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Cisco faces uncertain future.

“This was a painful lesson,” said Cisco CEO John Chambers after the announcement of the company’s interim results in May 2001. “We underestimated how quickly the valley could occur and the depth of it.” For its third quarter, ending 28 April, Cisco posted a net income of $230m, 77% down from the previous year. The company is also being hit by restructuring costs after making 8,500 employees redundant.

This was a slightly different picture from the upbeat soundings we got from Cisco’s UK FD Mike Tierney (pictured, right) when we interviewed him for our April issue.

There is no shortage of folk with opinions on why Cisco’s fortunes have hit the skids recently, and most of them seem to be pointing to pilot error.

An abridged version goes something like this. Having done brilliantly in the enterprise and internet space with its routers, Cisco saw the deregulation of the telephony sector as its chance to get into a huge market.

There were basically two ways to go here. Woo the incumbents, or court the newcomers. The incumbents were tightly wedded to their traditional vendors, players such as Nortel, Lucent, Alcatel and Fujitsu. Moreover the equipment they had all been buying for years was circuit switched point-to-point voice telephony stuff. Cisco’s game was internet protocol (IP) routing, a very different concept.

The new age telcos loved the IP story. Corporates ran IP on their networks, the internet ran IP. The new message to corporates would be that voice and data could converge. Voice over IP networks, known as VoIPs, were the way of the future.

With this slogan nailed to their mastheads, a number of new age telcos set about rolling out their networks and bought boatloads of Cisco kit to do it. As a note, it should be pointed out that not all new age telcos went down this route. Some, such as Storm Telecoms, looked elsewhere, to even newer router vendors such as Sycamore, which had an entirely different proposition, based not around voice but around the idea of giving user organisations the ability to tune bandwidth up or down on demand. This idea looks a far more powerful proposition in the medium term than saying to a coporate that it might wish to run its already excellent voice network on its not quite that excellent data network.

For a while, though, the wind was set fair for new age telcos, which looked much sleeker and faster than the slow moving incumbents. Venture capitalists and the stock exchanges of the world loved them. Unfortunately, once the tech bubble burst, and attention switched to earnings rather than potential, the disparity between market cap and income that characterised most new telcos suddenly looked daft. Money streamed out of the sector and the new age telcos were left floundering.

They couldn’t buy any more kit from Cisco and they were up for grabs by anyone with loose change in their pockets. This became a very handy way of buying loads of barely second-hand Cisco kit, and the net effect was to accelerate the shrinkage in demand for Cisco products still further.

So far, this story could be mere bad luck. As Cisco’s incurably optimistic CEO John Chambers commented recently, the kind of tidal turn experienced in his market is more than the equivalent of a 100-year storm, and is not the sort of thing management can be expected to plan for. However, blessed with hindsight, the analysts are starting to pick some nasty looking holes in Cisco’s strategy.

First, the habit Cisco senior execs have acquired in recent years of constantly referring to the large incumbent telcos as “old world” dinosaurs, now looks arrogant. The word is that Cisco has switched and is already energetically wooing established telco execs, but it is starting from a long way back.

Second, and this is a blunder acknowledged inside Cisco, the company got its inventory strategy back to front. For a company with a reputation for management slickness and having a firm grasp of the numbers (how else do you beat market expectations by exactly one cent a share for 14 straight quarters?), telling the world that you have to write off $2.5bn in excess inventory at a time when your share price is going South, is fuel on the fire.

It turns out that Cisco has been ramping up inventory in order to shorten lead times on new orders and has been caught with an unusually deep position on components for anticipated orders as the tide went out.

All of which doesn’t quite square with the comments made to us by Tierney, who explained a number of reasons why the company is able to close its books in a remarkable 24 hours. “We don’t have to go around counting capacitors and bits and pieces at the end of every month,” he said. “Our sub-contract manufacturers do, and there is some shared ownership of inventory, but generally that burden is theirs and not ours.”

Some analysts take the view privately that in declaring such a massive inventory write off, Cisco is playing with the numbers a little. The idea is that it is opting to take a huge hit in this quarter, which is already wrecked, so it can look better, with no inventory issues, in coming quarters.

There is even a suggestion that some of the written-off kit could make a 13th hour appearance later down the track at zero cost and 100% margin.

Mike Thompson, director of research at the Butler Group doesn’t give much credence to this point of view. He points out that inventory has such a short life in the IT sector that Cisco’s policy of writing off anything it thinks it cannot sell inside the year makes sense. The idea that it may have a second life later is just wishful thinking.

He also argues that, given Cisco’s deep pockets, the inventory issue is a side show by comparison with the more serious issue, which concerns the company’s ability to get back to high growth in the medium term. In his view those days are gone – and not just for Cisco.

“It all comes down to how you judge Cisco’s business model for growth pre this bust,” he says. That model was built around the idea of growing its own customer base at speed by investing heavily in new telcos. Basically, Cisco sold the telcos the kit, then lent them the money to buy it. “There is a school of thought that says that if your sales revenue is being generated by money you are lending, that is hardly a true reflection of desire in the market for your product. Vendor financing is not uncommon in this sector, but I would hazard a guess that Cisco was doing far more of it than most. Players such as Ariba are taking the same view, namely that growing customers will pull them out of the hole they are in – they may, but then again, they may not.”

He adds that, although Cisco was cash rich, there is an argument that says that having loads of cash on the balance sheet is not a good thing.

“In my view, from the point of view of Cisco’s technology strengths, their present woes should not cause them to fail,” he says. “But do not look to them or to any other IT organisation to make huge returns for the foreseeable future.”

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