Routers/Switches /

Chambers shrugs off bear market

By Jim Duffy
Network World, 05/29/00

Cisco CEO John Chambers last week shared his thoughts on the state of his company and the industry during a conversation with Network World Senior Editor Jim Duffy.

Does the current volatility in the NASDAQ indicate that techs are overvalued or that there are misgivings about the Internet Economy?

I don't pretend to be an expert in the stock market. What I am usually pretty good at is understanding the segment of the industry we deal with and what we see occurring on a global basis. If you really believe, as I do, that this is the second industrial revolution, high tech and the Internet has a long way to run.

At times, the market may get ahead of itself; at times, behind. But the reason we do 5-year stock options here is so people think in terms of 5 years, building a company to last. And we pass out stock options every year so that people don't go up and down based upon what their initial offer was and then don't get any for a period in front of that. I've always said that that the number I use was remarkably close to what Mary Meeker at Morgan Stanley said, which is the vast majority of companies who went public 2 years and beyond would not be back at the stock closing price of the first day.

Having said that, the others will so far outperform the market that it will still be a very good industry to invest in, even in the start-ups. So I don't worry about the short-term fluctuations up or down, and you'd be disappointing me as a reporter or an editor or as a shareholder if I did unnatural things or jerked the company around based upon how it's stock performed for one month. So I think what the market goes through is a very healthy scenario.

What we found is, even though it sounds a little bit callous, any time we catch a market in transition - the market can be economic, it can be product generations, it can be technology, it can be business models, it can be the application of Internet solutions - that's when we go after it and gain market share, or lose market share rapidly. So while it's always nice to be in a market that's growing very rapidly, when it consolidates the number of opportunities that we had come to us in the last two months was probably more than the prior six months before that. Where everybody thought they'd go public and that would have a sustainable run, people are realizing that if you can't make profits, if you can't scale at a given speed, if you can't build a management team that's built to last then you're not going to be in business long term. So actually this change will work to Cisco's advantage. The minute we saw it occurring it also opened up opportunities for us. You've just kind of got to readjust your strategy a little.

I think the pendulum always swings dramatically. If you watch what Cisco does in terms of our positioning, we've been saying ever since you've been covering us that the market was going to grow 30% to 50% per year. When we grew above 50% for a number of quarters in a row we said 'Don't get overexcited, it's going to be 30% to 50%.' When we grew below 30% everybody was saying, 'Boy, that's the end.' We said, 'Don't get excited. With or without us the market is going to grow in this 30% to 50% range.' And as I said in the last conference call we're as optimistic about the market as we've ever been. Are we tied to capital spending? Absolutely. Will there be times where the stock either lags or gets ahead of itself? Sure. But when you're growing at this rate you can grow into the multiples. It's the companies that are growing at 5% or 10% or shrinking, and have high P/E ratios or are not making any money at all that will have more severe challenges. I think it's actually healthy in the long run although it's very painful for all of us. I wish the market would just go very steady in the right trend and not have these gyrations up and down. It's part of the reason we want to be the most boring, predictable company on The Street.

How is it on the day you announce a $6 billion acquisition your stock goes up four points, yet when you announce another solid quarter it doesn't move?

First, our track record on acquisitions is pretty well known. So it's a strategy that's served us very well and will serve us extremely well going into the future. Companies that led in the 1980s did it themselves, companies that led in the 1990s did it themselves and acquired, and companies that lead in this next decade learn how to acquire and know how to partner.

Partnering will be the next billion-dollar relationship opportunity for us. So, when we acquired our first company our stock actually went down. But the market did not believe acquisitions worked - and by the way they were right on most of them - and we made part of our mark by not only having extremely strong internal development where two-thirds of our products come from, but very good at acquisitions and pretty good at partnering vs. anyone else. So we outlined to the market why we were moving into (Web switching), we outlined the size of the market, we outlined what our strategy would be and what additional follow-on activities would most likely occur. Then we said the market's going to decide can we execute well within this space. The market looked at it, and while the price tag was very high for it, they felt that our execution and our strategy were very good, and in the market the stock reacted very well. So the market trusts us to when we outline an opportunity and say, 'Here it is,' and then outline the positioning. They'll react to varying degrees based on how much leverage they think this has or does not have, our timing to the market - are we right on the money, are we a little bit ahead, are we a little bit behind - and the company that we acquired.

So coming all the way around, the market obviously got ahead of itself. It's correcting - I think that's very healthy as long as it doesn't overcorrect. But I worry about people depending on it flying too far. I don't think there's any doubt in many people's mind that it probably went too far before, and our own view is we don't try to jump in and out of the market. We just give out shares to our employees and we recommend people buy stock and just buy it consistently. And over time, if we execute well then the stock will be fine. So I base it on performance. I don't move things up or down based upon how the stock's performing on a given day or a given quarter. So I don't watch the peaks and the valleys, I watch what is consistent performance.

How would the changes being considered to the pooling method of accounting impact Cisco's ability to grow through acquisition?

I found the SEC [Securities and Exchange Commission] to have done a very good job on this industry and this economy. The FASB [Financial Accounting Standards Board] is in a tough scenario in that they're trying to apply Industrial Revolution processes to this Internet Revolution with nobody having a road map. And my key issue is, 'Here, let's move slower and let's not underestimate the decision that we can make on accounting principles and the effect it could have on the economy.'

Most government agencies have let business lead and moved slower in these areas during periods of change when it's so uncertain, and I'm cautiously optimistic that FASB will do the same. But in terms of the SEC and (Chairman Arthur) Levitt, I think they've done a very good job in this industry and the question we have is purely with FASB. Mr. Levitt's been very open to give me access to the FASB people and very helpful. Everybody wants to battle. I don't want to battle. My issue is how do we get FASB on speed. Part of the issue we have on any government regulation group is if you get to them once they've already made their decision, it's very difficult to get them to change. You've got to get people educated before they take a public stance. FASB took a very strong stance and now getting them to change is like getting politicians to change - very difficult. Where, when we spent time mutually educating each other - such as with Congress, the FCC [Federal Communications Commission] and other groups - we've found that they make excellent decisions. But you've got to get to them before they publicly take positions because getting them to change afterwards is very challenging.

Now back to your specific question.... I think the people who get hurt are the small companies. We have over 40 analysts who follow us full time. And even then it's difficult, to your point about the stock performance, for people to say, 'Here's what the true P/E ratios are and the cash-flow.' When the majority of investors are suddenly making these decisions on their own I think having P/E ratios that are meaningful are very important. But for a small company followed by three analysts... what do they do? The analysts will never get into that level of detail. So you really give the larger companies a huge competitive advantage. So you might say, 'John, why are you arguing on this,' well, because we never would have gotten to where we are now without this type of capability. It's an advantage for our economy; it's an advantage for our company. And so not to allow small companies to be able to grow in a similar range I think is a mistake.

A lot of the battles we fight - on stock options, on pooling decisions, on shareholder litigation - are ones that we've probably moved past and can handle given our size, that others could not. But the neat thing about the Valley is we really believe we're going to change the world. The Valley does, I'm not just talking about Cisco, Cisco does as well. But it creates a culture normally that helps bring others up. So Hewlett-Packard spent a lot of time with us when we got here, teaching us. So did several of the other companies. So did John Doerr, so did Don Valentine at Sequoia. And part of our culture is to give back so others can follow in the steps. Why are we fighting the battle on education out here? Doerr himself spends millions of dollars. I'm probably going to spend over a million dollars. The answer is because our children deserve better. And you don't want to leave behind a generation and create a digital divide-that absolutely is a product of the Industrial Revolution - in education.

But this technology can either bring it together or it could actually split it dramatically further apart. So I believe in giving back and leaving things in a better place. Will it change my acquisition strategy? Yeah, it will. It will slow it down. And I'll pay less. Now think about what I just said. What impact would that in and of itself have on the market if others do the same? So we're making economic decisions off of our accounting principles. And why in the world would we ever want to copy Europe on the accounting principles in technology? I don't know. If anything Europe ought to be following our technology leads. And our real competition is Asia. So I think what we're trying to do is applying old world processes to this new world.

Is Cisco's ability to acquire and assimilate replacing its ability to innovate?

Oh, there's always going to be that constructive challenge in the industry. I'd disagree with it, dramatically. Two-thirds of our products come from internal development. It's just that nobody likes to write about them. I mean, look what [we] did with cable; look at our [GSR] 12000. It outgrew its nearest small competitor 60% quarter-over-quarter last quarter. Look at the [Catalyst] 6500, which is an outgrowth that has been in our technology for 7 years. It grew in excess of 20% quarter-over-quarter. It has a $3.3 billion run rate. So we will get probably two-thirds of our products, give or take 5%, from internal development and one-third from partnering or acquisition. It's just that everybody likes to write about the acquisitions because most of our competitors fail. It's like a sports team. Nobody likes to write about the lines. The lines win or lose most games. And yet they'll write about the quarterback or the linebacker that made the tackle, etc. Any good sports coach would tell you you've got to go with the basics of the line, and that's what your company's culture is about.

The enterprise business was up 20% sequentially in the last quarter. Is that a one-time event or will that be sustainable?

It won't be sustainable at 20% quarter-over-quarter. That would put it at over 100% growth year-over-year. But you are seeing enterprise customers understand the role that technology's going to have on the future of their business and their survivability. As they understand that they are absolutely going to spend more money on technology. So that's why I'm so bullish, and it's Web-based applications where they get the payback. It isn't the client/server where they get the payback; it's all Web-based. When you think about it - e-commerce, employee services, customer support, virtual close, virtual manufacturing, e-learning - all are Web-based applications that have the big payback.

Second is the distinction between our enterprise business and service provider business is very difficult to see either in numbers or to be able to articulate to the community. So the way we articulate it now is which products do we put in the service provider line of business, which do we put in enterprise, when in fact those products overlap a lot. And we actually even move products back and forth or we move generations of products back and forth. So a large part of what happens in enterprise is going to be enterprise business whether they outsource it to service providers or they keep it all internally, or probably a combination of the two. So getting that market mix right is something that's very difficult to explain to the financial community and to the business community as a whole.

And yet it's the enterprise customers that are driving a large part of our service provider capabilities. Part of the reason SBC went with us is our ability to bring enterprise customers to the relationship. So, as some of our competitors have recently done, we were surprised - pleasantly - by the fact that they split their business in half. Cisco's a company that's lucky and expects to be lucky, but you don't get much more lucky when a very good competitor like 3Com withdraws from the market, Lucent splitting their business between service provider and enterprise at the exact time the market's going the other way. The only thing that would have been better is for Nortel Networks to get out of optical. But that'd be asking too much.

Do you view Lucent and Cabletron spinoff maneuvers as exit strategies from the enterprise market?

Our philosophies differ in terms of where the market's going. We think the lines are rapidly blurring between enterprise, service provider, small/midsize business and consumer. And we think there's going to be a lot of overlap of products, of distribution, of partnerships you bring to it. So our strategy is one that believes that those markets will be interrelated and that the products will be interrelated. Time will tell if we're right or wrong on that. But one of the things we've always done pretty well, Jim, is we've listened to the market and they've told us what we need to do. And when you talk to enterprise customers they'll tell you it will be a combination - internal and external implementations that they're going to execute. What you are seeing is a consolidation in the industry, which we've said, going back 5 years ago is going to occur. We said it will consolidate down to two to five major players. It's inevitable in an end-to-end type of architecture. So the question is, who's going to win? And it will be a consolidation marketplace because the market will drive toward fewer vendors or a preferred vendor throughout the network for cost-of-ownership, reliability, time-to-market reasons.

I think it is a strategy of making [enterprise and service provider] separate, which the financial markets may like in the short-term. I have a different view on how the market will evolve. We try to make our decisions on a 3- to 5-year type of basis, that's why we give our stock options in that range as well.

As Cisco becomes more dominant in the enterprise market as your competitors drop out, and with 80% of the Internet router market, do you see any antitrust red flags?

Well, I never use the term that you just did in terms of defining the market. What we've been able to do is focus on a new data/voice/video market, of which we are less than 10% of the total market. And if you understand how big the market is and we're less than 10% by definition, as this market consolidates, I'd like to have the problem of being at 30% or 40% of the total market, etc. So we've got a very long way to go in terms of anywhere near the market share we have in this near market vs. the market that just consolidated.

The second issue is we do not have the barriers to entry that many of the companies have had in this marketplace. This is an open standard marketplace that if you look at our toughest competitors they are often start-ups with remarkably small staffs and revenue, and yet they can attract capital and move very rapidly.

The third element goes back to our philosophy: I don't give away anything. When we face a small competitor who's really good you don't see us - even though it's legally acceptable - discounting dramatically on it. In other words, we don't only make profits on the products we make very good profit on it, and we focus on what the customers say are important to them. We don't try to use our economies of scale to compete in a way that I would consider personally unethical. So we compete very up front on people. You watch, we always try to get the same market share, we always try to get our margins the same level, and we don't compete vs. small companies the way that several of our large peers have done in the industry. If you ski or play lacrosse and you do it with competitors, your game gets better and better. If all the sudden you weren't to have a competitor for a couple of years, what would happen? They come in and completely unseat you. IBM learned that the hard way; Wang learned that the hard way. We wouldn't be there with the 12000 product if Juniper hadn't pushed us. We would not be moving as aggressively on content switching if other start-ups hadn't pushed us. We wouldn't be moving into optical like we did if it weren't for Nortel. So in sports, competition makes you stronger. The same thing's true here. So it's a philosophy.

At our off-site, we emphasize that competition not only is very good for us you want the competition. You'll have more market share later. And secondly, you treat people ethically like you'd like to be treated yourself. So if you have a problem with somebody doing something to you, don't do it to them. And it is a culture we will drive down through. Nothing teaches you how important that is like laying off people like I did [at Wang]. And that was probably one of the mistakes both IBM and Wang made.

Should the Worldcom/Sprint merger go through?

I try not to comment on what our peers are doing in the industry that I really don't have the background on. So I'm not dodging your question, but without really understanding it in more detail I wouldn't be able to comment intelligently. I have found both the FCC and the Department of Justice, in our segment of the industry, make some pretty good decisions.

Do you see sales to regional Bell operating companies (RBOC) ramping up significantly in the near-term and eventually overtaking sales to ISPs and competitive local exchange carriers?

The neat thing is that whole segment of the market is growing very rapidly with or without Cisco. The RBOCs have been a little bit slower to move than some of the other players. What SBC really said to the market is, 'This is the future. We're going to bet on the company we think can best position us to move into this new world. We're going to get very, very close to Cisco and it will be our data architecture, which over time will be data/voice/video.' So when you have a player of that strength and that much respect saying that, that's like the enterprise customers when companies like Merrill Lynch, Citicorp and Chase went our way. They were the predecessors for what the whole market did. So if we execute well here that will probably be looked back upon as a key event that really opened up the dam for Cisco to play in the arena in a big way, where before we were getting elements of it.

And if you watch, we're making similar progress in a number of other big players around the world. We're suddenly viewed as the No. 1 or No. 2 player in most of these accounts, which is a huge difference vs. when you and I last met. Your real key is, just watch our data infrastructure win. Remember when we said voice would be bundled, commoditized over time and eventually be free? Everybody said, 'No, this is never going to happen,' including several of our competitors, who said it won't be for decades. And yet it happened in 2 years. So we've been pretty good at predicting the market. But we do that because we listen carefully to what the customers say. And we listen to criticism pretty well.