Cisco facing up to challenges

Interesting times are ahead for Cisco

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 percent to 15 percent annual growth targets it sets, and has a distribution channel second to none.

Yet as Cisco prepares to meet with thousands of customers at this week's Networkers conference, it is facing several challenges: Sales to U.S. enterprises is 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 percent to US$35 billion, while earnings are expected to jump 21 percent.

The trick will be sustaining that growth.

Global outreach

While the U.S. enterprise market accounts for about 13 percent 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 percent 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 percent to low 40 percent range. Analysts agree, noting that emerging markets has a sustainable growth rate of 30+ percent for the next three to four years, while domestic sales grow at around 10 percent and Europe/Asia at 15 percent.

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.

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 percent 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."

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