Can Cisco Shift Into Higher Gear?

Innovative rivals pose a rising threat in the company's biggest growth market

In June, 2003, Cisco Systems Inc. (CSCO ) unveiled what seemed a landmark deal. Long known for making the gear used to move data around office networks and the Internet, the company trumpeted a major victory in telecom, saying it had persuaded BellSouth Corp. (BLS ) to install one of its products in the core of BellSouth's massive telephone system. For two years, Cisco engineers had whittled down a list of 158 improvements demanded by BellSouth technicians. With only a few to go, the companies went public with the deal. "We have made a tremendous amount of progress," said Cisco Senior Vice-President Jayshree Ullal at the time.

Not enough, evidently. BusinessWeek has learned that, 15 months later, BellSouth has not deployed a single piece of the Cisco gear. Because Cisco never finished the last of the requested improvements, so far the phone company has opted for products from rival Lucent Technologies Inc. (LU ) "Cisco is still coming up the learning curve," explains BellSouth Vice-President Mark Kaish, who says his company may start installing the Cisco product by yearend.

Cisco needs to graduate fast to make the most of its single biggest growth opportunity. While the networking market it dominates settles into maturity, telecom and cable companies are beginning to make massive investments in new Internet gear. After decades of building separate networks to deliver telephone service, cable TV, or Net access, giants from AT&T (T ) to Verizon Communications (VZ ) are building next-generation networks to deliver all that and more over one set of pipes that use Net technology. The market is expected to surge some 20% a year, roughly twice that of the corporate market.

But Cisco is struggling to fully cash in on the opportunity. A host of rivals, particularly Juniper Networks (JNPR ) and China's Huawei Technologies, are gaining ground in selling Net gear to carriers. Juniper's share of the market has jumped from 4.5% in 2002 to 8.3%, while Huawei has gone from 3.8% to 8.2%, according to the market research firm Synergy Research Group Inc. Meantime, Cisco dropped from 45% in 2002 to 33% late last year, before recovering somewhat to 38% in the second quarter.

No doubt, Cisco will be a prime beneficiary of this Net migration to combo networks. At 38%, it's still the top player in selling Net-style equipment to phone and cable companies. And that position has helped boost Cisco's share of the overall market for communications gear to 6.1%, from 5.5% in 2002, because sales of older phone and cable gear have been declining in recent years. As Net equipment sales climb and Cisco markets new products, the company figures its share of total communications-gear sales is sure to rise. "The market is coming to us," says Carlos Dominguez, the Cisco senior vice-president leading its telecom push.

Cisco isn't waiting passively. On Sept. 23 it announced a $32 million investment to create a Shanghai research and development lab to work with Asian communications companies. It also has been putting its $19 billion in cash to work, buying promising startups.

Still, the company must confront a reliability gap. Cisco's gear is more than sufficient to keep office networks up and running most of the time. But for big telecom and cable outfits, a break of even 50 milliseconds can interrupt millions of phone calls or video transmissions. Customers say such disruptions would be too common with current Cisco equipment. "Today, you still have to hit the reset button on Cisco's routers [to add a new service]. That doesn't cut it," says David M. Fellows, chief technology officer for cable giant Comcast Corp., which buys Cisco equipment for Net traffic but wants improvements before buying its gear for video and voice services.

Whether Cisco can rise to the challenge may well determine if Cisco Chief Executive John T. Chambers can meet Wall Street's expectations for brisk 15% annual growth over the next five years. It leads in some emerging markets, such as consumer wireless gear, but none is big enough to make much difference for the $22-billion-a-year giant. Unless it increases its 38% share of the Internet land grab with communications companies, it will fall short of that 15% mark, says JMP Securities LLC analyst Sam Wilson. "Cisco needs to get at least half of this market to meet Wall Street's growth expectations," says Wilson.

Gaining that much share seems unlikely anytime soon. Consider core routers, the refrigerator-size behemoths that shunt billions of bytes across countries and continents. Despite spending $500 million in R&D, Cisco's new CRS-1 model is off to a slow start. By the time it was announced in May, some carriers already had chosen the routers they would consider for the next phase of their network overhauls. "I've seen it on paper, but not in the lab," says AT&T chief technology officer Hossein Eslambolchi, who just decided to extend by five years a contract to buy from Avici Systems Inc. (AVCI ) rather than Cisco. Cisco router chief Mike Volpi waves off criticism that the CRS-1 will be a disappointment. He says Cisco shipped one unit in August and that it is being evaluated by a dozen other customers.

Still, evaluations could take a year or more, and Cisco could lose important deals in the meantime. China Telecom Corp. is close to awarding a handful of contracts that could top $500 million, say insiders. While it relied almost exclusively on Cisco for big routers in the past, the Chinese carrier is expected to give much of the business to two teams: one comprised of Huawei and Avici, the other Ericsson (ERICY ) and Juniper. "Anything less than 100% [share of these contracts] would be an embarrassment for Cisco, and anything under 50% is a disaster. And I'm hearing numbers like 20%," says Tom Nolle, founder of telecom consultant Cimi Corp. China Telecom declined to comment for this story. Cisco's Volpi says the company is "in decent shape with China Telecom," but he won't say how much of the contract Cisco is likely to get.

Even impatient customers, such as BellSouth, are giving Cisco the time it needs to meet their needs. "Cisco hasn't fallen out of the race," says Kaish. Still, if it doesn't pick up the pace, its best chance to regain hot-growth status may slip away for good.

By Peter Burrows in San Jose, Calif.

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