Ciscos softer side

Cisco Systems is not the largest of the network equipment suppliers, either in terms of revenues or employees. To many people's surprise, European behemoths Alcatel, Ericsson and Nokia are all bigger. But when it comes to influence, profile or column inches, none of these rival the US west coast giant.

The company's sway is clearly felt on the stock markets: back in early 2001, Cisco's unexpectedly poor results signalled the start of the tech industry's recession; and when the company released better than expected quarterly results in May 2002, the whole market lifted.

For nearly a decade, the company's influence has been felt even more directly in the venture market and among the many pre-initial public offering (IPO) companies that have 'get-acquired-by-Cisco' high up on their exit strategy list. Cisco exerts its will on networking technology development not just by the traditional method of strong-arming standards bodies such as the Internet Engineering Task Force (ITEF), but also by its capability to make or break entrepreneurial dreams. It even regularly briefs the world's top venture capitalists on which areas they should be investing in. As Cisco goes, so goes the networking industry – literally.

For years, analysts participating in its regular briefing sessions have been overwhelmed, not only by the charts showing how Cisco appears to be taking control of every sector that it takes seriously, but also by the mantra that the engaging CEO John Chambers preaches: listen to the customer. With rivals such as Ericsson, Lucent and Nortel Networks – big as they are – marginalised financially for now, Cisco seems to be in complete control of its sector and set to return to the double-digit annual growth rate its investors were accustomed to in the 1990s.

It may not, however, be as straightforward a proposition as it seems.

A&D timed out?

Cisco is a company to leaped to greatness by creating a disruptive technology. Its first generation of routers swept aside and ultimately destroyed mature networking technologies such as IBM's SNA – a multibillion dollar networking business that was so dominant that it became the subject of anti-trust scrutiny in both the US and Europe. From that base, the company became the driving force for a range of IP (Internet protocol) products that powered the Internet revolution.

But that was a long time back: critics say that Cisco has not yielded a knockout market winner from its internal research laboratories for many years. But by its own figuring, the company still depends on its core router and switch products for approximately two-thirds of its revenue. Cisco holds a dominant market share lead in those segments.

This, of course, is largely because it has favoured a different strategy that has been dubbed A&D – acquisition and development. Cisco has swallowed over 70 companies since 1993, mostly in all-share transactions that affected neither profitability (purchases were recorded as a ‘pooling of interests', meaning they were offset against profits) nor, in most cases, its share price. But while Cisco is largely admired for its ability to turn the new technologies and the employees of these acquisitions into revenue-generating units, observers still say it has failed to deliver a knockout punch since the 1996 acquisition of frame relay switch company Stratacom.

Does that matter?

The sacrifice of such a strategy, say industry experts, is lucidity and efficiency. As an example, Cisco, by its own admission, has a mind-boggling array of features and versions for its core Internetworking Operating System (IOS) – the software that runs its router based networks. This, say competitors and analysts, has created such a nightmarish tangle of software complexity for partners and customers that it may ultimately hinder the upgrade plans that Cisco is banking on for future growth. Some fast moving network equipment makers with simpler designs have been able to exploit this.

Another problem: financial analysts – and financial regulators – have become much more critical of the A&D strategy; the former are asking deep questions about underlying profitability; the latter are requiring acquisitions to be recorded against profits. The net result is that acquisitive companies such as Cisco must now be more choosy about who they buy, and how much they spend.

Nevertheless, it would be folly for investors and industry watchers to claim that Cisco is therefore weak and exposed in the networking market. The company had a market capitalisation of more than $90 billion (€98 billion) in mid-May 2002, no outstanding debt and approximately $21 billion (€23 billion) in cash and short-term investments.

But it is telling that the segments that Cisco dominates are still filled with competitors. More than a dozen companies are targeting its market share in edge routing technology, and several more go up against it in Ethernet switching. Even core routing, where Cisco had nearly a 90% share as late as 1998, attracts a healthy handful of competitors, including many recent entrants.

Compare this to the software industry's equivalent, Microsoft. It has many competitors for its ancillary product lines, but virtually none in its core desktop operating system and applications markets. Financiers and engineers must sense something about Cisco's positioning that offers at least a whisper of vulnerability.

So, where are the fissures? Analysts and competitors mostly point to the industry's growth areas, and note that, notwithstanding some attractive products and some powerful marketing, Cisco is either not dominant, or not a player at all, in any of them. In the enterprise networking market, these areas include wireless local area networks (W-LANs), enterprise voice-data integration systems and storage.

In the public network sector, where the company has set out an ambitious roadmap to become a leading supplier, Cisco has one market leading product line – its core routers. But even here, it faces genuine competition from California-based Juniper Networks. In other crucial areas, such as optical networking and packet network-to-public switched telephone network (PSTN) integration, it is trailing badly.

Indeed, much is made of Cisco's relative financial success versus its competitors, Lucent, Nortel and the European telecommunications giants, all of which are awash with debt. In a conference call announcing the company's recent quarterly results, CEO John Chambers proudly noted that Cisco grew an admittedly modest 7%, while its top competitors dropped a combined 43% in revenue.

That success, however, was the lucky result of its failures to make headway in the service provider market. Between 1997 and 2001, Cisco's primary marketing focus was the service provider market, consisting of a global army of telecoms and Internet companies keen to build out their networks to drive the broadband revolution.

But Cisco failed to break the incumbents' stranglehold, partly because it would not cede to carriers' demands for tailored solutions and partly because it was advocating a ‘big-bang' equipment-replacement strategy, while service providers were committed to a more gradual migration approach.

Having missed the telecoms spending boom of the late 1990s, Cisco was saved, ironically, by its very inability to become a leading supplier to the carriers.

Enterprise opportunities

Of all the possible growth areas in the enterprise sector, Cisco's conservative stance on W-LAN technology is puzzling many analysts. That conservatism is all the more confusing because, at recent Cisco events, it has proudly shown off its capabilities in this area.

After a number of notable false starts, IT decision-makers are slowly beginning to expect big things from W-LAN technology. Previous efforts, which offered data rates of up to 2Mbit/sec, were never really taken seriously by corporate network buyers, because they were slower even than the now aged 10 Mbit/sec Ethernet standard.

Recently, however, perfection of the IEEE's 802.11b standard, which allows for 10Mbit/sec connections, has raised hopes – especially given the increasing miniaturisation of the connected devices. The great market opportunity is perceived to be for home networking and public spaces, such as airports and coffee shops (see Broadband guerrillas, Infoconomist, February 2002). Analysts at market researcher IDC reckon that revenue from hardware supporting 802.11b – commonly referred to as Wi-Fi – will more than double from $1.5 billion (€1.6bn) in 2001 to $3.2 billion (€3.5bn) by 2005 in the US market alone. In Europe, to, enthusiasm is now gathering pace, with many seeing an opportunity for Wi-Fi networks to complement, if not challenge, 3G wireless UMTS services in certain areas.

In spite of all this, most Cisco-watchers say the company remains on the sidelines, reasoning that prices for the required network interface cards and transmission gear remains too high for wide-scale adoption. Some even speculate that Cisco is wary of upsetting wireless service operators, some of whom see public space Wi-Fi as a threat.

Another perceived untapped growth area is for packetised voice applications in corporations, as well as in smaller businesses – so called Voice over IP (VoIP). The technology to integrate voice and data applications is finally perfected, say technologists, and both cost savings and the prospect of new applications should now drive adoption. But while Cisco can claim a leadership stake in the piping required to set up IP voice calls, this is largely because they will run over its router and switch infrastructure. The applications and systems – from which much of the growth will derive – are a different story.

"The most room to grow is in voice applications, and Cisco is trying to change the game," says Steve Cramoysan of analyst Gartner. "Yes, they have a good story, but they don't figure in our rankings." The leaders in this area include Alcatel, Avaya, Ericsson, Nortel and Siemens.

Storage systems and storage-area networking are other proposed hot spots for enterprise networking growth, and Cisco is a relative newcomer to the technology. It clearly has big ambitions: the company recently ended its relationship with Brocade Communications Systems, the leader in the area of systems to mediate between the Internet Protocol (IP) network and storage systems, apparently because it is developing its own solutions. Now, Cisco is hinting that it will eventually like to provide the storage interconnection and switching systems themselves as well as the networking gear – a major departure.

"It will be a huge growth area for Cisco," says Dave Smith, Cisco's head of optical product marketing for Europe, Middle East and Africa. It will have to play catch-up to get that growth, however.

Finally, it is not a foregone conclusion that Cisco can even bank on its most likely source of growth – corporate upgrades of Ethernet infrastructure. It has been assumed that the rise of gigabit Ethernet switching would follow that of its predecessor, 100Base-T, as a replacement for older, slower systems. Gigabit Ethernet has, indeed, proved to be a generous source of revenue for Cisco: the technology accounted for roughly 25% of all worldwide Ethernet revenues in the first quarter of 2002, according to Dell'Oro Group, a California-based research company.

The catch? Gigabit Ethernet accounted for 25% of worldwide Ethernet revenues in the first quarter of 2001 as well. Cisco believes that the recession stalled upgrade plans, and there is now pent-up demand. But analysts also say that this demand might take a lot longer to convert into orders: "Two things have held gigabit Ethernet back: requirement and price," says Gartner's Cramoyan.

Dell'Oro analyst Seamus Crehan agrees; he cites gigabit Ethernet connections to corporate desktop systems as the untapped growth area in that market, but he still doubts that there is genuine demand for such power in the short-term.

The broadband condundrum

Just as it has been the ambition of the European network giants to sell more switching equipment to corporate accounts, it is Cisco's to move beyond its core market – the corporate buyer of routers and switches. While Cisco executives expect to grow their business on enterprise networking equipment upgrades, they know that true long-term growth will have to come from service providers.

The data networking bottleneck, according to conventional wisdom, lies between the enterprise and the public network – rather than within either of them The key to Cisco's success – and that of the industry as a whole – is the widespread adoption of broadband access, which will drive demand for core network upgrades.

"Carriers are deploying digital subscriber line (DSL) broadband services that do not exploit its full capabilities, so it doesn't deliver what customers are expecting," says Alain Fiocco, Cisco's director of product and technology marketing for core technologies. "SME [small and mid-sized enterprise] demand, however, will drive carriers to deploy richer services, which will have an impact on the edge and core."

Predictably, Cisco takes an optimistic view of its role in service provider recovery. "If they do invest in networks, they invest in packet networks," says Fiocco. That, of course, is where Cisco plays.

But according to another Cisco executive, this has not been a lucrative business lately, for obvious reasons. "Three years ago, large service providers had projects to convert their backbones to IP, and the operators have halted that," says John Baldwin, Cisco's service provider voice marketing manager. While the company – and, indeed, the industry – still believe that this convergence on IP will eventually occur, it is paying more attention to helping service providers deliver profitable, value-added IP-based applications from the infrastructure they already have in place.

And, again, this represents a game of catch-up for Cisco. Competitors such as Alcatel and Lucent are better positioned with carrier accounts to deploy the technology required to mediate between the IP infrastructure and the PSTN, offering a strategy of migration, not replacement.

"The real driver will be converged applications, not IP telephony," says Olivier Houssin, president of Alcatel's eBusiness Group. Cisco is not ignoring this opportunity. "Service providers are addicted to their traditional services," says Baldwin, "and we've worked very hard to come up to speed" with regard to IP-to-PSTN migration. The question is whether it is too little, too late to capture the revenues that will arrive when service providers inevitably start spending again.

The same is true for optical networking. While much has been said about the over-provisioned bandwidth in long-haul fibre-optic networks, many technologists still expect a large market to emerge for metropolitan-area dense-wave division multiplexing technology – essentially a way to get more power out of existing infrastructure without going through the time and expense of digging up streets and laying more fibre.

Despite internal efforts and millions of dollars of acquisition investment, Cisco still owns only 4% of the optical transport market (see charts, above), according to Dell'Oro Group. That means Cisco is missing out on a lot of money: that much-maligned market, at $2.8 billion (€3 billion) in the fourth quarter of 2001, is about as big – in the worst of times – as the entire router market. Faster progress in this market is essential if it is to meet revenue growth objectives.

Some in the industry hope and expect that it will be difficult for Cisco ever to be a significant supplier to carriers.

"There are no object examples of vendors being best of class in both carrier and enterprise markets," says Joe Furgerson, Juniper's vice president for strategy and product management. "Carriers are going to succeed, but in a downturn, where did Cisco go?"

Ultimately, Cisco's apparent vulnerability in important future growth areas, might trigger a big acquisition. It has a sizeable cache of money available to acquire its way out of holes, and its share price remains relatively strong. Often, however, its recent actions have been defensive, rather than offensive. "Many of its acquisitions have been to take competing companies off the market," says Tere Bracco, analyst with Virginia-based Current Analysis. Moreoever, the company has traditionally eschewed acquisitions intended to give it revenue and scale, preferring to concentrate on technology.

Competitors can have some success attacking Cisco in its strong markets, as exemplified by Juniper in core routing and Siemens-owned Unisphere Networks in edge routing. The competitive effort in these market segments can be expected to intensify now that Juniper has announced plans to acquire Unisphere, in a cash and stock deal worth roughly $740 million (€803.3m).

All this adds up to a company that is dominant and yet also vulnerable. For the most part, "companies don't have the organisation to attack Cisco," says Bracco. New or untapped growth areas, however, do exist, providing the chance – however slim – for innovation to succeed. "Cisco is a formidable player," concludes Alcatel's Houssain, "because they have a formidable installed base, not technical superiority."

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Ben Rossi

Ben was Vitesse Media's editorial director, leading content creation and editorial strategy across all Vitesse products, including its market-leading B2B and consumer magazines, websites, research and...

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