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Cisco's Consuming Ambitions

By Peter Burrows and Olga Kharif When it comes to doing acquisitions, networking giant Cisco Systems has long been known as high-tech's leading shopaholic. But when it forked over $500 million for Irvine (Calif.)-based Linksys Group in March, 2003, many industry insiders held their breath.

Until then, Cisco (CSCO) had stuck to buying high-tech startups that made high-priced corporate gear in order to help Cisco sustain its sky high profit margins. But Linksys specialized in low-end home routers -- a brutally competitive market with far more in common with the nearly profitless PC industry than with anything Cisco had dealt with before. "Obviously, the consumer marketplace is more price sensitive," Cisco M&A chief Dan Scheinman said at the time. "This will require a different financial model for us."

Now, Cisco is convinced it has figured out a business model that will allow it to play successfully in the rough consumer market. Although Linksys products typically carry gross margins roughly half as high as Cisco's overall 68%, the division has pushed so much volume through its low-cost operation as to deliver double-digit net profits, say analysts.

SPREADING THE BRAND. That's not quite as high Cisco's overall 24% average, but certainly not the drag on its bottom line that skeptics of the deal had feared. "Linksys has exceeded our expectations in financial terms," says Cisco Chief Executive John Chambers.

Now, Cisco is cranking up its plans for Linksys. Chambers says it will use the Linksys brand on a growing portfolio of low-end products, both for consumers and increasingly for the medium- and small-business market.

To that end, the company has arranged its first two consumer-oriented acquisitions since buying Linksys. In April, it bought Sipura Technology, which makes the gear that consumers need in order to use Voice over Internet Protocol (VoIP) phone-calling plans from the likes of Vonage. And on July 22, Cisco bought Denmark-based KiSS Technology, which makes new-fangled entertainment equipment for the home, such as networked DVD players and even a sofa with built-in speakers.

STUFFING THE PIPES. The strategy in many ways aims to reprise Cisco's critical role in the 1990s, when it designed and evangelized Internet-based technologies that rewired most corporations and phone companies. Now, it wants to do the same for consumers.

As the leading provider of basic home routers, including wireless models based on the now-ubiquitous WiFi standard, Linksys has had a key role in providing the basic pipes for Jane and Joe Consumer. Now, Cisco wants Linksys to focus on filling those pipes, by driving usage of new home-networking applications -- whether it's making phone calls, having family videoconferences, watching TV or sharing photos.

It's an audacious project, one with the potential to make Linksys more of a household name -- maybe not as a maker of phones, TVs, and cameras, but as the company that makes them all work together. With the number of networked homes expected to rise from 2.5 million in 2004 to 21.6 million in 2009, according to IDC analyst Jonathan Gaw, there's a rich potential market.

PHONE CONNECTIONS. "We won't [make] TVs, but we can license technology to TV makers to help them make connected displays," says Cisco Senior Vice-President and Linksys General Manager Victor Tsao, who founded Linksys with his wife Janie in 1988 (see BW Online, 8/5/05, "Cisco's Link to Your Living Room"). "Linksys will play a major role, by partnering with many players."

In many ways, Cisco is uniquely positioned to develop that market. Not only does it have $16 billion in cash, but the company has deep ties with the carriers that will offer most of these services, such as Comcast, Sprint (FON), and Verizon (VZ).

That means it can design not only the gear in your living room, but also the bigger iron it connects to -- ostensibly giving Cisco the ability to help carriers deploy services that are easy for consumers to set-up and use. "Home networking isn't a very friendly thing," says IDC's Gaw. "What [Cisco is] betting on is that a good networking experience will be harder to implement than just a DVD player."

VoIP OUT. Cisco's success in the VoIP market could provide a roadmap for how it will attack other segments of the consumer business. For more than a decade, people have talked of using the Internet to make basic phone calls, enabling customers to forgo the century-old phone networks for a cheaper, more flexible approach. But the market didn't really begin to develop until Cisco got serious about it -- pouring huge investments into developing the necessary technologies, partnerships and products.

First, Cisco focused on the corporate market, where it already dominated and where margins were thicker. Although it didn't necessarily want to be in the phone-making business, it developed models that would showcase the features of VoIP, such as the ability for office workers to program any VoIP phone on the corporate network to ring their extension. That helped Cisco take a lead role in what's now a multi-billion dollar corporate VoIP market -- and has made Cisco a primary rival to long-time telecom suppliers such as Avaya (AV) and Nortel (NT).

Late last year, Cisco turned its attention to the almost non-existent consumer VoIP market. While pioneers such as Vonage had begun to sign up customers for Net calling, service quality was poor and required customers to use clunky PC microphones and speakers to make calls. So Linksys forged partnerships with Vonage, Verizon, and AT&T (T), to provide gear that consumers could use to attach their existing phones to their PCs.

FLOATING ENTERTAINMENT. Just nine months after launching these partnerships, Cisco has sold more than 2 million of these VoIP connections -- making it Cisco's fastest-growing new product ever. This includes VoIP packages sold through retailers such as Best Buy (BBY), Office Depot (ODP), and (AMZN), and the company now is looking to boost its advertising. "Certainly, more direct marketing is something we're looking at, and probably will engage in in the future," says Cisco Chief Development Officer Charlie Giancarlo, who oversees the Linksys division.

Linksys may be just starting in the hunt to find new ways to pump traffic through its home routers. It's also turning its attention to so-called networked entertainment, a market that should grow from $3.9 billion in worldwide revenues in 2004 to $16.1 billion by 2009, according to tech consultancy In-Stat.

Cisco envisions a world in which various digital devices can talk to each other, so a pay-per-view movie or Faith Hill song, for example, could be stored on the living room set-top box, and then played on the TV or stereo in the kids' room, on Dad's laptop, or even the entertainment center in the SUV.

NET-TV READY. "As an industry, we've all been talking about [networked entertainment devices] for the past four or five years," says Tsao. "But who has these capabilities today? I don't have it in my home. My friends don't have it. So Cisco is making a stand. We want to really promote this, to make it a reality."

That's where KiSS comes in. The 65-person outfit specializes in making networked DVD players, so that a movie isn't confined just to the TV that the DVD player happens to sit next to. And because it has a hard drive, such a device essentially becomes a digital video recorder (DVR), capable of storing reams of movies, music, and other content.

By adding a TV tuner and a Net connection, it can be used as the basic set-top box for a new generation of services -- particularly so-called Internet Protocol TV (IPTV), which streams video content over broadband connections. Major carriers around the world are already rolling it out. These services could potentially give consumers hundreds of channels to choose from, or even the ability to start their own -- say, the Jones' home video channel -- to share with friends and family. "Cisco wants to make sure that if IPTV does take off, they get a piece of it," says JMP Securities analyst Sam Wilson.

FAMILY MEETINGS. Which pieces of the overall networked entertainment business Cisco will be able to claim remain to be seen. After all, a host of rivals are also eyeing this opportunity, including Microsoft (MSFT), TiVo (TIVO), set-top box manufacturers such Motorola (MOT) and Scientific-Atlanta (SFA), and possibly Apple Computer (AAPL) -- not to mention, of course, old-guard consumer-electronics giants such as Sony (SNE), Samsung, and Philips.

Tsao suggests that Cisco would rather partner with consumer-electronics companies than compete with them. "We want to help grow the segment," says Tsao. But Cisco is prepared to introduce new kinds of gear itself to help spur new markets. For example, Tsao says Cisco plans to continue selling KiSS's DVD players in Europe, and will introduce them in the U.S. as well.

And Giancarlo hints that Cisco may begin selling high-end systems that would let consumers hold videoconferences in their living room, using their TVs. Forty years after AT&T first showed such a capability at the 1964 World's Fair, "We're on the verge of making this reasonably inexpensive, at reasonable quality," says Giancarlo. His goal: to offer a package, including speakerphone and camera, for under $200.

PRICE PLUNGE. Success in sparking growth in the consumer market isn't just a nice-to-have for Cisco. Instead, it's critical if Cisco is to remain the fast-growing company it wants to be. Already, analysts are looking for much of Cisco's overall growth to come from Linksys, whose sales are expected to increase from $620 million last year to as much as $1.2 billion in 2006, says Joel Fishbein, an analyst with investment bank Janney Montgomery Scott, which holds some Cisco shares.

The question is how to keep that growth alive. "Ten years from now, everyone is going to have some kind of wireless networking thingee in their home. If Cisco doesn't get a share of that, it's not on track to become a $50 billion company," say JMP's Wilson.

Trouble is, falling prices are expected to dampen growth in the basic low-end router market where Linksys now plays. IDC expects the market to grow slowly in coming years, from $2.2 billion last year to $2.7 billion in 2009. That means it's imperative that Cisco spark new uses for home networks -- and it won't be easy. For starters, Cisco will have to prove it can figure out products and services that consumers love -- much as Apple did with its iTunes music service.

CATCH A WAVE? Not everyone agrees that consumers will pay for the super-charged, do-everything devices Tsao describes. "This is big talk," says Patrick Lo, CEO of NetGear, Linksys' nearest rival in the home-router market. "But this idea isn't going to work. Consumers will always want to pick the best-of-breed technology." While NetGear might start offering networked DVD players if there's demand, Lo says he's focusing on routers and VoIP adapters for now.

And there's still that nasty question of whether the strategy will produce profits. Linksys has managed to deliver good enough earnings so far by catching huge growth waves for WiFi routers and VoIP adapters. If other markets don't develop so explosively or attract too much competition, Cisco may yet find that some consumer markets are just too tough. For now, at least, Cisco seems intent on finding out.

Burrows is computer editor for BusinessWeek in Silicon Valley. Kharif is a reporter for BusinessWeek Online, based in Portland, Ore.

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