© 2006 DOW JONES & COMPANY, INC. ALL RIGHTS RESERVED.                    www.barrons.com        OCTOBER 9, 2006

annual sales to Cisco within five      Leader of the Pack
years.                                 Cisco has outgrown its ne...
“When we do a good job as a vendor, we get                                                    more productively. He’s got ...
working. Microsoft and Cisco products
     Sooner or later Cisco will pay a dividend, though                              ...
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Getting The World Wired


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Getting The World Wired

  1. 1. © 2006 DOW JONES & COMPANY, INC. ALL RIGHTS RESERVED. www.barrons.com OCTOBER 9, 2006 Cover Story For Cisco, the bundling of voice, video and Internet service heralds the dawn of a new, more profitable age. Getting the World Wired by Bill Alpert In recent years, Cisco Systems Chief Executive John Chambers has had trouble persuad- ing investors that data-networking still is a growth business. § The company’s routers and other networking gear lie at the heart of the Internet and most of the world’s large organizations. But does all that electronic plumbing ever need upgrading? After all, a notebook computer cracks when you drop it, but network switches rarely wear out. § As 2006 began, Cisco’s sales were rising by less than 10%. With its annual revenue around $30 billion, the San Jose, Calif.-based company needed to find new sources of growth, and in very large increments. § Apparently, it has. At a meeting with Wall Street analysts last month, Cisco said that several mar- kets look ripe enough to nourish its next growth spurt: oil- rich nations looking to wire their people; telephone and cable providers locked in an arms race for Internet gear; corporations bundling e-mail and voice messaging on their networks and a coming flood of Internet video traffic. Any one of these new markets could be worth $10 billion in Cisco CEO John Chambers Timothy Archibald THE PUBLISHER ’ S SALE OF THIS REPRINT DOES NOT CONSTITUTE OR IMPLY ANY ENDORSEMENT OR SPONSORSHIP OF ANY PRODUCT, SERVICE, COMPANY OR ORGANIZATION. Custom Reprints (609)520-4331 P.O. Box 300 Princeton, N.J. 08543-0300. DO NOT EDIT OR ALTER REPRINTS ● REPRODUCTIONS NOT PERMITTED !
  2. 2. annual sales to Cisco within five Leader of the Pack years. Cisco has outgrown its network-industry rivals, but its share price has just begun to reflect its growth prospects in new markets for communications, online Cisco CEO John Chambers collaboration and entertainment. If the company continues to win new business in these markets, its shares could grow at least 15%. The earnings says even he is surprised by the numbers below don’t include stock-option expenses, the approach still favored by most tech companies, including Cisco, and industry analysts. company’s early success in Market Price/5-Year Revenues (bil) Earnings Per Share Price/Earnings these new ventures. “We are Company Ticker Recent 52-Week Price Change Value (bil) 2006E 2007E 2006E 2007E 2006E 2007E Earnings Growth (E) winning almost all the new jump Cisco Systems* CSCO $23.90 36.6% $145.9 $28.0A $33.0 $1.10A $1.27 21.7 18.9 1.4 balls,” he says. “We will become Alcatel ALA 12.20 -6.7 17.4 18.0 19.0 0.72 0.87 17.0 14.1 1.4 the leading company as the net- Juniper Systems JNPR 18.20 -17.6 10.3 2.3 2.6 0.75 0.88 24.4 20.6 1.4 work enables all forms of com- Nortel Networks NT 2.18 -34.1 9.5 11.0 12.0 0.03 0.14 77.9 16.1 9.7 munication.” Redback Networks RBAK 14.71 51.5 1.0 0.3 0.3 0.38 0.64 38.5 23.1 1.7 In appreciation of these Avaya** AV 12.06 9.9 5.5 5.1 5.4 0.46 0.60 26.0 20.0 2.6 prospects, analysts have been Polycom PLCM 25.75 61.1 2.3 0.7 0.7 0.99 1.18 26.0 21.8 1.7 raising their sales growth fore- A=Actual E=Estimated *Fiscal year ends in July. **Fiscal year ends in Sept. Source: Thomson Financial/Baseline casts for Cisco from the low Emerging Opportunity Heading Higher Fatter Pipes, Fatter Profits teens to 15% or more per year. In coming years Cisco expects to double Cisco’s shares, which went nowhere for five Growing demand for Internet video services As for profits-which totaled $6.8 its sales in emerging markets, chiefly in years, have rallied 40% in recent weeks, will force providers to upgrade and enlarge oil-rich nations wiring their populations suggesting investors believe in the company’s their networks. That’s good news for Cisco, billion, or $1.10 a share in the to create jobs and improve health care. improved growth prospects. the leading supplier of routers and switches. fiscal year ended July 2006-the Street sees $1.27 a share in fis- FY 2006 Revenue By Region (bil) Cisco Systems (CSCO - NNM) Data Demand Per Home cal ’07, and $1.47 in fiscal ’08. Weekly close on Oct. 5 Millions of Bits Per Second Japan Cisco, like most technology com- $1.5 $80 80 Emerging panies, reports earnings before Markets $2.6 60 67 60 option expenses. Asia Pacific Investors seem to have $2.7 40 40 $15.5 marked up their opinions of Europe $6.3 20 20 Cisco, as well. Since early Au- 12 gust, the company’s shares North 0 0 (ticker: CSCO) have risen al- America ’00 ’01 ’02 ’03 ’04 ’05 ’06 Current By 2010 most 40%, to a recent 23.90. Yet, Sources: Bloomberg; Piper Jaffray at 18.8 times next year’s esti- mated earnings, the stock sports a lower A few years back, Cisco’s router sales is Cisco’s forte. price/earnings multiple than most other flattened when Juniper Networks (JNPR) Similar efforts are unfolding abroad, networking shares. As sales and profits seized the high end of the market with where upstarts like France’s Neuf and begin to flow from new customers and new powerful routers designed for the core Italy’s Fastweb are challenging their coun- markets, like Internet video,Wall Street is networks of telephone-service providers tries’ former telecom monopolies. CEO likely to raise its stock-price targets. A like Verizon Communications (VZ). The Chambers says Cisco designed products number of analysts think the shares easily competition forced Cisco to spend $500 like the CSR-1 with a vision of the coming could tack on another 15%. million to develop a new router, the CSR- convergence. “We did not build the CSR-1 1, which could carry 100 times more traffic to do a billion phone calls,” he says. “We Cisco didn’t invent the Internet, but few than Juniper’s. Since its launch in 2004, built it to do 100 million videos.” other companies did as much to help it the CSR-1 has stormed the market, form- Suppliers of traditional telecommunica- come of age. In the 1990s, as the dot-com ing the core of new networks at Sprint (S), tions equipment, such as Lucent Technolo- bubble was inflating, Cisco’s sales in some Comcast (CMCSA), British Telecom gies (LU) and Nortel Networks (NT), have years grew more than 50%. Revenue (BT) and Japan’s Softbank BB, while Ju- seen flat or falling demand from their growth since has slackened to a comfort- niper has struggled to come up with a re- phone-service customers in recent years. able low-to-mid-teens pace. Fiscal ’06 sales sponse. According to the Dell’Oro market- But spending on Internet equipment by rose 15%,bolstered by the February acqui- research group, in Redwood City, Calif., phone and cable operators is growing by sition of Scientific-Atlanta, a supplier of Cisco now enjoys about a 60% share of the 17% a year, says Mike Volpi, who runs Cis- cable-television equipment. router market for such customers. co’s router and service- provider businesses. Today almost 40% of Cisco’s revenue The development of the CSR-1 helped Volpi views his business unit as the arms comes from the sale of switches, the basic place Cisco once more on the ground floor merchant in a war of competing communica- movers of data packets through electronic of a revolution, this one involving the deliv- tions companies. But unlike the network networks. Routers-the brainy parts of a ery of multiple services over a single net- spending of the 1990s, which was financed network, which control and direct traffic- work. Until now, telephone, cable and by stock sales, today’s outlays are funded by chip in a bit more than 20%. Around 20% satellite television each has been delivered these companies’ copious cash flow. comes from new technologies like Internet via a different network technology. Now, The spending is likely to increase. telephony and video, on which the compa- companies in all three industries are gear- When Verizon began installing its FiOS ny is pinning much of its hopes for future ing up to offer customers a “triple play” of fiber-optic network in Massachusetts last growth. Services account for the remaining voice, highspeed Internet and television year, Comcast countered by boosting the 15%. Total revenue topped $28 billion in service-and, before long, wireless and download speed of its cable-modem ser- fiscal ’06 and is expected to rise to $33 bil- wireless TV-over a single network that vice. That required the cable company to lion in the current fiscal year. uses the Internet Protocol technology that upgrade its routers. 2
  3. 3. “When we do a good job as a vendor, we get more productively. He’s got a credible record in productivity improvement; Cisco 80% of the business and the second source pulls in more than $700,000 in revenue for each employee, triple its nearest competi- gets 20%,” says Cisco executive Mike Volpi. tor. Cisco will roll out its telepresence product to its 70 sales offices next year, “When we don’t do a good job, it’s 50/50.” and estimates it will break even on the in- vestment in less than nine months. It ex- Volpi is encouraged by Cisco’s win rate chief executive, Boaz Raviv. His company pects to save an annualized $100 million in so far. “When we do a good job as a ven- created a consumer video-calling product travel expenses by year-end 2007. dor, we get 80% of the business and the for Fastweb that uses the living-room tele- second source gets 20%,” he says. “When vision as the conference-call’s video moni- Cisco’s video plans are but a piece of a we don’t do a good job, it’s 50/50.” tor. With Cisco and Northrup Grumman larger ambition to lead in all forms of com- (NOC), Radvision is building the world’s munication. In the same way that a phone In the triple-play race so far, cable com- largest video-conferencing network, by company can run all communications over panies have had great success selling tele- linking 1,500 meeting locations for the U.S. a single Internet-Protocol network, a large phone service. They can charge a low fixed Defense Department. business now can use one IP network to price because they run calls over Internet Cisco’s Chambers has used current- unify its various systems for e-mail, in- style routers, most provided by Cisco. stant-messaging, project collabo- Within about six months, Volpi says, Cisco ration, physical security and Growth Engine PBX phones. Cisco believes the routers also will incorporate digital-video technologies. Internet Protocol-based tele- While Cisco’s other businesses are growing at a measured pace, annual market for “unified com- vision, or IPTV, is the delivery technology sales of advanced technology have rocketed it recent quarters munications” solutions will reach on demand for Internet video, telephony and conferencing. $10 billion within three to five of choice for new providers of TV service like AT&T, Verizon and Italy’s Fastweb. years. The technology also will enable Cisco to Cisco Product Segments The company’s first communi- Past five quarters: sales in billions cations products have been suc- bring the home-alarm industry into the digital age. Indeed, the company thinks it $3.0 cessful. In just a few years, Cisco could create a billion-dollar market for grabbed the lead in the market 2.5 for PBX [private branch ex- gear that transmits video from your baby’s crib to your cell phone, or from a break-in change] internal phone switches, to the local police station. 2.0 winning a 23% market share with Best of all, the “data packets” carrying its Voice-over-Internet-Internet- video are bigger than other kinds of net- 1.5 Protocol systems, according to work traffic, and would require networks figures from Synergy Research to upgrade their switches and routers. Group. In the July 2006 quarter, 1.0 Cisco shipped more than a mil- High-definition video conferencing, for in- stance, might use 10 times the network lion VoIP telephones. For a bandwidth of other network traffic. “The 0.5 branch office or a medium-sized more bits, the better for Cisco,”Volpi says. business, getting a PBX can be To beguile enterprise customers with as simple as adding a card to Cis- the virtues of video, Cisco soon will unveil FY FY FY FY co’s Integrated Services Router, 2006 2006 2006 2006 a sophisticated high-def video-conferenc- a Swiss Army knife-style product Switches Routers Services Advanced ing system. Companies such as Polycom Technology that also can become a network (PLCM), Radvision (RVSN) and Nor- Note: Fiscal year ends in July. Source: Piper Jaffray firewall and a Wi-Fi network way’s Tandberg have been selling video- base station, also by inserting conferencing products for years, but Cisco generation video-conferencing products to new cards. Video surveillance soon will be- could quickly become the market leader. confer with other executives, such as come another add-in feature. Bob Hagerty, CEO of Pleasanton, Calif.- IBM’s Sam Palmisano. Chambers says he Cisco sells tens of thousands of ISR based Polycom, guesses there have been can barely tell who’s who on the TV routers every quarter; the ISR ramped to around a million video-conferencing sys- screen, and that he’d never use it to talk to a $1 billion annual sales rate within its tems installed around the world, about half customers. But next-generation products first year, faster than any other Cisco sold by his company. In May Polycom in- are another story, capable of delivering a product. troduced its latest $250,000 video-confer- “telepresence.” Voice-over-Internet-Protocol solutions encing set-up. In coming months it will up- “It’s video conferencing and data con- have dominated the PBX market with sur- grade its product to high-definition. ferencing and IP telephony conferencing,” prising speed, forcing incumbent vendors Competing with a high-def product of says Chambers. “You can play Texas like Avaya (AV) to revamp their product its own will be Fair Lawn, N.J.-based Hold’em with three other groups at the lines. In 2002, VoIP products were about Radvision, whose video-conferencing gear same time in different locations, as if you 15% of all PBX phone lines sold, says has been sold under the Cisco label. Video were all at the same table.” Avaya CEO Lou D’Ambrosio. This year, transmission over Internet-protocol net- Time permitting, you could also get he expects IP products will be 60% of PBX works means video calls no longer need be some work done, and Chambers believes industry sales. The computer-like IP-PBX a luxury for CEOs only, says Radvision’s collaborators would work 20% to 30% systems save companies money by letting 3
  4. 4. working. Microsoft and Cisco products Sooner or later Cisco will pay a dividend, though may compete with each other, but at least shareholders aren’t demanding one yet. The they’ll be able to talk to each other; the two companies say they’ll work to ensure company would like its eventual payout to be compatibility. Gupta says it’s a huge mar- ket they’re both chasing: perhaps as large more meaningful than Microsoft’s 1.5% yield. as $40 billion in annual sales. While these new technologies are giv- them use cheap Internet links, instead of fied-communications market that Cisco is ing Cisco’s current customers reason to expensive trunk lines. They also allow targeting. In June Microsoft announced upgrade, Cisco also is seeing growth of third-party software writers to invent several products planned for late 2007 that nearly 50% a year in its sale of networking clever new applications. At the Wynn Las would handle VoIP phone calling, instant systems in emerging markets like Saudi Vegas resort, for example, an Avaya IP messaging and video conferencing. Micro- Arabia. That growth results from sales in- phone lets guests use many of the casino’s soft plans to take advantage of its huge in- vestments Cisco made in the past couple of services from their night tables. stalled base by bundling some of the new years, just as it had done previously in D’Ambrosio concedes that Cisco enjoys communications features into its ubiqui- India and China. A large sales force of an advantage in selling IP products, as tous suite of PC applications, Microsoft Of- Cisco representatives is now making the most large organizations own Cisco switch- fice, while adding other features to its pop- case for oil-rich nations to invest in net- es and routers. So PBX incumbents like ular e-mail-server software, Microsoft works as a way to improve health care in Avaya and Nortel strive to compete on the Exchange. There are more than 400 mil- those countries and create high-value jobs. quality of their software applications. lion users of Microsoft Office and over 100 Today such countries represent 10% of Many customers want their mission-critical million workers with mailboxes on an Ex- Cisco’s sales, but Chambers thinks they phone systems to remain separate from change server. will contribute 30% to 50% of future their networks, says Avaya’s CEO. Communications is a natural next step growth. The University Hospitals Health Sys- for Microsoft, says Anoop Gupta, a vice If Cisco revs up its sales growth with tem in Cleveland, Ohio, is not one, howev- president of the company’s unified commu- products for unified business communica- er. The hospital complex has hired Cisco to nications group, “What are the key pain tions or consumer quadruple plays, its replace its existing PBX, cable TV and points that information workers have?” he gross margins should remain in a range of computer networks with a grand, unified asks. “Twenty years ago, it was creating 64% to 66%, says Dennis Powell, the com- network, in an 18-month project costing documents and spreadsheets. Today, it’s pany’s company’s chief financial officer. tens of millions of dollars. The hospitals’ how worldwide partners can collaborate.” That’s because the value added, in most phone center will feature triple-redundant At the June announcement, Microsoft Cisco products, is software, whether it’s systems, says the system’s chief informa- demonstrated how a worker on the road embedded in computer chips or part of the tion officer Ed Marx. Medical records will could phone into the Exchange e-mail company’s network operating system. be accessible instantly to authorized peo- server and tell it to read aloud from the Cisco generated free cash flow of $7 bil- ple anywhere. Intercom announcements of text of freshly arrived e-mail messages. A lion in its July 2006 fiscal year. Financial the “Code Blue, Unit 5700” variety will be writer could click on a person’s name chief Powell says the company wants to a thing of the past as the network wire- where it appears in a Word document, and give shareholders the cash it isn’t invest- lessly summons the required doctors and instantly be able to phone or e-mail that ing in new ventures or acquisitions. Since nurses. person. A video conference demo featured September 2001 Cisco has shrunk its The Cleveland system did not solicit a a tabletop gadget with a 360-degree cam- shares outstanding by about 25% through network vendor other than Cisco, satisfied era at the top of a six-inch stalk. This $35.4 billion in stock buybacks. It still has with the company’s promise of a certain “Roundtable” video-conferencing device $4.6 billion of firepower left under its level of network performance, with finan- sends a panoramic view of everyone as- share-buyback authorization. Sooner or cial penalties if the service fell short. sembled, and can zoom in on any speaker. later, Powell expects expects Cisco will Indeed, many Cisco customers make But apart from devices like the Round- start paying a dividend, but there has been just that one call, instead of soliciting com- table camera, the Microsoft unified com- no ground swell of shareholder demand petitive bids. In a survey of 500 informa- munications solution is all software-with yet. When Cisco does initiate a dividend, tion-technology buyers conducted in software’s attendant economies. “In our Powell would like it to be more meaningful March by SG Cowen, 35% of respondents approach, there is no PBX,” says Gurdeep than the token 1.5% yield paid by Micro- indicated they planned to move more of Singh Pall, another Microsoft VP. “It’s a soft (not including its special dividends). their network spending to Cisco, while totally distributed architecture.” Investors probably will be happy to only 4% expected to shift more to competi- If Microsoft sees communications going continue betting on John Chambers and tors. Customer satisfaction is one reason from computer to computer, Cisco foresees his team. “We were $1 billion in sales why strong challengers, such as China’s communications functions running on its when I took over, ten years ago,” he Huawei, have yet to crimp Cisco’s 67% network gear. One Cisco advantage is its says.“We now move into new markets and gross profit margins. head start; it has been selling communica- do $1 billion in each of them. No company tions products for a few years, and can de- in the history of IT has ever done that in If Cisco is leaving most of its traditional liver solutions that work out of the box. more than a couple of products, and we’re networking rivals in the dust, there’s a Microsoft plans to start selling its software doing it repeatedly. We’re in the right spot new competitor looming: Microsoft. The around the middle of 2007, and its third- at the right time, and we’re trying not to Redmond, Wash., software behemoth party hardware and software partners mess that up.” (MSFT) has its sights set on the same uni- may need more time to get everything Chances are, it won’t. n 4