Cisco looks to reboot its business model

Margin erosion sapping funds for new markets, which are distracting company from maintaining those margins

As Cisco prepares to embark on the largest workforce reduction in its history, company watchers openly wonder if its business model is collapsing. Core markets like switching and routing, with their fat profit margins, were helping fund Cisco's incursions into its 30 or so market adjacencies.

And Cisco entered most of these market adjacencies through acquisition - about 150 acquisitions since 1993.

Yet when those switch and router margins eroded during recent quarters and adjacent markets like consumer shrunk, Cisco's model became a house of cards. Couple that with a sluggish public sector - which is 20% of Cisco's business - and you have a full blown crisis on your hands.

Cisco has already shut down Flip, it's ill-fated, $600 million venture into consumer video; similar moves are expected in other areas of the company as it looks to shave $1 billion in expenses, mostly through workforce reduction. Cisco is expected to eliminate about 4,000 jobs in the coming quarters, the largest downsizing in its history.

Cisco's moves into adjacent markets were intended to drive growth of 12% to 17% per year as growth in more mature core markets of routing and switching slowed. Yet margins and consistent revenue in those core markets were to have funded entry into adjacent markets.

But that model is now breaking down. And it's not just the wobbly model itself - it's misexecution as well. Cisco mismanaged the Catalyst/Nexus product transition from higher margin legacy switches to lower margin switches featuring better price/performance. Cisco took its eye off the ball.

In the recent Q3 conference call with Wall Street analysts, CEO John Chambers says the company is overhauling its business model.  Cisco is divesting or exiting underperforming operations, and those that do not fit the company's five priorities - routing, switching and services; video; data center, virtualization and cloud; collaboration; and business process architectures.

That means many of those market adjacencies are likely to be abandoned. And the high growth they were hoped to generate will go with them too. There goes the 12% to 17% growth target.

And the trend in switching is for the price/performance improvements to accelerate. Moreover, the movement towards "open" routing and switching and IT, with efforts like OpenFlow and OpenStack, do not bode well for Cisco. Cisco's thrived on holding its IOS operating system very close to the vest, opening it up as little as possible to third-party extension and augmentation.

But that game is changing. And so is the one Cisco's been playing for years.

The current business model is now obsolete. Time for Cisco to deal a new hand. Cisco's working on it, according to Chambers in his Q3 remarks:

We will be in a position to outline the next phase of our transformation when we report Q4 earnings. As a result, while Q3 met expectations, Q4 will continue to show weakness while we do the hard work behind the scenes to be able to execute these changes, and we will provide for Q4 guidance that reflects that light. We know what we have to do. We have a clear game plan. We are a company with a track record of constant market-shaping innovations.

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