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Telecom Turmoil

Information Technology: Special Report

Telecom Turmoil

Some big players are sagging, but this is no dot-com crash

Only a few months ago, the opportunities for telecom players seemed boundless. From long-distance giant WorldCom Inc. to upstart Level 3 Communications, companies were building sprawling communications networks across the country to carry the booming Internet traffic. Communications equipment makers Lucent Technologies Inc. and Cisco Systems Inc. were struggling to keep up with demand for their gear. And investors were all too happy to finance this construction of the Digital Future, buying $33 billion worth of telecom IPOs just since the beginning of 1998.

Now, formerly high-flying telecom players are struggling to regain cruising altitude. The Big Three long-distance companies have seen their stocks plummet more than 50% this year. AT&T shares got hammered 13% on Oct. 25 when CEO C. Michael Armstrong announced plans to break the company up amid deteriorating financial results. Even Verizon Wireless, the largest provider of mobile-phone services in the U.S., had to postpone its initial public offering because of stock market turmoil.

It may be tempting to conclude that the prospects for telecom players were as overhyped as those of flavor-of-the-month Internet startups. Certainly, profits across the telecom industry are dropping as too much capital investment chases too little revenue. Blake Bath, an analyst for Lehman Brothers Inc., estimates that the return on assets in telecom will drop to 8.5% this year from 12.5% last year.

Look carefully, though, and you'll see that there are bright spots in telecom. Younger, more nimble players that aren't bogged down with creaky technology have been able to capitalize on fast-growing services like Internet and wireless--and have been turning in stellar financial performances. Qwest Communications International Inc., the long-distance upstart that acquired Baby Bell US West Inc., reported sparkling third-quarter results on Oct. 24. "Let's not throw the baby out with the bath water," says Joseph P. Nacchio, Qwest's CEO. "From our point of view, we think this industry is strong."

The key is keeping up with lickety-split changes in technology. The latest communications gear is evolving at a rate that's dizzying even compared with the computer industry. The capacity of optical equipment, for example, is doubling every nine months--twice as fast as semiconductors. Such change creates opportunities for nimble startups and hazards for today's leaders. Consider how badly Lucent Technologies has stumbled. It missed the latest evolution of optical gear and blew Wall Street's financial expectations four quarters in a row. The missteps ultimately cost CEO Richard A. McGinn his job.

Even once-invincible Cisco is threatened. The networking giant's strategy, executed brilliantly for years, has been to buy upstarts just as their technology was going to be adopted broadly. But the latest twists and turns of the communications-gear market have left Cisco playing catch-up. It's losing share in the $2 billion high-end router market to upstart Juniper Networks Inc., and hasn't made much progress in the optical arena.

The lesson? The troubles of yesterday's stars shouldn't mask the prospects for tomorrow's up-and-comers. For every Cisco, there's a scrappy Juniper. For every AT&T, there's a speedy Qwest. Older telecom players may well recover from their current problems, but if they don't, new companies will take their place.Return to top

Cisco: Navigating Choppy Water

New rivals, a brain drain, and the stock drop could make for a tough year ahead

Cisco Systems Inc. and CEO John T. Chambers have been firing on all cylinders. For the fiscal year ended in July, the networking giant boosted revenues 55%, to $18.9 billion, and increased net income 56%, to $3.9 billion. Even more impressive, the company has racked up 10 consecutive quarters of accelerating sales growth, reaching a 61% sales hike in the latest quarter. With that kind of sky's-the-limit performance, Cisco's market cap has surged to $356 billion, making it the second-most-valuable company in the world behind General Electric Co.

Yet, weird as it may sound, there are growing signs of trouble at the once-invincible tech giant. Cisco has suffered lapses in key technologies, and it's getting crunched by upstart Juniper Networks in the critical high-end router market--gear that directs traffic around the Internet. Employees are starting to jump ship, and investors are beginning to lose their once-unshakeable faith in Cisco's future. The stock has slid 38%, to 51, since its peak of 82 in March. "You have to ask yourself how much more upside is possible," says Art Bonnel, manager of U.S. Global Investors Bonnel Growth Fund, who sold his 40,000 Cisco shares this year.CURRENCY DROP. A prolonged stock slide is a serious threat to Cisco. For starters, it may make it too expensive for Cisco to buy networking companies--an approach the Silicon Valley tech outfit has used for seven years to move into new markets. So far, Cisco has used its high-flying shares to acquire cutting-edge technologies in some 60 companies. Consider, for example, what would happen if it were to try to buy hot optical players Corvis Corp. or ONI Systems Inc. Cisco would have to issue one-third more shares today than it would have in March. That would dilute earnings and damage existing shares even more. "If the stock pulls back any more or stays down a long time, they may have to think twice about some of the bigger deals," says analyst Martin Pyykkonen of CIBC World Markets.

A languishing stock also makes it harder for Cisco to hang on to top executives. It used to be almost impossible to talk the brass into leaving Cisco, since the company's stock options kept making them rich. Cisco's stock has soared thirtyfold since Chambers became CEO six years ago, and thousands of employees have become millionaires. But the percentage of Cisco employees who leave voluntarily has crept up from 4.7% in 1999 to 5.6% in 2000. More than 50 former Cisco employees have defected to rival Redback Networks Inc. alone. And the departures have included some high-profile execs, including Executive Vice-President Don Listwin, who took the CEO job at in August. "A year or two ago, we never even got a return call from Cisco employees," says Andy Price, a headhunter at recruiting firm Schweichler & Associates.

Clearly, Cisco is going through one of the most difficult periods of its 14-year life. Interviews with current and former employees, analysts, venture capitalists, and corporate recruiters suggest that the next year could be Cisco's most challenging yet. For years, the company ran circles around rivals such as Lucent Technologies in the communications-equipment market. Now, the rapid changes in Internet technology have Cisco facing some of the same difficulties as its older brethren. How does it keep up with more nimble upstarts such as Juniper? How can it move quickly with 35,000 employees--almost double the number of a year ago? And how will Cisco keep up with the demands of new phone-company customers when Chambers and other top execs have to spend much of their time serving a large, lucrative customer base in the corporate market?

Chambers, Cisco's irrepressible CEO, says fears about the company's prospects are overblown. While he worries that a prolonged stock drop could dampen employee morale in the short term, he's not losing any sleep over it. He says the company has too many things going for it: strong technology and products, a tight relationship with corporate customers, and businesses that are growing in every region of the globe that Cisco competes in. "If we can maintain 30% to 50% [revenue and earnings] growth, the stock will take care of itself," he says.

As for those who have left the company, Chambers argues that many simply wanted a slower pace of life after years at the hard-charging company. He's confident that most of his top lieutenants are staying put. Chambers, for example, recently persuaded Senior Vice-President Mario Mazzola to stay by putting him in charge of a new unit developing network-storage gear.

And acquisitions? Chambers says the bear market in tech stocks has hit upstart equipment makers even harder than Cisco, so the company will be able to buy companies when it needs to. Foundry Networks' stock, for example, has tanked 66% from its high, and Sycamore Networks' stock is down 67%. "If we execute well, we will control our own destiny," he says.

Most important, Chambers thinks Cisco is inextricably linked with the booming popularity of the Internet. He believes businesses no longer view spending on networking gear as an expense but as a strategic investment. Chambers argues that Cisco has credibility with customers because it uses the Net to improve its own business. And the company's three-year-old Internet Business Solutions Group, he says, is stoking demand by showing customers how to improve productivity using Cisco gear. Cisco is "at the center of the next industrial revolution," he says. "We have never been better positioned."

There are good reasons not to bet against Chambers. When Lucent and Nortel began buying data-networking companies several years ago, many pundits predicted the phone giants would pulverize Cisco. But Chambers aggressively pursued young phone companies, persuading them to build networks around the Web rather than using traditional phone gear. At the same time, corporate sales started to climb again after slowing to near single-digit growth in 1997. "Cisco has shown time and time again that they can weather these kinds of storms," says analyst Chris Stix of Morgan Stanley Dean Witter.

Many outsiders agree. With its 80% share of the market for corporate networking gear and a growing business selling to phone companies, Cisco looks as if it's on track to meet Wall Street's expectations near-term. And though Cisco's turnover rate has crept up, it's still only half the average at other tech companies. No one is expecting "gloom and doom for Cisco," says C. Richard Kramlich, founding partner of venture firm New Enterprise Associates, which has sold six companies to Cisco.

Yet the company's very success has created some of its biggest challenges. Cisco has eaten its way to the top of the networking food chain by making scads of acquisitions. While that has given it entree into new markets, it also has created a hodgepodge of corporate cultures. "Cisco looks like the bar scene from Star Wars," says recruiter Price. "A lot of people don't want to be part of that."

Part of the reason is a growing concern that Cisco may be getting too big to move fast. A former software developer for Cisco's corporate switching unit says some employees feel "boxed in" by an increasing amount of drudgery. For example, it now takes twice as long--about four hours--to change one line of code in the software that runs Cisco's routers and switches because the program is so large and cumbersome. "It was getting tough to be productive," says the employee, who left Cisco in August for startup TiMetra Networks.

Worse, corporate recruiters say senior execs are exiting Cisco as never before. Price says his firm has lured away three vice-presidents in the past two months. One of them is Kevin Smith, who headed optical-manufacturing operations and left to take a similar role at Redback. Smith won't talk about why he left, but he helped the upstart manufacture two new Net-equipment products that contributed nearly half of Redback's third-quarter sales of $81 million. "He made our quarter," says Chief Financial Officer Craig Gentner.

A weak stock price also could make it difficult for Cisco to catch up in key markets. For example, Cisco has been trying to move more aggressively into the market for optical gear, but the companies with the latest technology are expensive. Corvis, which makes optical routers for the long-distance market, has a market cap of $20 billion--three times more than Cisco has ever paid for a company. Cisco considered buying ONI, another maker of optical gear, but the company decided to go public instead and is worth $9 billion. Because of such sky-high valuations, optical companies have "got stars in their eyes," says Mike Volpi, Cisco's chief strategy officer, who oversees acquisitions.

To reach the stars, Cisco might have to find another way--say, throwing in a bundle of cash to close an acquisition. On Oct. 20, Cisco used a combination of stock and cash when it bought the broadband-software unit of CAIS Internet Inc., for $170 million. Cisco's Volpi insists that the company will do whatever it takes and will not change its acquisition strategy. "We plan to be equally aggressive," even if that means diluting earnings with a large optical purchase, says Volpi. "If we decide to do some optical deals, those will be expensive, but our customers expect us to be in those businesses." For now, Cisco hopes to gain ground in the optical market by rolling out gear it nabbed as part of its acquisitions of Cerent and Queyton Systems last year. Cerent, which Cisco bought for $7 billion, is generating $1 billion in sales per year."PAINFUL." It could also be tough for Cisco to catch up to Juniper, the biggest threat on the horizon. Juniper is gaining share in the market for big Internet routers, one of Cisco's most lucrative businesses. The upstart boosted its share of the $2 billion market to 20% in the past quarter from 17%, while Cisco's share dropped to 75% from 80%. Although Cisco has reorganized its team that builds big Internet routers and upped its product-development budget, it won't match Juniper's product speeds until at least March or April. "It has been painful to watch a company with that many resources repeatedly stub their toe" on router development, says Mike O'Dell, chief scientist at WorldCom Inc.'s UUNet service. Cisco was once the primary supplier of UUNet's routers, but now, Juniper is its No. 1 source.

Cisco's ability to acquire new technology is crucial. Every year, the company gets 30% to 50% of its sales from products it didn't have 12 months before. Given how fast the networking industry changes and the breadth of gear customers need, Cisco can't make all it needs by itself. If Cisco can't buy startups on the cheap, it may have to spend more than the 14% it now spends on R&D. That could crimp the bottom line.

The current difficulties have some institutional investors worried. Bonnel had long counted Cisco among his top 10 holdings before he bailed out this year. The University of California Endowment & Employee Retirement Fund also has been paring its Cisco holdings throughout 2000, says Jim Cottle, the fund's technology analyst. Although it still owns more than $100 million in Cisco shares, that's less than half of what it held at the beginning of the year. To fly high again, Chambers needs to convince people such as Cottle that Cisco is not only a great company but also a great investment.By John Shinal in San Mateo, Calif.Return to top

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