Cisco's Comeback

After an initial period of denial, CEO Chambers seized on the tech slump as an opportunity to rethink every aspect of the company. Now, the once-sullied highflier is stronger than ever. How did Chambers and his team pull it off?

For the first few weeks of 2001, John T. Chambers, the irrepressibly optimistic CEO of Cisco Systems Inc. (CSCO ), thought the networking giant might neatly sidestep the tech wreck. Twice he had canvassed his top lieutenants, only to rebuff their advice that he lay off workers for the first time in the company's history. But on the evening of Mar. 8, 2001, Chambers landed in Silicon Valley shaken by what he had learned during a two-week business trip around the world. Customer after customer had told him they were slashing spending. Finally, he succumbed: It was time for a massive overhaul. He stayed up all night, hitting the treadmill for hours in his Los Altos Hills home. "I just ran and ran and ran, and thought through the alternatives," he says. At 4 a.m., he decided to call a meeting of his top managers for 6:30 that morning.

It would be a gut-wrenching session. An unusually downbeat Chambers huddled with his top execs and then O.K.'d 8,500 layoffs -- 18% of the payroll. "This is the toughest decision I've ever had to make," he said, according to one person who was in the room. At 9:30, he left to break the news to employees at his monthly breakfast with workers celebrating birthdays that month. "He had serious feelings of remorse, of 'what could I have done differently?"' says Peter Solvik, the company's former chief information officer. "For a year after that, he was somber."

How times have changed. On Nov. 5, when Cisco announced its quarterly results, Chambers was back to his ebullient self -- at one point jokingly asking a vice-president if he was sure he didn't want to raise his forecast in response to an analyst's question. His giddy mood spoke volumes, as did Cisco's results: The company's profits zoomed 76%, to $1.1 billion for the quarter, while sales hit $5.1 billion, the highest level since January, 2001. With orders on the upswing, Cisco said it expects to post 9% to 11% growth in the current quarter.

Cisco isn't just back in fighting trim -- it's stronger than ever. The company's share of the total $92 billion communications-equipment business has jumped to 16% from 10% in 2001, according to Synergy Research Group Inc. -- the biggest land grab in Cisco's history. While battered rivals Lucent Technologies (LU ) and Nortel Networks (NT ) are only now glimpsing black ink, Cisco is racking up record profits. It earned $3.6 billion in the most recent fiscal year, nearly a billion dollars more than its previous best in 2000. And with no long-term debt and $19.7 billion in cash and investments, Cisco's balance sheet is among the strongest in the tech industry. Says Chambers: "We've executed to the point that we have 100% of the industry's profits, 100% of the cash, and about 70% of the market cap."

Rebuilt Foundation

Indeed, Cisco could be a case study of how a sullied highflier can use a slump not only to clean house but also to build a better foundation. While Chambers was late to recognize the worst tech downturn in history, once he realized it was no mere dip, he seized the moment to rethink every aspect of the company -- upending its operations, its priorities, even its culture.

Chambers replaced the chaos that went with growth at any cost with the order of a company managed for profits. Under a six-point plan, he imposed operating discipline on entrepreneurial staffers who had been too busy taking orders and cashing stock options to bother with efficiency, cost-cutting, or teamwork. Engineers who had been able to chase any idea willy-nilly suddenly had to work only on technologies approved by a newly appointed engineering czar. Midlevel managers with the authority to invest $10 million in a promising startup saw the open checkbook snapped shut. Execs encouraged to compete with one another found that teamwork would count for as much as 30% of their annual bonuses. And staffers who fueled Cisco's 73-company buying binge from 1993 to 2000 by scooping up any networking outfit with a shot at success were told they would be held personally accountable for a deal's financial results. "Process was a dirty word at Cisco, including for the CEO," admits Chambers.

In all, it's the rare tale of an Internet star that turned out to be more, rather than less, than it seemed to be. It would be hard to overstate the battering Chambers' reputation took in the first few months of 2001. He was relentlessly upbeat even as evidence of trouble mounted. Lucent, Gateway (GTW ), and others announced layoffs, and still Chambers waxed optimistic. He didn't back off projections of 50% revenue growth until Feb. 6 -- and then only to 30%. He assured investors that Cisco's hyperefficient e-business systems enabled it to forecast demand with near-scientific precision. Then he was proven wildly wrong. After Cisco announced layoffs and a staggering $2.2 billion inventory write-down, Chambers looked like a corporate Goodtime Charlie, incapable of managing in turbulent times. But once his eyes were open, he threw himself into the reality of a new, harsher environment with the same near-religious zeal he had the Internet boom.

Cisco's conversion has been agonizing for many involved. More than 3,000 resellers and 800 suppliers were squeezed out as Cisco reduced its partnerships to cut costs. Some employees felt the mass layoffs were a draconian overreaction. Even Chambers has paid a price. The 54-year-old West Virginian looks like he has aged 10 years in the past three, with the lines around his eyes and mouth visibly deeper. "It was obviously the most challenging time in my business career," he says.

With the trying times behind him, Chambers now wants to put more distance between Cisco and its rivals. While he won't commit publicly to a specific growth target after being burned so badly, two high-ranking executives say the internal goal is a scorching 20% a year. Is it possible? Cisco sees three engines of growth. For starters, the company already gets 14% of sales from six fast-growing markets it targeted during the downturn, including Wi-Fi and security software. It's also banking on an upgrade cycle in its primary business of selling routers and switches, the large computers that direct the flow of data on the Net and corporate networks. The third leg of Chambers' growth plan: grabbing a large share of the telecom-gear market as the world's phone companies go from running separate networks for voice, data, and video to a single, more cost-effective network to handle all three. Chambers thinks Cisco can boost its share of the $64 billion telecom market from 3% now to at least 15%, though he won't specify a time frame. Investors are optimistic: Cisco's shares have surged 80% over the past year, to 23.

Still, Chambers will struggle to live up to such sky-high goals. Investors and top execs may think of Cisco as a turbocharged growth company, but it simply isn't anymore. Even in the much-celebrated first fiscal quarter, Cisco's revenues rose only 5%. And that's not going to improve much in the years ahead. Why? It's the law of large numbers: The networking-equipment biz that accounts for 80% of Cisco's revenues is expected to grow a piddling 6% in coming years, according to JMP Securities. Cisco will get a lift from expanding into new markets, particularly telecom, but it's unlikely that top-line growth will pass the low double digits for the foreseeable future. "I think they can get to 10%," says analyst Brantley Thompson of Goldman, Sachs & Co. (GS ). "I don't think they can get to 15%. At some point, all the tech giants slow down."


Ironically, the going may get tougher as the economy rebounds. At the downturn's nadir, most corporations grudgingly paid Cisco's premium prices rather than incur the cost of switching to weaker rivals that might not survive for long. Now customers are starting to shop around -- and there are bargains to be had. Dell (DELL ) and China's Huawei Technologies, in particular, are aggressively undercutting Cisco's prices. "Cisco is in denial," says Dell Inc. President Kevin B. Rollins. "In every tech market we've seen, prices and margins come down. It's a law of gravity." Also worrisome are the resellers and suppliers Cisco squeezed during the slump. With the economy bouncing back, many bruised ex-partners, such as networking specialist Xtelesis Corp. in Burlingame, Calif., are eager to help rivals take Cisco down a notch. "They're not hurting now," says President Scott Strochak. "But once customers are investing again and Cisco has lost half of its smaller distributors, I'd like to think it will hurt them."

Cisco also must prove that its newfound discipline hasn't dampened its hard-charging zeal. Some recent departees say there have been frustrations with all the new procedures, and they worry that bureaucracy may slow Cisco down as it battles nimble rivals. One sign of potential trouble is Cisco's inability to hold off upstart Juniper Networks (JNPR ) in the market for high-end routers that telephone companies use to handle massive data flows. While Juniper has been gaining share, insiders say Cisco's years-long effort to field a competing product has been stymied by engineering delays. "Cisco has been too conservative," says Tom Nolle, president of consulting firm CIMI Corp.

Still, there's no doubt that Cisco's rebound positions it as a powerhouse for years. The company is more disciplined and cohesive, and Chambers' plans for new markets may change the very nature of Cisco. Besides security software and wireless gear, it's moving into storage-networking products, optical gear, even consumer gadgets. Selling Wi-Fi gear is worth nearly $1 billion, and Cisco has begun rolling out consumer offerings, such as a $149 wireless security camera. All told, analysts expect the new businesses to count for 30% of Cisco's revenues in 2006.

The company's remarkable journey began as many difficult transitions do -- reluctantly. In late 2000, contract manufacturers began warning that parts were piling up in their warehouses and asked for permission to cut back on orders. Cisco execs told them to keep ordering. Even after Cisco narrowly missed Wall Street's earnings expectations in the quarter that ended Jan. 30, 2001 -- its first miss in 11 years -- Chambers couldn't break from his growth-oriented mind-set. "John had always boldly gone where no one else would go," says Gary Daichendt, his former No. 2, who retired in December, 2000.

All that changed during Chambers' around-the-world business trip in late February and early March. He realized the world had changed -- and Cisco would have to adjust. "At times like those, you have to analyze what you did to yourself, vs. what the market did to you," says Chambers. "You almost always get surprised [by a downturn], but you determine how deep and long you think it will be, take appropriate actions, and start getting ready for the next upturn."

That process began at the meeting on the morning of the layoffs. From the start, the team agreed that the ultimate goal should be to maintain Cisco's net profit margin of 20%. They hammered out details of the six-point plan Chambers had begun sketching. Then they turned to the harsh task of determining how many jobs needed to go. Many were dismayed -- even embarrassed -- at having to issue so many pink slips just a month after they had hired 2,400 new workers. But Chambers wanted the layoffs to be large enough that he wouldn't have to issue wave after wave of cuts, as Hewlett-Packard (HPQ ), Sun Microsystems (SUNW ), and Siebel Systems (SEBL ) have had to do . To ease the blow, Chambers insisted on rich severance packages and urged his team to be brutally frank about the deteriorating situation.

For weeks, Cisco's top 20 execs gathered daily in a conference room called Napa Valley, overlooking the green hills east of San Jose. One morning in April, then-CFO Larry R. Carter delivered more painful news: Because Cisco had been buying parts like mad until demand fell off a cliff, it had mountains of inventory that was obsolete. He recommended moving quickly to take a roughly $2 billion write-off -- 20% of Cisco's accumulated profits since it was formed in 1984. Senior Vice-President Randy Pond at one point offered to break the news to Cisco's board himself, since inventory was under his purview. Chambers cut him short. "Don't even go there," he said. "We got to this point based on decisions that were rational at the time." Still, even Chambers' reassuring tone couldn't soften the blow. "There were a lot of heads in hands," recalls Pond. When Cisco announced the $2.2 billion write-down on May 8, Cisco's battered stock slid 7% more, to 19.50.

It was over the summer of 2001 that Chambers and the rest of Cisco's management team began to control their own destiny. One of Chambers' first moves after the write-down was to visit Mario Mazzola, a well-respected engineer who had joined Cisco in 1993. The Italian native, now 57, had long planned to retire -- an internal memo about his departure had already circulated. But over several meetings at Cisco's sprawling collection of squat, three-story office buildings, Chambers told Mazzola that Cisco needed him. The company's engineering efforts were a jumble of overlapping development projects. At one point, Cisco had five separate efforts aimed at data-storage switches, according to JMP analyst Sam Wilson. Chambers told Mazzola that only he could corral the company's 12,000 engineers and make Cisco a stronger innovator, less reliant on acquisitions. In August, Mazzola agreed.

Strict Diet

He quickly got to work. Many iffy projects were axed, including a broadband wireless technology when the two biggest potential customers decided not to pursue it. In all, Cisco cut the number of models it sells from 33,000 to 24,000. Still, insiders say there's far more fat to cut. Says a former exec: "If you're 50 pounds overweight, you can lose 20 pounds just by walking -- but [it takes more] to lose that last 10 pounds."

There's no question Cisco has trimmed its once-freewheeling investment practices. In the past, acquisitions and investments in other companies were haphazard. That ended when Senior Vice-President Daniel A. Scheinman took over corporate development in August. An attorney who had been Cisco's general counsel, Scheinman set up an investment review board that analyzes investment proposals before they can move forward. Roughly 50% are O.K.'d, he says.

The acquisition free-for-all ended, too. Scheinman set up monthly meetings with the heads of operations, sales, and finance to vet potential deals. Besides making sure an acquisition makes sense for the company as a whole, the group works up detailed operational plans to make sure the business can be successfully integrated into Cisco -- and a deal's sponsor must commit to sales and earnings targets. That put a screeching stop to the buying binge: Cisco bought two companies in fiscal 2001, down from 24 the year before. The company is doing deals again, but more carefully. When Cisco bought home-networking leader Linksys Corp. in March for $500 million, Scheinman and his group talked for six months before proceeding.

Some of the most painful progress began during the fall of 2001 on the operations front. With Cisco's sales plunging, Pond's staffers began playing hardball with suppliers to keep profits up. The CEO of one supplier said Cisco wanted to take 90 days to pay for his products instead of the normal 30. It also wanted the supplier to extend the warranty on its goods to three years from one. When he balked, the CEO got a call from a midlevel manager. "If you don't [agree to our terms], we'll instruct our people not to use your products," he recalls the manager saying. The supplier, like many others in such tough times, couldn't afford to lose Cisco's business and buckled under.

Many others lost out entirely. Cisco's list of key suppliers has fallen from 1,300 to 420. That lowered administrative costs and led to volume discounts worth hundreds of millions of dollars each year. Pond also outsourced more production to lower costs, from 45% in 2000 to over 90% today. At the same time, he spent millions to shift production work from nine contract manufacturers to just four. And smaller resellers complain that Cisco began giving discounts to strategic distribution partners such as IBM (IBM ) and SBC Communications (SBC ), leaving hundreds of smaller players unable to compete against these behemoths. "Cisco went from being our best partner in good times to our worst enemy in bad times," says the former CEO of one reseller. SBC says the closer relationship is helping it sell more to its business customers.

In early 2002, with Cisco making progress in adopting Chambers' new marching orders, the CEO considered an even more ambitious goal: He approached CIO Solvik and asked him if it was possible to double productivity, to $1 million per employee, by 2007. That way, Chambers figured, Cisco could capitalize on the next spending upturn without having to add many workers, sending profits through the roof. After a few months of studying industry leaders such as Wal-Mart Stores (WMT ) and Dell, Solvik said it was doable -- but only if Cisco stopped behaving like a confederation of startups and more like a mature, cohesive corporation.

In Cisco's cowboy culture, this was explosive stuff. When Solvik explained his findings at Chambers' vacation home in Carmel, Calif., in April, 2002, the response was chilly. Execs listened uneasily while gazing at the 180-degree view of Monterey Bay. When Solvik asked for volunteers to investigate how Cisco could emulate the best company in a certain area -- say, Dell in operating efficiency -- not a single exec followed through. "It didn't resonate well with the group at all," recalls Pond. "But Pete wouldn't let go of it."

Chambers backed Solvik. Just after the Carmel gathering, he instituted an Internet Capabilities Review. Three times a year, top managers share how they use the Web to boost productivity. At the same time, they're measured on how well they implemented the best ideas from previous sessions. He also created a series of committees to get all parts of the company working together. Now, most decisions -- what parts to buy, what products to design, what distributors to use -- must be cleared by Business Councils that focus on Cisco's overall performance.

All the new procedures created some controversy. Product managers were stunned at the extra steps required to get anything done. Under the new structure, Ish Limkakeng, a product-development manager for switches, must get clearance from a committee of executives from various parts of the company rather than just chat up a few associates. He says the change was difficult, though he came to understand the benefits for the company.

Some salespeople still feel hamstrung. One of Chambers' initiatives is an e-customer project that will consolidate 19 different databases into a single repository. It's designed to boost efficiency and prevent mishaps such as the double ordering by customers that contributed to the inventory write-down. But a salesperson can no longer log in an order for a new customer without first clearing it with a support team that makes sure the customer isn't already in Cisco's records. One insider says salespeople in Europe have been "thumbing their noses" at the e-customer rules and not following the new guidelines. Sales chief Richard J. Justice acknowledges some griping and says Cisco may refine the process to address the complaints.

Calling Telecom

Chambers took other steps to rein in Cisco's Wild West culture during 2002. Most pointedly, he made teamwork a critical part of top execs' bonus plans. He told them 30% of their bonuses for the 2003 fiscal year would depend on how well they collaborated with others. "It tends to formalize the discussion around how can I help you and how can you help me," says Sue Bostrom, head of Cisco's Internet consulting group.

When it came time to divvy up those bonuses, it was clear that Chambers' overhaul had resulted in a leaner, more efficient Cisco. On Aug. 5, the company announced that it had earned $3.6 billion for the year -- almost double net income for the year before, even though sales were flat, at $18.9 billion. And employees were getting more comfortable with the new Cisco. "There's been huge progress," says Justice. "There's a sense of redemption and vindication."

Today, revenue growth remains the biggest challenge. The company is off to a fast start in a number of promising markets. In security software, Cisco already has taken the lead from Check Point Software Technologies Ltd. (CHKP ), with a 27.3% share in the second quarter, up from 20.1% in 2001, says Synergy Research. And Cisco is building quickly on its Linksys acquisition. Charles H. Giancarlo, a senior vice-president responsible for Linksys, says Cisco plans to introduce a dozen more home gizmos over the next year. "Who knows?" he says. "Linksys might become a household name, while Cisco may only be for portfolio planners."

Still, to get revenue growth back to double digits, Cisco will finally have to make headway with the big phone companies. And they're wary shoppers. Established carriers such as BellSouth Corp. (BLS ) had serious reliability problems with Cisco gear in the '90s. To make matters worse, Chambers served as the arms merchant for scores of their upstart rivals -- only to see most of them disappear in the telecom bust.

Now, Cisco has been on a crusade to get into the telecom industry's good graces. Chambers himself called top telecom execs to apologize for his past arrogance. "He said maybe they'd forgotten one of their fundamental rules: Listen to your customer," recalls BellSouth Chief Technology Officer Bill Smith. Cisco also began pouring over 50% of its research and development budget into new gear that could be used more easily with the phone companies' existing switches. Cisco's most recent quarter suggests the plan is going well: Orders from carriers were up 20% over the previous year -- far more than at rivals such as Lucent or Nortel. And phone company execs say Cisco has made progress. "I think they are capable of becoming a top one or two provider," says SBC Chief Technology Officer Ross Ireland. BellSouth plans to deploy a Cisco switch next year to handle voice and data traffic.

After a difficult three years, much has changed at Cisco. At one point during the annual sales powwow at a San Francisco convention center in August, a wizened Chambers came out from behind the podium to be closer to the 10,000 salespeople. Dressed in casual clothes, Chambers squatted on the steps of the stage and struck an intimate tone. Recalls sales manager Gregory H. Lynch: "Chambers said, 'I think we're ready to grow again. I'm asking you to help me."' The words are toned down from the wild years, but Cisco looks poised to continue its dominance.

By Peter Burrows

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