Cisco grapples with transition to new products
FRAMINGHAM, Mass. — Cisco Systems Inc. is in the throes of a companywide transition away from the switches and routers that form the bedrock of its business toward new markets to fuel future growth — and the shift is affecting its revenue.

The transition is broader and more profound than just a product line overhaul, and the company is struggling with new competitors, customers, pricing strategies and profit pressures.

In fact, reinventing itself means Cisco has been forced to scale back its growth ambitions, announcing last week it is cutting its 12 to 17 per cent annual growth targets to more modest nine to 11 per cent in fiscal 2011.

“The 12 to 17 per cent growth target is causing them to be much more aggressive in targeting new markets to sell into that they are taking their eye off the ball,” says Zeus Kerravala of the Yankee Group, referring to Cisco’s plan to address 30 or more market adjacencies. “Why wouldn’t they stick to the stuff they do well and move into 10 markets instead of 30? You can’t continually grow at 17 per cent when you’re a US$40 billion company.”

For the first time in company history, revenue in Cisco’s core routing and switching markets has been overtaken by sales of new products and associated services in data centre, virtualization, video, collaboration and mobility. 

“As customers continue to transition from traditional router and switch products to Cisco’s next-generation products and services, the company will need to take a hard look at restructuring itself in order to meet the revenue growth and margin expectations it has set with the market,” Scott Denehy of Technology Business Research stated in a research note to TBR clients.

Others agree.

“Cisco’s going through a period of transition on multiple levels,” says Jim Metzler, vice-president of IT consultants Ashton, Metzler & Associates of Sanibel, Fla. “The short-term transition is the product shifts from Catalyst to Nexus, etc. The longer term is really a fundamental shift in the marketplace.”

On Tuesday the company named Gary Moore as its first chief operating officer, a move seen as a way to give CEO John Chambers help shift the company’s balance.

In Cisco’s second fiscal quarter, announced last week, switching revenue was down seven per cent from last year and 11 per cent from the first quarter. Routing revenue was up four per cent from last year but down seven per cent from Q1. In switching, Catalyst 2000 and 3000 customers are migrating to newer platforms, while Catalyst 6000 customers are making their way to the Nexus 7000 line. Catalyst switching is a US$10 billion-plus business for Cisco and any disruption will be felt widely throughout the company and the industry.

But Metzler says this upheaval might be a positive sign that Cisco is preparing the company for the future by getting into new markets and developing new products rather than relying on its legacy switching and routing portfolios.

“It’s about time,” he says. “Switching and routing’s been funding all of these for years. When was it going to take off and bring some revenues in?”

Instead of taking its eye off the ball, Cisco movement into new markets is making the company more vulnerable to market share and profit margin erosion, and competition, Metzler says. Cisco’s entry into the data centre server market in 2009 cut off two channels for its product: IBM Corp. and Hewlett-Packard Co. IBM is reselling Juniper gear and also acquired blade switch maker Blade Network Technologies; HP bought 3Com and EDS, which also used to resell Cisco gear but now pushes HP’s networking equipment.

And moves into the consumer and home entertainment markets are proving more challenging than perhaps Cisco anticipated. Indeed, in the Q2 conference call with analysts, CEO Chambers admitted that Cisco’s value-add higher-end consumer products “got crushed” at Christmastime.

The product and market transitions are putting a squeeze on Cisco’s gross profit margins. Chambers said this is due to customers moving to switching platforms that offer better price/performance. But analysts note the margin pressure also indicates that Cisco is dropping prices in order to defend market share.

“(It’s) a reflection of multiple concurrent switching product transitions as well as Cisco needing to aggressively protect its installed base,” states financial analyst Ittai Kidron of Oppenheimer & Co. in a bulletin to investors. “We believe the strong uptake of Cisco’s new switching portfolio suggests it’s playing defense well.”

“The product transitions indicate the competitive pressures they’re under,” says Yankee Group’s Kerravala. “Customers don’t believe in an end-to-end architecture anymore. Cisco can’t force customers to buy up and pay a premium anymore.”

Oppenheimer also notes that Cisco is “quietly backing away” from its 12 to 17 per cent long-term growth target. It all adds up to Cisco being a bit too bullish on its prospects and not anticipating the timing or disruption of a) switching customers transitioning to newer platforms and product lines; and b) the upheaval new products born of entry into market adjacencies would have on core routing and switching.

According to TBR’s Dennehy, “(It) raises the question as to whether or not the company’s future growth prospects are as bright as they were just a few quarters ago. The company may simply be too large and dispersed to achieve growth rates comparable to smaller and more focused competitors.”

And Cisco’s strategy of marketing its products as components of an overall end-to-end, architectural approach will be under pressure to deliver as well, especially in enterprise IT where HP and IBM are now competitors instead of cooperators. Says Metzler:

“Are the bets they’re taking on a unified infrastructure going to pay off on two levels: 1) that IT organizations adopt the unified infrastructure; and 2) that Cisco’s one of if not the major player in that space?”

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