Cisco facing up to challenges

Company attempts to tap new sources of growth as others mature

Cisco’s success means it must continually seek new markets.

Cisco is both envied and vilified for its success in the network industry.

The company is the market leader of both routers and switches to both enterprises and service providers, is usually the No. 1 or No. 2 vendor in every market in which it competes, has little problem attaining the 10% to 15% annual growth targets it sets, and has a distribution channel second to none.

Slideshow: Who will Cisco buy next?

Yet as Cisco prepares to meet with thousands of customers at next week's Networkers conference in Anaheim, Calif., it is facing several challenges: Sales to U.S. enterprises are slowing, forcing the company to look for growth overseas; margins are eroding in some markets; the company faces new low-cost competitors; and its core technologies are becoming increasingly commoditized.

Not that any of that is reflected in current financials. The company’s fiscal 2007 ends in July and sales are expected to climb 22% to $35 billion, while earnings are expected to jump 21%.

The trick will be sustaining that growth.

Global outreach

While the U.S. enterprise market accounts for about 13% of Cisco’s total sales, demand is softening, with U.S. enterprise spending rates stabilizing in the mid-single digit range, according to UBS Warburg.

Cisco is feeling it: US enterprise orders grew in the mid single digits in the third quarter, down from 20% in the third quarter of last year. So Cisco is looking overseas for growth.

“We have been investing in sales coverage around the world, with a specific emphasis on investing in emerging markets,” says Rob Lloyd, Cisco senior vice president for U.S. and Canada field operations.

Cisco’s emerging markets include more than 130 countries in Central and Eastern Europe, Russia and the Commonwealth states, the Middle East, Latin America and Africa. It represents about 2.3 billion people and has a gross domestic product that exceeds the GDP of developed countries such as the United States, Japan, and Germany.

Emerging markets could add up to a $10 billion opportunity by the end of the decade, according to Cisco, and Lloyd says growth has been fluctuating in the high 30% to low 40% range. Analysts agree, noting that emerging markets has a sustainable growth rate of 30+% for the next three to four years, while domestic sales grow at around 10% and Europe/Asia at 15%.

Lloyd acknowledges, though, that U.S. enterprise sales and sales to the federal government have slowed, attributing it to the “war effort.” He says, however, that U.S. enterprises have been shifting spending to global operations – many in the emerging markets Cisco is tapping – and that overall, the enterprise business on a global scale has been “solid.”

Margins, commoditization, saturation

Yet Cisco must always confront the specter of declining prices in the enterprise market, analysts note.

“The big challenge is commoditization and competition from lower-cost providers,” says Dave Passmore, research director for network and telecom strategies at Burton Group.

This is particularly true at the lower end of the market.

“The overall trends are not in Cisco’s favor,” Passmore says. “The prices keep getting lower and lower, and everybody who’s a Cisco network guy knows they can go to their favorite big-box retailer and buy a switch and router for two orders of magnitude less than what they pay Cisco for enterprise-class gear. A lot of the consumer-oriented products are becoming more and more sophisticated, and it’s really getting people to ask the question, ‘Why are there two more zeros stuck on the end of a Cisco product?’”

Some “companies want to start to use consumer goods because they see a Linksys router doing the exact same bloody thing they’re buying Cisco for,” says Frank Dzubeck, president of consultancy Communications Network Architects in Washington, D.C.

Obviously the Linksys routers appeal more to small and midsize businesses that do not require the features and functionality – such as video, WAN acceleration and mobility – of Cisco’s enterprise-class Integrated Services Routers, which have been selling well for the company.

But Dzubeck points to market saturation as another force at work. Cisco, for example, has sold so many Catalyst LAN switches over the years – it had a 74% share of the Layer 2-3 fixed and modular switch market in the first quarter, according to Dell’Oro Group -- that users still have plenty of capacity on existing switches, and can redeploy them in data center consolidation instead of purchasing new units.

Lloyd downplays the saturation argument.

“You could have said the U.S. enterprise market was saturated 10 years ago, and then five years ago, because almost all of those enterprises have Cisco switches or routers,” he says. “But here’s the fundamental question: Is there a reason for the existing installed base of routers and switches to upgrade to a new capability?”

Lloyd says the drivers behind those upgrades are collaboration applications, unified communications and video, three markets Cisco is concentrating on. Cisco recently rolled out its Telepresence videoconferencing platform for large enterprises, which allows far-flung attendants to conduct meetings as if they were in a virtual conference room.

“This stuff is all coming to the enterprise,” Lloyd says. “And when it comes it starts to have a tremendous impact on how those enterprise networks are designed and the services that they need to carry.”

Climbing the stack

Cisco’s incumbency in and long-time relationship with large enterprises also provides some insulation from the saturation and pricing trends, Passmore notes. But it forces Cisco to “move up the stack” and rely more on software sales in order to maintain its 60+% gross profit margins.

Cisco, for example, has been modularizing and repricing its traditional IOS software, and is branching out into the unified communications and collaboration space and into software-driven service-oriented architectures (SOA). Cisco recently acquired Web conferencing and collaboration service provider WebEx for $3.2 billion, and last year unveiled its own contribution to SOA -- Service Oriented Networking Architecture (SONA), an attempt to better marry applications and networks.

Cisco is also a big player in Network Admission Control (NAC), with software for its switches and routers, network-attached clients, and security monitoring and response systems.

But as Cisco fills out its software portfolio, it collides with entrenched behemoths –- and partners -- like Microsoft and IBM. Increasingly, it becomes a challenge for Cisco to balance its reliance on these companies while competing with them as it broadens its software presence.

Dzubeck says Cisco will run square into IBM in SOA/SONA. Two years ago, IBM bought Data Power, a privately held maker of integration and security appliances for processing XML and Web services traffic, ingredients IBM believes are key to its SOA initiative and that will go up against Cisco’s SONA.

Unified communications (UC), collaboration and NAC will pit Cisco against Microsoft as well as IBM’s Lotus Notes group. Microsoft has an alliance with Cisco competitor Nortel in unified communications, and is a key member of the Trusted Computing Group (TCG), an organization promoting specific NAC standards, of which Cisco is not a member.

Microsoft earlier this year released its NAC client protocol publicly through TCG. Cisco rival Juniper demonstrated interoperability with the protocol.

Cisco is offering its NAC work to the IETF, which is also defining a NAC client protocol.

The foundation for unified communications is VoIP, and Cisco has a leading position in the market alongside Nortel and Avaya. Cisco acquired social networking firm Five Across earlier this year and views that technology as key to helping businesses connect with customers through individual profile pages, friend lists, discussions, and posting of blogs, videos and podcasts.

Where the rubber meets the road, however, is in the applications built to ride on top of the unified communications platform.

“Much of Cisco’s growth is tied up in the things that the network enables you to do,” says Zeus Kerravala of the Yankee Group. “Owning UC and presence is important not only from the fact that you get the sales revenues, but that is the platform for the next 10, 15, 20 years.

“The question is, ‘Who’s platform are you going to build it on,’” Kerravala says. “Cisco’s been positioning itself as the vendor you would build on, but the one thing Cisco doesn’t really understand is how to build a software ecosystem. The company that does is Microsoft.”

The Cisco/Microsoft battle for next-generation network applications is just beginning and could play out over decades, Kerravala notes.

Service provider alignment

The service provider arena is a different story. Service providers are transitioning their legacy circuit-switching gear to IP packet switches and routers, which plays right into Cisco’s strengths.

Indeed, Cisco’s CRS-1 core IP router is gaining significant momentum in the market. Cisco has shipped 900 of the systems since its launch in 2004 and has won back some core market share lost to Juniper over the same time period.

But Juniper just announced its next-generation core router – the T1600 – which will ship in the fourth quarter. Juniper is looking for the T1600 to upgrade current users of the company’s five-year-old T640, and regain market share momentum from Cisco.

In service provider edge routing, Cisco faces pressure from Juniper, Alcatel Lucent, Redback Networks and others pitching service edge routers – systems that are service- or subscriber-aware. Service routing helps “flatten” a network topology, Dzubeck asserts, which threatens Cisco’s approach of hierarchical routing.

Cisco still owns the lion’s share of the edge router market, but after four straight quarters of growth in 2006 it saw that share slip from 58.6% in the fourth quarter of 2006 to 51.4% in the first quarter of 2007, according to Dell’Oro.

Service provider customers are consolidating, Cisco’s Lloyd says, resulting in fewer customers that are demanding a more customized approach to their requirements. Competitors are also consolidating, creating larger companies but ones with more baggage, Lloyd says.

“We don’t have the same footprint of legacy technologies in that space, and we have a balance across our business which has enabled us to do very well,” he says. “Our position has probably never been stronger in service provider.”

As for margin pressure from lower-priced competitors like Huawei, Lloyd views that as more of a regional issue. Most of it is occurring in emerging markets, in areas where Cisco does not have a presence, and in niche applications, such as wireless access and optical transport, Lloyd says.

Cisco’s $6.9 billion acquisition of cable set-top box giant Scientific-Atlanta (SFA) is also key to its service provider and consumer forays. SFA and Cisco’s Linksys routers are key to the company’s interest in addressing the burgeoning consumer networking and digital entertainment market, while allowing service providers to increase revenue by offering more advanced IP services into the home.

Yet SFA is mostly a U.S. and North America play, analysts note. Cisco will be challenged in scaling SFA to international markets where cable is not as prevalent as DSL or passive optical networking.

Lloyd says international expansion begins with integrating the Cisco and SFA customer-facing teams. That effort is almost complete, and Cisco is ready to present a “joint face” in fiscal year 2008, which begins next month. Lloyd also says there’s significant cable opportunity on a country-by-country basis in Europe.

Opportunities in other international regions, such as Asia, Australia and the Far East, will be “very targeted,” he says, and already included in Cisco’s road map for fiscal year 2008. He also indicated that Cisco plans to take SFA beyond cable access.

“I think it’s very possible to imagine that the set-top box will become the home-delivery vehicle for all converged personalized services, regardless of the access,” Lloyd says.

So Cisco’s plate continues to expand. Its product breadth and sales and marketing savvy is unparalleled, but the company’s work is clearly cut out for it.

“Interesting times are ahead for Cisco,” says Yankee Group’s Kerravala. “Here’s a company that’s executed on all cylinders for years. But there are some things that really might impact their long-term business.”

Yet as Cisco prepares to meet with thousands of customers at next week's Networkers conference in Anaheim, Calif., it is facing several challenges: Sales to U.S. enterprises are slowing, forcing the company to look for growth overseas; margins are eroding in some markets; the company faces new low-cost competitors; and its core technologies are becoming increasingly commoditized.

Copyright © 2007 IDG Communications, Inc.

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