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Cisco: Hedging rather than betting

Cisco SystemsBy Executive MBA students Marc Simony, Sherrie Zollinger, Kellie Teelander, Casey Hirschman, Fayda Khalek and Dewan Simon

What do you do when you have $40 billion in the bank, net profits of $7.7 billion, an average annual unlevered free cash flow of around $9 billion, the world economy in shambles, and you need to continue to grow because stagnation will kill your stock price?

At Cisco Systems, Inc. (NASDAQ: CSCO) you announce a $10 billion share buyback to protect your stock price, and you try to maximize your sunk costs and IP (pun intended; both Intellectual Property and Internet Protocol). Cisco has a plethora of business units, but most are geared toward supporting packet flow over Cisco’s core business — networking infrastructure. Networking infrastructure, in this case, represents a large portion the sunk costs, because sold gear does not return any post-sale revenue scaled to the use and value it provides the purchaser.

Cisco doesn’t want to just sell shovels; it wants to be part of the gold rush. The easiest solution would be to attach a packet meter to Cisco’s switches and routers, give them away for free, and charge for their utility. It is unlikely, however, that businesses would buy into this. Option two would be for Cisco to “stuff” the network pipe and exhaust its use, leading to higher online capacity demand, and  enabling Cisco to sell more of its routers, Unified Computing Systems, and cloud-enabling virtualization technology—the full data center stack!

Cisco has around 70,000 employees worldwide, and operates many business units—networking equipment; computer servers; data center virtualization; telephony; Web meetings and presentations; TelePresence; consumer goods in HD video and tablet computing (the forthcoming Cius) smart grid meters; video content management systems; spam and spyware protection; cable TV set-top boxes—just to name a few.

Because of Cisco’s size, wealth, and operational excellence, it is difficult for any one company to attack Cisco completely. HP and IBM have the competencies required to go toe-to-toe with Cisco, but none of them will completely replace one another in the market. But that doesn’t mean there isn’t still room for improvement at Cisco.

Vision: Yes. Strategy: No.

Cisco is a prisoner of its own success. Beholden to the stock market, it needs to continually produce top-line and bottom-line growth. On November 11, 2010, even though Cisco beat analysts’ expectations that day, it didn’t beat them by enough and couldn’t give rosy enough guidance for the next quarter. Its stock dropped 17% that day, eroding $23.5 billion dollars of market capitalization.

Strategy requires that companies develop defensible positions. Owning everything is one way to go about that, but Cisco’s all-you-can-eat approach to growing the company is hardly strategic. It is risky however, as it needs every investment and acquisition to have a sizable financial payoff.

A source within Cisco told us that the company will not compete in a market unless it can achieve number one or number two status. But when asked about Cisco’s strategy, the quizzical answer was “world domination?” Really? Cisco’s many business units appear more complementary than synergistic.

Cisco operates more on a vision. Selling more networking equipment is important to Cisco, and enjoying tertiary effects from digital media growth is nice, but pipe stuffing is not infinitely scalable, not sustainable, and ultimately not defensible.

Cisco won’t fail, but as it grows ever larger it will likely repeatedly falter, and investors will not reward this.

Hedging, Not Betting

Cisco is competing at the high-end. It has tremendous brand equity to protect, but its ability to satisfy the needs of the market and adapt to changing usage and consumption patterns is just as critical.

Cisco could easily hedge its acquisition and investment strategy. By pursuing a complementary parallel strategy of offering the customer true convenience by having software equivalents of some of its hardware products, Cisco can expand its markets and become even more customer focused. Rather than investing and betting on one path only, a parallel approach would give Cisco the ability to better protect itself against failure in one segment.

All of Cisco’s products and services deal in digital bits, data, and information. An analysis of three connected yet independently operating divisions—data center technology, TelePresence, and the Flip video camera—reveals that Cisco has much to protect, and many guns pointing at it. And for every situation a software equivalent exists that would allow Cisco to expand its customer base, offer a wider variety of solutions, and hedge its risk by serving the market from multiple angles.

Strengthening the Hub

A core collection of three of Cisco’s units—networking technology, data center virtualization, and the Unified Computing System— combine to present and direct data to the end-user, and form the backbone of the fastest growing consumption enabler: hosted services (The Cloud).

Think Salesforce.com, Facebook, and Netflix, and you get the picture. Who needs local storage, local content, or local applications anymore? But there are chinks in the armor; Cisco only leads the market in networking equipment. The rest—servers and virtualization—it is only very good at, but not market leading. Dell, HP, and VMware hold those crowns. Unlike in software, where powerful suites prevail in the enterprise, hardware buyers prefer best-of-breed over one-vendor shopping. And even in networking equipment, Cisco has formidable competitors, such as HP, 3Com, and Huawei.

Cisco holds the quality and high-end crown, and no enterprise would operate without having Cisco somewhere in its IT infrastructure. But Huawei, with $15 billion in annual sales and more employees than Cisco, is turning out to be a thorn in Cisco’s international expansion plans, and Cisco desperately needs to expand internationally to maintain its growth.

Huawei is beginning to be considered a low-cost alternative to Cisco. Cisco could compete on price, but that would only reduce margins, not necessarily significantly increase market share. Cisco’s real strategic issue is it is cost versus utility. Hardware ties up corporate working capital because of the need for redundancy for disaster recovery and business continuity purposes. It’s like buying two cars in case one breaks. Bean counters don’t like this.

VMware Offers a Clue

All hardware in reality is software optimized for maximum performance in a custom-configured, mass-produced shell. Therefore, anything that can be done in hardware can also be done in software, which is usually more affordable because of reduced overhead and inventory costs, and also more flexible.

VMware is not the performance leader in virtualization, but it is the value leader. What makes VMware’s software virtualization successful compared to hardware-based virtualization? It works just as well, though perhaps a bit slower, but can be deployed on any server with the push of a button. This turns one server into multiple machines with a higher utilization rate and requires less resource usage such as electricity and rack space. The efficiency benefits are apparent to technologists and bean counters alike. What does this mean for Cisco?

Living on the Edge

VMware’s software model by no means suggests that Cisco should get out of the hardware business, but it should consider two strategic acquisitions: Zeus Technology Ltd and Vyatta Inc., two companies that themselves should have merged by now. Zeus offers software-based local and global load-balancing, and Vyatta offers software for network virtualization, routing, firewalls, and VPN products.

Together, Zeus and Vyatta offer a powerful dynamic stack for rapid data center provisioning on white-box servers (generic servers that are just as good as what HP, Dell, and IBM offer). These combined elements live on the “edge” of the network, but are encroaching closer and closer to the middle. They won’t replace Cisco Catalyst switches at the very core, but these components can play a critical role in agile IT.

With Cisco acquiring both companies and integrating them into the data center business, Cisco can satisfy the needs of cost-conscious customers, not currently a market that Cisco plays in well, but also offer leading online enterprises rapid scalability. A software subscription model would provide steady and growing cash flows as the adoption curve gets steeper, and eliminate some capital expenditures for Cisco’s customers. Cisco would also be able to compete in all global markets more rapidly.

How Much?

If anyone remembers the early days of video chats, you may be surprised to find out that Cisco has built the $300,000 version of CuCMe (See You, See Me), called TelePresence. It also acquired a leading provider in the TelePresence space called Tandberg.

TelePresence enables in-person-like meetings via live video. Cisco’s TelePresence minimizes signal delay, lets all participants read nonverbal queues, and provides most of the other benefits of meeting in person. The additional big benefits are that people don’t have to travel, which is costly and time-consuming; people can meet on a whim (if they don’t have to schedule a room ahead of time); and participants can be in multiple locations around the office, country, and globe. All factors should help increase communication and productivity.

Cisco has certainly applied some good math to the TelePresence business model. Although impossible to verify, it is highly likely that Cisco networking equipment is deployed by every global Fortune 1,000 company. Cisco is likely not the only networking hardware vendor to supply these companies, but it is highly probably that Cisco has the direct-dial telephone number for every CTO and CIO, so it can assume it can quickly build a sales pipeline.

Video is extremely network- and bandwidth-intensive. What better plan to stuff the network pipe than to charge $300,000 per installation and then sell additional networking equipment to handle all these packets? This is highly desirable marketing strategy.

Two questions remain, however. When the global economy recovers, will handshakes come in vogue again—will TelePresence diminish in its importance? And will companies want to pay for the best solution—Cisco is the quality market leader—or will a more affordable solution with only slightly less quality be deemed good enough? Cisco itself is marketing a competing product and service, ūmi (You-Me). ūmi is a high-end consumer teleconferencing solution that costs $600 to purchase and $25 per month to operate. Could this possibly be good enough for some companies?

Skype Me

Returning to software, vendors such as Skype, Google, or ooVoo are offering free teleconferencing solutions. Eventually they will charge, but for now the cost is nil. And they work pretty well. All that’s needed is a PC, laptop (most are now being sold with built-in cameras), or a next-generation TV with built-in computing capacity; Panasonic and Samsung are already making them.

Skype would be a perfect offensive and defensive acquisition to bolster Cisco’s overall global communication vision and to keep Skype’s customer base out the hands of any competitor. Skype has a real business model and currently carries just under 12% of the global cross-border phone/voice traffic, essentially making it the largest long-distance telco in the world based on volume. Skype would be a great complement to Cisco’s telephony business, but is an even better hedge for Cisco’s TelePresence efforts as video traffic over Skype will explode in the future, further stuffing the pipe with bits.

Last year EBay sold 65% of Skype to a consortium of investors for $1.9 billion, which values the company at $2.75 billion. The company is estimated to have $800 million in revenues for 2010. Skype may still be considered cheap, but it won’t be for long, because there’s money to be made. And by buying the company, Cisco would gain an easy way to upsell other products and services to Skype customers.

Hi Grandma

Cisco has entered the consumer market with the ūmi TelePresence service, the Flip HD video camera, the Valet home network router, and early in 2011 will release of the Cius, a tablet device with built-in camera for easy video chatting.

ūmi is positioned as a luxury product for affluent families, and the Flip appears intended as an add-on to ūmi, for families to capture and easily share home movies over this consumer TelePresence service. The Valet router is a highly rated, easy to set up wireless home network router, and the Cius appears to be the device to maximize packet delivery and bandwidth utilization facilitated by the Valet.

Cisco is rich and smart, but can it compete with Sony, Samsung, Kodak, Panasonic, Apple, and DXG in consumer marketing? Flip’s competitive differentiator is how easy it is to capture and share movies. But it is a single-purpose device that, just like the digital photo cameras that are waning in popularity, is being replaced by smartphones because of convenience.

Cisco’s forté is R&D; it has proven that by building its own market-leading enterprise TelePresence solution. It should consider augmenting its consumer packaged goods strategy to include software. Instead of pursuing a hyper-competitive strategy against Sony, Apple, and others, Cisco should develop Flip camera and movie software for all major smartphone platforms: iOS, Android, Windows Mobile 7, BlackBerry, and WebOS. To overload the networks, Cisco doesn’t need to own the camera; it needs to control the user.

Cisco’s mobile photography and movie software must incorporate features for easy sharing and integration into the most popular social networks if it wants to move the needle on the bit meter. Integration into Facebook, Skype, ūmi, and other services should be a breeze.

While that takes some dynamism that Cisco hasn’t perhaps displayed to date, it is easier to accomplish than to beat the incumbents in the digital video camera market at their own game.

Realizing that people are also a network would give Cisco tremendous insight into a sustainable growth strategy.

Customer-Centric

Cisco needs to break out of its own confines and begin to compete on terms it controls rather than its competitors’ terms. Growth by acquisition can still be accomplished successfully, but Cisco needs to look at the white space it can occupy, rather than continually focusing on taking market share away from the competition.

Adding parallel competitive elements will allow Cisco to serve more needs of more customers, protect its market-leading position while successfully reaching down-market, and build multiple revenue streams for the same industries.

Most importantly, because of better fit and greater granularity, Cisco could develop an even more compelling customer experience, because it can better serve the needs of a particular market. To that end, Cisco should seriously consider turning into a true holding company, by splitting the company into stand-alone business units.

Its networking equipment business is a market leader and can easily stand on its own and readily absorb the server business (Unified Computing System) and data center virtualization technologies under one umbrella. Add to that Zeus and Vyatta, and “Cisco Networking” will easily remain the dominant vendor, but with broader appeal.

Two additional companies should be “Cisco Business Services” (TelePresence, Web conferencing, telephony, and Skype), and “Cisco Consumer Products” (Flip hardware and software, ūmi, Cius, Valet).

Cisco’s myriad other divisions and products—smart-grid meter reading technology; cable set-top boxes, etc.—either need to fit into these three companies or be spun out as separate companies themselves. This independence and separation from the “hub” should foster true innovation as each new company strives to prove itself in the marketplace based on demand and capabilities.

Unshackled from previous processes, these companies could then forge their own alliances and begin to grow market share organically. “Cisco One,” Cisco’s recent realignment of its sales force, would become part of every new company, but get rematrixed not by functional capabilities but by industry solutions (e.g., education, healthcare, media/entertainment, transportation) as the fit for industry solutions are determined by each company.

As a true holding company Cisco would benefit from this new position in more ways than one. The primary benefit would be realized in Cisco’s ability to quickly alter its path in an ever-changing competitive environment. Strategic acquisitions could be made in multiple fields, but more importantly, Cisco would also gain the ability to easily divest itself of previous acquisitions and business units. This would make the company more nimble and it could seize opportunities more quickly as they arise.

With this new agility and better customer focus Cisco would be well primed to continue its growth in the 21st century.

This report was a group project for the Global Strategy class of Thunderbird School of Global Management Professor Nathan Washburn, Ph.D.