Is That a Virtuous Cycle at Cisco?

The networking giant is scoring by pushing promising new tech, such as VoIP, which then requires customers to upgrade existing systems

In tech industry circles, nothing is more sought after than what's known as a virtuous cycle: a state of existence where one favorable circumstance gives rise to more of the same. That's what Microsoft (MSFT) and Intel (INTC) enjoyed when each new version of Windows required millions of PC owners to buy a computer with the latest Pentium chip. That in turn enabled consumers to buy the latest version of Microsoft Office, which set the stage for the next round of upgrades.

Judging from its most recent set of quarterly results, announced Feb. 7, it seems networking giant Cisco Systems (CSCO) may be spinning up a virtuous cycle of its own. The evidence is in the surprisingly strong orders for Cisco's biggest businesses: the basic routers and switches that corporations use to run internal networks and link them to the outside world. Actual sales for these units grew in the high single digits in the quarter just ended, a main reason why Cisco's sales grew 9.3%, to $6.6 billion -- roughly in line with Wall Street estimates.


  But while these businesses are often dismissed as "mature" and slow-growing, Cisco Chief Executive John Chambers enthused about order growth that bodes well for the rest of the year. He said orders in the $4 billion-plus router business increased nearly 10% in the quarter over the previous year, while orders for Cisco's $8 billion-plus switch business rose more than 15%.

So what's Cisco's virtuous cycle, and why might it be appearing now? For the past half-decade, Cisco has been steadily building a portfolio of so-called advanced technologies businesses. The company defines these as technologies with the potential to become $1 billion businesses. Three -- voice-over-Internet-protocol (VoIP) phone systems, network-security products, and consumer-networking equipment -- have now reached this mark. Others are on the way, while some are just getting off the ground. A digital video-networking effort will go into high gear once Cisco's acquisition of Scientific-Atlanta (SFA) closes in the third quarter (see BW Online, 2/7/06, "Cisco on IPTV: 'When, Not If'").

But while these sexier, emerging markets tend to get all the attention, they provide a lucrative twofer for Cisco: To take advantage of the new technologies' capabilities, corporate buyers often must step up to Cisco's latest routers and switches. "There's a legitimate upgrade cycle coming," says Erik Suppiger, a networking specialist at Pacific Growth Equities. "It's just getting started."

Indeed, Cisco is increasingly folding certain advanced technology features right into the basic networking gear. It reported that sales of its ISR router, which comes with integrated wireless networking and security features, passed $2 billion last quarter, just 18 months after it was introduced.


  Or consider VoIP. Cisco announced on a conference call with analysts that it has now sold 7.5 million phones that use Internet-style technology, rather than traditional phone-only networks. Once a company decides to scrap its traditional phone system for one that runs over the Internet, it needs a lot more than just newfangled handsets. The customer also needs special gear to replace the old-fashioned private switching system, or PBX, as well as new routers and switches to provide all the extra bandwidth -- which employees will be using not only to send e-mail and surf the Web, but to make phone calls, have videoconferences, and the like.

In most cases, companies will opt for a feature called power over Ethernet, so these phones can get juice right over the line -- as traditional phones do via copper lines -- rather than being plugged into electrical outlets. Michael Howard, head of networking-market researcher Infonetics, learned this the hard way when his firm decided to switch to VoIP after changing offices. "We're an example of the fact that corporations are definitely going to have to upgrade their wiring closets" to take advantage of new technologies. "That's definitely helping Cisco."

Of course, not all virtuous cycles are created equal -- and Cisco has yet to convince investors that this one makes it worthy of a higher market cap. For years, the outfit claimed that it will be able to sustain revenue growth of as much as 15% and sky-high gross margins of more than 65%. But not all investors have bought on. While Cisco shares jumped more than 5% in extended trading on Feb. 7, the stock still hovers around $18 -- about where it was four years ago, and far from its peak in 2000, when Cisco briefly had the world's largest market capitalization.


  What's more, Cisco had some potentially worrisome news to report. Its top-of-the-line CRS-1 router, used by the largest phone companies, is selling at a clip of just $100 million or so a year. That's not bad, but Cisco will need to do better to win share lost in recent years to the likes of Juniper Networks (JNPR). And after Cisco worked for years to get its operating costs down to 35% of total sales, that measure crept up to 37% this quarter. Chambers says this was because the company has decided to crank up spending to hire salespeople.

"Our goal remains 35%," the CEO told analysts. "But in the short term, we see too many opportunities" that need to be exploited now, he said. Writes Technology Business Research analyst Bill Lesieur: "Everyone will be watching Cisco's results closely during the next several quarters" to see if the change is temporary.

Still, the overall news from this tech bellwether was the sort that builds confidence. With so many corporations and consumers looking to use the Net to do so many new things -- from VoIP at big companies to IPTV rollouts by telecoms like AT&T (T) and Verizon (VZ) -- there's little doubt that Cisco holds an enviable hand. "Companies and service providers have no choice but to buy bigger, faster gear just to keep up with the rise in data traffic," says Infonetics' Howard. "And Cisco is sitting in the best spot to take advantage of this force of bandwidth, which simply cannot be stopped."

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