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Dow 30 component Cisco Systems (CSCO - Free Cisco Systems Stock Report) is one of the most admired and successful enterprises to ever emerge from Silicon Valley. The tech icon’s breadth of product and correlation to GDP makes it one of the most closely watched stocks in the telecom equipment industry. Management’s keen ability to foresee technological trends, coupled with massive cash balances, allow it to make attractive acquisitions and develop leading technologies internally. Highly efficient and innovative operating practices, along with a focus on working with, learning from, and assisting customers are also strengths that contributed to revenues rising from $1.2 billion in 1994 to $43 billion in fiscal 2011 (ended July 30th). The company had an average annual revenue growth rate of 11% over the past decade. Cisco looks to maintain growth with new products in the data center virtualization, cloud computing delivery, videoconferencing, and collaboration markets. 

Company History

It’s been rumored that the idea for Cisco’s first product, the router, was motivated by a Stanford University couple’s desire to send emails to one another across the university’s disparate computer networks. Although any claim of romantic inspiration is an exaggeration, it is true that in the early 1980’s Leonard Bosack, director of Stanford’s computer science department, along with his wife Sandy Lerner, director of the business school’s computer facilities, recognized the need for individual networks located in separate buildings of a campus to transmit data to each other quickly, reliably, and without having to go through large and expensive centralized minicomputers. Acting on this notion, they enlisted the help of other Stanford engineers to come up with a device that could execute such a task. Many contributed, but Stanford researcher William Yeager is known to have developed the crucial operating system and routing code, services Cisco never publicly credited him for even though they eventually licensed the technology from the University in 1987. Regardless, the OS worked well and after the first boxes were built, the team went to work scattering them throughout the campus and connecting them with an infrastructure of coaxial cables. Over several months, a functional wide area network was constructed, allowing information to be transmitted across distances never seen before.

The system went on to become Stanford’s official network. Meanwhile, word spread to other research facilitates of its capabilities, resulting in numerous purchase offers. Still, the administration denied the team permission to use University funds to support commercial sale of the technology. Subsequently, the couple quit their jobs and began independently financing their own startup in 1984 using savings and credit cards. The company was first called cisco with a lowercase “c” to signify the end of “San Francisco”. Over the next several years the startup made software and hardware improvements until its product (dubbed a “cisco”) was commercially viable, and the first multiprotocol router shipped in 1986. This invention essentially created a new section of the IT industry: Internetworking or the practice of using devices and software to route information packets between networks.

It was around this time that venture capital investment became necessary to meet escalating demand. After dozens of failed pitches, Don Valentine of Seqouia Capital saw the vast investment potential in connecting personal computers and agreed to pay $2.5 million for 32% of the company. Although those funds were never used due to the strong initial sales growth, Mr. Valentine provided much needed credibility and corporate knowhow to the startup by establishing an efficient operating structure and hiring a well-seasoned management team. Ms. Lerner stayed on as vice president of customer service, Mr. Bosack got the title of chief technology officer, and they together retained 30% of the company. However, due to the structure of the contracts, much of the power rested in the hands of Mr. Valentine. Eventually, Ms. Lerner’s uncompromising approach led to dissension between the founders and the newly appointed VP’s leading the latter party to give senior management an ultimatum: us or them. The result was Ms. Lerner being fired from the firm a few months after its IPO in February 1990. Shortly after her exit, Mr. Bosack quit and the two donated most of the $170 million in Cisco stock they received to charity.

With the founders out of the picture, management was free to establish Cisco’s primary operating ethos. Leading the effort was CEO John P. Morgridge, a frugal and candid businessman who liked to keep control at the top. One of his greatest contributions to the firm’s culture and early success was a dedication to customer service. Instead of selling routers to technicians his team pitched to the upper management of large corporations, a strategy that allowed the firm to collect numerous deep-pocketed clients who were clamoring to connect workers across campuses. Cisco was not only great at winning new customers, but also at keeping them. The engineering staff was told to satisfy complaints and suggestions when creating new products. Innovative web-based applications like a “bug-report database”, online ordering, and a message board where clients could post questions and get responses from other customers proved very popular. This gave engineers more time to resolve the most difficult problems and kept technical support staff relatively low. Mr. Morgridge recognized high customer satisfaction as a driving force behind Cisco capturing 80% of the router market by 1996. A few years after that, the company established an entire unit dedicated to assisting customers in running their networks. In 2010, the highly profitable Services segment made $7.6 billion, or 19% of revenue.

Another key element of Cisco’s corporate philosophy cultivated by Mr. Morgridge was diversifying the product base. Management correctly believed that the rapid rise of Internet traffic would require new technologies beyond “backbone” infrastructure like routers, and concluded that Cisco would need to provide them in order to keep growing. The company wanted to be a one-stop shop for corporations’ networking needs and did not care whether technologies were developed internally or gained through acquisitions. It determined that switching technology was the next big thing and in September, 1993 it bought Crescendo Communications, Inc. That company’s Catalyst Operating System would be used for Cisco’s Catalyst line of switches which predominately connect computers in single buildings into local area networks. Crescendo was purchased for $92 million when it had less than $10 million in annual revenues. Catalyst products would go on to be a $7 billion-a-year business for the Switching unit.

In January, 1995, current CEO John Chambers took control of the company. Mr. Chambers was more aggressive than his predecessor and chose to dial up the pace of acquisitions, making four in his first year. In 1996, Cisco bought a leading supplier of Asynchronous Transfer Mode (ATM) technology, StrataCom, Inc., for $4.67 billion. This now outdated switching technology directs traffic across long distances without needing routers and reduces latency, making it well suited for voice and video transmissions to branch offices. Too, StrataCom owned Frame Relay switching devices that were heavily demanded by telecom companies looking to connect local area networks into wide area networks. This deal helped Cisco to expand its customer base beyond large corporations, educational institutions, and government agencies to service providers, a group which now makes up approximately one third of sales.

Although management had always been good at predicting which technologies would prove successful, the acquisitions made in the late 1990’s were the result of particularly visionary thinking. One was NetSpeed, a company that made digital subscriber line (DSL) equipment for homes and small businesses to access the Internet using existing telephone lines. Cisco was also an early entrant into wireless networking for the home and fiber optic networking used by service providers. John Chambers famously predicted that all phone calls would be transmitted over the Internet, an idea that justified the acquisition of voice-over-IP business LightSpeed International. Mr. Chambers credits talking to customers, and identifying social, economic, or technological shifts for his strong track record of foreseeing “market transitions”.

In many regards, Cisco was the quintessential growth stock of the 1990’s. Annual top-line growth fluctuated between 30% and 50% and the market capitalization rose from $400 million in 1993 to more than half a trillion dollars at its peak in 2000. However, the stock quickly fell from grace as the dot-com bubble burst and corporations and service providers became much more conservative with IT budgets and capital expenditures. It became apparent that CSCO could no longer maintain historical growth rates. Thus, investors were not willing to pay a premium valuation for the shares. Although growth would never be as high as in the 1990’s, Cisco was able to recover nicely during the mid-2000’s, as bandwidth demands escalated and it continued to provide cutting-edge technology through acquisitions and internal research and development. Still, at this time, some started to believe that Cisco’s massive size would force growth rates and profitability to plateau. 

Investors began to question whether Cisco was spread too thin as it was competing in over 30 markets at one point, including virtual healthcare, safety and security, smart communities, consumer camcorders, and stadium-sized TV screens. Additionally, Cisco's managemnt structure was overly complex with an inefficiently high number of teams, "boards", and "councils". This was causing delays in the product approval process, reduced accountability, and less success at anticipating market transitions. Correspondingly, revenues and earnings declined considerably and market share was lost to rivals who proved quick to adapt to changing demand conditions.

In April 2011, CEO John Chambers admitted that unacceptable operational execution had disappointed investors, confused employees, and caused the company to lose credibility with customers. He took action to rightsize the business in 2011, cutting a significant portion of his workforce, divesting some consumer businesses (Flip HD video recorders), and streamlining the management hierarchy. Total annualized savings reached $1 billion in the 2012 January quarter, and the company has returned to double digit revenue growth thanks to its "value engineering" efforts and more competitive pricing. This has come at the expense of margins and it is yet to be determined if gross profits will demonstrate sustainable improvement. Nonetheless, core business have stabilized and the company continues to look for growth in Video products, collaboration and the data center to fuel long term gains.

 

Competitive Dynamics

Fierce competition is nothing new to Cisco. Its dedication to customer service, improving the functionality of its devices, and purchasing any companies that grow big enough to become a threat have allowed it to maintain a strong share in its core markets. The company has around 70% of the Ethernet switch market. Cisco’s biggest competitor in the space is Hewlett Packard (HPQ - Free Hewlett Packard Stock Report), which claims around 10% of the market. Overall, we expect this market to grow in the low double digits for the foreseeable future as it continues to mature.

 Cisco has been supplying switching technology to data centers for a number of years with its Nexus line, and is now looking to branch out into storage, servers, and virtualization software. Its data center solution, the Unified Computing System, aims to reduce total cost of ownership and improve scalability by integrating the different components into a cohesive platform that can be managed more efficiently as a single unit. Cisco has developed its own blade and rackmount servers that compete head-to-head with computing heavyweights International Business Machines (IBM - Free IBM Stock Report) and Hewlett Packard. The former has an extensive portfolio of servers and previously used Nexus switches for its data center needs. Due to CSCO’s move into IBM’s turf, we believe much of this switch business will go to Juniper Networks (JNPR) and Voltaire, companies with competing solutions in this space. HP also commands a large presence in the data center market. Its acquisition of 3Com filled out its switching portfolio, but it is still at a disadvantage, as the products are not compatible with other vendors’ equipment. We like the alliances Cisco has formed with VMware (VMW) for virtualization software and EMC Corporation (EMC) for storage, as these companies are both leaders in their respective markets. Although it will be difficult to take market share from incumbents, we believe Cisco will continue to find success in the rapidly expanding data center virtualization/consolidation and cloud computing delivery markets.

Service providers account for 80% of worldwide router sales, with the rest going to enterprises. The $11 billion carrier routing market has exhibited strong growth over the past several years thanks to the rapid rise in video transfers from businesses and on Websites like Google (GOOG) owned YouTube and Facebook, as well as streaming TV service Netflix (NFLX). We expect these trends to continue pressuring bandwidth, leading carriers to purchase more core routers. Cisco boasts more than a 50% market share in core routers; Juniper is second with 30%; and emerging market vendor Huawei has around 15%. The market for IP edge and Ethernet aggregation routers are around four times bigger than core routers. These devices are able to identify the type of traffic being transmitted (voice, video, or data) and prioritize it. They help service providers offer video and voice over IP with low latency, and replace legacy ATM and Frame Relay technologies. This subsector should experience mid-teens growth for the next several years as carriers upgrade to next-generation routing technology based on Ethernet and Internet Protocols. Cisco has lost market share over the last several years due to new business in China and other emerging markets going to Huawei.  

At the time of this article's writing, the author did not have any positions in the companies mentioned.