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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.

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