Practical Analysis: Cisco's Conundrum

For the vast majority of its 27-year existence, Cisco has enjoyed the leadership position in a high-growth, highly profitable business. Few companies have maintained gross margins north of 60% and double-digit annual revenue increases for such an extended period.

But now the Great Recession along with evolving market demands are changing the rules of Cisco's very lucrative business. While Cisco hasn't exactly been caught flatfooted by those changes, it hasn't adapted as well as it might have. It's the sort of change that will give leaders like CEO John Chambers his share of sleepless nights. After all, customers and shareholders don't care if the rules of the game change; they care only that Cisco continues to innovate and win.

So, after a quarterly report that saw revenue rise a bit but profit fall, Chambers sent a rare company-wide memo (he more typically delivers these messages over Cisco videoconference) to explain how he wants to go about bringing the company out of its earnings doldrums. That Chambers wrote a memo rather than giving a speech was no accident. He wanted to make a statement not only to employees, but also to financial analysts and press outlets alike. The message: "Our strategy is sound. It is aspects of our operational execution that are not."

The rest of the memo outlines broadly how the company would attack its operational inadequacies, including a number of references to new COO Gary Moore, who now clearly has license to make some changes within the networking and systems giant. Chambers' statement, however, begs a couple of questions.

First, is Cisco's strategy as sound as Chambers says it is? Second, if one assumes the strategy is sound--or can be made sound--can the company actually produce operational efficiencies that will return it to high growth while maintaining those fat profit margins?

Cisco puts its business into five buckets: routers (20% of revenue); switches (42%); advanced technologies (30%); and other products (8%). The four product areas account for $32 billion of its $40 billion in revenue. The other $8 billion bucket is services.

Routers are a stable business, growing in the single digits last year. It was hit very hard by the recession in 2009, and though it's susceptible to economic swings, it's a business where Cisco can hold its margins. Switching was less hard hit by the recession and has bounced back well this year. Cisco's advanced products group contains everything from unified communications offerings, including phones, to security, storage networking, and other data center technologies. These are the products and technologies Chambers has talked about most, and this category weathered the recession better than routers and switches. The aptly named "other technologies" group includes the newest growth areas for Cisco-an odd combination of consumer products, including the Flip video cameras; telepresence video systems, including the acquired Tandberg; set top boxes; and unified computing system (UCS) products.

Chambers' strategy is basically a set of concentric circles with routers at the center, then switches, and then the rest. The challenge is that the core routing and switching business, while huge, can easily stagnate. His notion is to grow the outer circles of the product strategy, and as the outer circles grow, they also grow the inner circles -- causing more demand for switching and routing. Sell more telepresence and you'll sell more switches and routers. It's a simple yet powerful image that builds the company's dominance in these so-called core technologies by growing new satellite technologies.

The strategy is, however, predicated on maintaining market dominance in routing and switching, something Cisco has managed to do for more than 20 years. However, through its efforts to add ever more concentric circles to its strategy and because of the changing nature of corporate device use, Cisco has found itself facing new competitors--many of which are tougher than anyone Cisco has faced before.As noted earlier, Cisco hasn't been flatfooted about all this. For example, in the data center, it saw that there was a good chance that private cloud environments could be a fertile ground for single-vendor systems, and that if it didn't have a server offering, it could lose one of its most lucrative enterprise markets -- that being data center switching, once dominated by the Cisco 6500 family and now the Nexus family of switches.

But in creating its UCS product line, it has started a war on multiple fronts, with Hewlett-Packard as the main enemy combatant and IBM (along with Juniper and Brocade) and Dell not too far behind. Beat up as HP may seem to be, it has the products, services, and reach to go toe to toe with Cisco in an awful lot of data center environments. And in most cases, HP will likely win that business if it comes down to a unified server, storage, networking, and network/system management sale. That UCS is a novel product is a short-term problem for Cisco. For many customers, it's simply a bridge too far with a technology that's untested. Cisco's 2010 total sales of just $181 million for UCS show just how far it has to go in that market.

Cisco's unified communication products face similar challenges. While at one time it was a safe bet that Cisco would produce better products than those from its beleaguered legacy PBX competitors, it did so by putting a lot of capabilities into the phone, which suddenly became about as expensive as the computer sitting next to it. Microsoft's Office Communicator replicated many of those functions, letting buyers look to cheaper, less capable phones with the laptop becoming central to UC.

And while fixed-mobile convergence hasn't happened as predicted, a new generations of tablets with roots in the telecom industry threaten to shake up enterprise unified communications even more. The days of pushing $400 landline phones are about over, particularly in light of $400 tablets that can do the same functions while providing an immensely superior user interface, on a device that users can take with them.

Cisco faces challenges like these in most parts of its business, and its competitors are almost universally accustomed to living with smaller profit margins. And while it would be foolish to count Cisco out of any market it wants to compete in, it would be equally foolish to expect that Cisco will be able to maintain its historical growth and margins.

But that doesn't mean that COO Moore doesn't have an important job ahead of him. Like any company of Cisco's size, it suffers under its own weight. Decision-making is said to be cumbersome. Good ideas that don't come with billion-dollar visions get lost or pushed aside. The need to service a broad and diverse customer base is an expensive proposition that can slow product development and bloat engineering and support teams. All of those challenges need to be addressed within Cisco's walls, but even if Cisco gets it perfect, there's still that new batch of competitors.

For enterprise IT planners, there's an opportunity in all this. If you're tired of eye-popping Cisco price tags, there are less expensive, worthy products from viable competitors. Closer to the core of Cisco's strategy, however, it may be tougher to find alternatives. Complex routed infrastructures and wireless networking are two areas where Cisco still commands huge market share, and where competitors are the ones with a lot to prove. On the flip side, for those who love Cisco, there's the opportunity to do even more with the company.

Art Wittmann is director of InformationWeek Analytics, a portfolio of decision-support tools and analyst reports. You can write to him at [email protected].

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InformationWeek: April 25, 2011 Issue

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