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Commentary: Sorry, Cisco. The Old Answers Won't Work

By Peter Elstrom

It was a sobering moment for Cisco Systems Inc. (CSCO) and its chief executive, John T. Chambers. On Apr. 16, the networking giant announced its revenues for the quarter closing Apr. 30 would drop 5% from a year earlier--and a stunning 30% from the previous three months--to about $4.7 billion. Cisco also said it would lay off 8,500 workers and take a staggering $2.5 billion charge to write down inventory. Cisco, which had been boosting year-over-year sales 50% to 70% in recent quarters, simply hadn't anticipated that orders could decline. "We never built models to anticipate anything of this magnitude," conceded Chambers.

The new era may require a new kind of Cisco. The company became a juggernaut of the Internet Age by using its high-flying stock more effectively than perhaps any other outfit. Rather than develop most of its new technology internally, Cisco used its stock to buy more than 70 companies since 1993 and get its hands on the latest networking gear. Then, it would use its vaunted sales force to market the new technology to its corporate customers and telephone companies. It turned out to be a wildly successful formula. Revenues hit $18.9 billion for fiscal year 2000, more than four times the level of four years earlier.

But Cisco's stock is no longer the high-powered currency it once was. After averaging 100% returns over the five years ended in March, 2000, Cisco's shares are off 78% from their peak, at $18. That could make Chambers' acquisition machine as outdated as a Model T. "He's not going to be able to acquire the way he used to," says David Matheson, CEO of Smart Org, a strategic consulting firm. "He needs to drive organic growth by finding value within the organization." After buying 23 companies last year, Cisco has yet to make an acquisition in 2001.

If Cisco can't buy as many upstarts, it's likely to have a hard time expanding into promising markets and returning to anything close to the torrid growth of the past. In particular, the company wants to push further into the fast-growing and lucrative optical market. Also, it needs to regain market share in high-end routers, which direct data traffic around the Net.

That's going to be a big challenge without acquisitions. Upstart Juniper Networks Inc. (JNPR) had already grabbed 34% of the high-end router market by the end of 2000, up from 17% at the end of 1999, according to the Dell'Oro Group. At the same time, Cisco's share has dropped from 78% to 65%. Meanwhile, in the optical segment of that market, it remains a small player. "We don't see them very often" competing for bids, says Patrick Nettles, chairman and CEO of Ciena Corp. (CIEN), a leading optical player.

Despite his current troubles, Chambers doesn't think Cisco's business model needs an overhaul. He claims demand for networking equipment will pick up shortly. Sure, the company is budgeting revenues in its fourth quarter, which ends in July, to be flat to down 10%. But over the long term, he says, revenue growth for networking equipment of 30% to 50% is "very realistic." While Cisco will lay off the acquisitions over the short term, in part because it's reducing its workforce, buying new technologies will still be critical. "We will continue to use acquisitions as a way to grow," he says.

NO SURE THING. If anything, Chambers thinks the current tumble in tech stocks gives him a competitive advantage. He argues that many of the companies Cisco is interested in are bargains since they've seen their value fall even more than Cisco's has, and many are desperate for capital. "Almost every company is for sale and we've been asked to buy most of them," he says. Some outsiders agree. "I don't think this busts their business model," says B. Alexander Henderson, an analyst with Salomon Smith Barney.

But Chambers may be just as surprised by the future as he was by the current quarter. Many analysts seriously doubt his growth projections. Paul Sagawa, an analyst at Sanford C. Bernstein & Co., for example, anticipates long-term revenue growth of just 17%. One reason: Entrepreneurs may be less willing to sell out if they don't think Cisco's stock will rocket upwards. "It's no longer a sure thing," says Jeanette Symons, chief technology officer at upstart equipment maker Zhone Technologies. That seems to be something Mr. Chambers still hasn't accepted. Elstrom covers technology in New York.

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