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Cisco (CSCO - Free Cisco Stock Report) chief executive John Chambers recently sent a memo to his employees acknowledging that unacceptable operational execution has disappointed investors, confused employees, and caused the company to lose credibility with customers. This has contributed to the gross margin falling well below its historical average, earnings per share missing expectations in each of the past four quarters, a reduction in the long-term revenue target range, and the stock price falling 35% from its 52-week high reached on April 26, 2010. In keeping with his aggressive, no-nonsense management style, Mr. Chambers has expressed his intent to take sweeping action to streamline operations.

We believe the primary reason competitors have seriously outperformed the networking bellwether over the past year is its 2007 decision to alter its organizational structure by placing executives and vice presidents into boards and councils. Instead of doing one or two aggressive moves a year, Cisco has used the new structure to enter 30 new markets adjacencies over a three-year time frame, including virtual healthcare, safety and security, smart communities, consumer camcorders, and stadium-sized TV screens. This has been an effort to reach its aggressive 12%-17% long-term top-line target growth rate (which management temporarily lowered to 9%-12% for fiscal 2011), but has ultimately resulted in reduced management accountability and efficiency, in our view.

The structure has small teams of two to 10 people bringing opportunities to approximately 50 boards, each with 15 people, two of which are senior VPs or VPs. The boards then report to councils, each with 15 people, two of which are executive VPs or senior VPs. The councils finally report to the operating committee of 15 executives, which includes Mr. Chambers. The majority of Cisco’s decisions are now reached collaboratively through this system versus a small minority in 2007.

The plan has been for council heads to collaborate in order to quickly identify “market transitions” allowing them to make decisions faster and “more effectively prioritize resources across cross-functional opportunities as well as within each of our corporate functions.” When the new structure was first being implemented, Mr. Chambers told The Wall Street Journal his strategy was to “spread them thin” so that they would “realize they can’t keep their head above water and if they want to swim they have to give (some responsibilities) to their teams.” 

It appears that the new structure has had the opposite effect on the timing of competitive moves. One example is Cisco’s failure to match a warranty made by Hewlett-Packard (HPQ - Free Hewlett-Packard Stock Report) on switching technology due to the time it took to work its way through various councils. The end result has been a marginal loss of market share. We believe the new structure has also resulted in market share losses to F5 Networks (FFIV) in the application delivery controller space since that company has managed to beat Cisco to market with more advanced technology. Too, the company’s failure to anticipate changing customer demand dynamics resulting from technology transitions in the Ethernet switching space may have also been partly due to the unwieldy structure.

Although Mr. Chambers never explicitly pointed to the new management structure as the reason for the weak performance, he did admit that “We have been slow to make decisions, we have had surprises where we should not, and we have lost the accountability that has been a hallmark of our ability to execute consistently for our customers and our shareholders.”

Mr. Chambers made it clear that operational execution needs to change quickly and Cisco needs to have more discipline. Although specifics were not revealed, he indicated that healthy disruption is forthcoming, saying they will “make meaningful decisions in a timely, targeted and measurable way” and “we will address with surgical precision what we need to fix in our portfolio.”

We interpret this to mean that certain markets Cisco has ventured into will be divested. Primary candidates are certain consumer businesses that management has already expressed interest in curbing investment in due to weak sales of Flip HD video recorders and Linksys home and small business networking products.

A regression back to the prior top-down management approach may also be in the works. This would help resolve the loss of accountability that spreading power over too many people has created.

Mr. Chambers has made it clear that he’s not trying to fix what isn’t broken nor will he revise areas, which are doing well, like the Unified Computing System and telepresence. In the memo, Mr. Chambers reestablished the company’s main priorities: leadership in core routing, switching and services; collaboration; data center virtualization and cloud; architectures; and video.

On the employee front, Cisco is looking to simplify the way employees work and how they focus their attention and resources. “We will reshape the operational foundation in order to empower our teams, integrate our major functions, and allow our people to focus on inspiring and important work” said Mr. Chambers.

The response by the investment community has been positive thus far, with the stock starting to firm. We view the changes as constructive and believe any future management restructuring will eventually prove beneficial for Cisco’s bottom line, its highly talented workforce, and its shareholders.

 

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