvii Blumenstein, Rebecca and Zuckerman, Gregory. “Telecom Industry LeadersStruggle with Growing Debt, Overcapacity.” The Wall Street Journal. March 13, 2002.xviii Hacki, Remo, and Lighton, Julian. “The Future of the Networked Company.” TheMcKinsey Quarterly. 2001, Quarter 3.xix Ibid.xx International Data Corp.xxi “Juniper Ratchets Up Router Race; New Box May Crimp Cisco’s Share.” The WallStreet Journal. January 30, 2002.xxii Carrns, Ann. “Jabil Says Net Income Declined 91% In 2nd Quarter Amid TechSlump.” The Wall Street Journal. March 20, 2002.xxiii Ibid.xxiv Gaither, Chris. “Cisco and Sprint Venture has First Big Client.” The New YorkTimes. March 11, 2002.xxv Torres, Alberto. “The Next Tech Shopping Season.” ZD Net. January 16, 2001.xxvi Heskett, Ben. “Crack’s in Cisco’s Empire.” CNET News.com. March 7, 2002.xxvii Ibid.xxviii Ibid.xxix Ibid.xxx Ibid.xxxi Ibid.xxxii Ibid.xxxiii Gaither, Chris. “Cisco and Sprint Venture has First Big Client.” The New YorkTimes. March 11, 2002.xxxiv “Juniper Ratchets Up Router Race; New Box May Crimp Cisco’s Share.” The WallStreet Journal. January 30, 2002.xxxv Gaither, Chris. “Cisco and Sprint Venture has First Big Client.” The New YorkTimes. March 11, 2002.xxxvi Blumenstein, Rebecca and Zuckerman, Gregory. “Telecom Industry LeadersStruggle with Growing Debt, Overcapacity.” The Wall Street Journal. March 13, 2002.



xxxvii “Cisco Says Potential Velocita Loss Is Covered.” The Wall Street Journal. March21, 2002.xxxviii “Juniper Ratchets Up Router Race; New Box May Crimp Cisco’s Share.” The WallStreet Journal. January 30, 2002.xxxix Ibid.xl Ibid.xli Ibid.xlii Ibid.xliii Ibid.xlivKharif, Olga. “Time to Dial In to Cisco.” Business Week. March 22, 2002.xlv Calculation based on Cisco’s weighted average cost capital, which we derive fromthe Capital Asset Pricing Model.

Carnegie Consulting

Documents

Transcript of Carnegie Consulting