Shifting to optical networking products is a do-or-die proposition for New Economy powerhouse
. Now, to make sure it can provide the right stuff for the next phase in network building, it's reaching back into the Old Economy to get a grip on its future: It's getting ready to manufacture its own optical gear in a massive plant one hour north of Boston that was once used by
Digital Equipment Corp.
The plant will be Cisco's largest manufacturing facility -- a 674,000 square-foot facility that should be up and running by year-end. And, while it's a logical response for a company that needs to catch up in a hurry, it represents a dramatic strategic shift for Cisco. A vaunted near-virtual corporation, the data-networking equipment leader has often boasted about its ability to outsource much of its manufacturing and its skill at buying, rather than building, the cutting-edge technology it needs.
That strategy has created rapid growth and healthy margins. But it hasn't been enough to keep Cisco ahead in the new field of optical products, where such rivals as
have raced ahead.
And for a company priced to perfection, sinking cash into building and running a giant factory could threaten a valuation that is still a lofty 151 times earnings. "It's a hairy move because it takes them into some very difficult stuff that they have never dealt with before. So from a managerial point of view, it will be a real interesting stretch for them," says Clayton Christensen, the
Harvard Business School
professor and man of the moment in corporate technology strategy circles. Christensen has studied how dominant companies attempt, and sometimes fail, to shift strategies quickly enough to catch major new opportunities.
Christensen is a great admirer of Cisco's abilities to introduce and capitalize on what he calls the "disruptive" technology of its routers. But Christensen, who wrote
The Innovator's Dilemma: When New Technologies Cause Great Firms to Fail
(Harvard University Press, 1997), questions how smoothly Cisco will operate when it takes on its own optical development and manufacturing.
Plan B for Build
Building is also seen as plan B if plan A -- acquiring leading technology -- is out. Potential changes in accounting rules threaten to put a kink in Cisco's much-touted acquisition program. Cisco may be forced to rely more heavily on its own talents rather than buying leading companies with its gilded stock.
Cisco has used its highly valued stock to acquire leading edge technology at ungodly premiums. Investors didn't even flinch when Cisco spent in excess of $25 million per employee on acquisitions. Cisco's two largest deals --
at $6.9 billion and
at $5.7 billion -- are two cases in point.
But Cisco's buying spree could get curbed if it can no longer benefit from the pooling-of-interest accounting, a technique popular among technology companies that minimizes the impact of acquisitions on earnings. The
Financial Accounting Standard Board
, the body that sets rules on accounting practices, is pushing to require all companies to use purchase accounting. Under purchase accounting all assets, including intangible ones such as goodwill, must be amortized, which can mean a major blow to earnings. Mandating purchase accounting would mean any high-priced acquisitions would take a big bite out of earnings at Cisco, further complicating its effort to catch up in the optical game.
"It's always important to have the latest hot box," said a New York-based hedge fund manager, referring to the latest and greatest technology. "If Cisco can't go get it, it will be hard for them to compete," said the hedge fund manager who has no position in Cisco, and asked not to be identified.
But make no mistake, if Cisco can't buy the brightest minds through acquisitions, it can certainly recruit them. Cisco chose the Salem location -- near the hub of optical innovation around Boston -- to be close to the talent.
"The primary advantage to the Boston area is that we are within a one hour plane flight of 80% of the optical talent in North America," says Cisco's head of manufacturing Carl Redfield.
Photons Trump Electrons
Cisco has won Wall Street's unconditional love because of its mastery of the data-networking domain. Its routers, the electronic traffic boxes that connect one computer system to another, have become the linchpin of the Internet.
But some investors have concerns over Cisco's glaring
weakness in optical-networking equipment at a critical time when network operators are clamoring for equipment to help them migrate from electronics to optics.
Cisco has a distant and dwindling 4th place in the network backbone gear known as the optical transport market, according to a recent report by research firm
Ryan Hankin Kent
. This is a glaring shortcoming since Cisco prides itself on being number one or two in every market that it competes in.
And the telcos, which find the economics of photons irresistible, may not be willing to wait. Far more bits of information can travel faster and cheaper on beams of light than they can as streams of digits carried on electronic circuits.
president and COO Afshin Mohebbi noted at a
Banc of Amercia Securities
conference recently, moving to an optical platform "reduces network operating costs by 70%."
"The all-optical network threatens IP routing, which is Cisco's first-born child. A parent never wants to kill its child," says industry futurist David Isenberg of
. Isenberg works with many early-stage networking firms and has done no consulting for Cisco, Nortel.
To defend against obsolescence and step quickly into optical, Cisco finds itself in a somewhat awkward and vulnerable position. Building a factory is not the direction Cisco is accustomed to going in, but this is the Cisco paradox, says Isenberg. To get where they need to be, "they have to meet the old business at least halfway on its own turf."
Cisco's Redfield downplays the notion that the Salem plant is a departure from the company's lean manufacturing model. He says that even though optical manufacturing is complex and extremely labor intensive, Cisco is not going to get bogged down in staffing and management for very long. Redfield says he guarantees that "a good portion" of the production will be handed off to contract manufacturers by the end of next year.
"We have gone into a heavy investment strategy to provide that set of solutions now that we know the direction of that marketplace," says Redfield, who concedes that Nortel is two years ahead in this race.
The Long Shot
"It's tough," says Christensen. "There is Nortel, Lucent and Corning and they have all made this stuff before. They are all pushing the bleeding edge of performance and they all face challenges. But this is a bigger step for Cisco than anybody else."
At least one investor has doubts about how agile this 31,000-employee company can be.
"It's a classic problem for Cisco really. What does a company do when it gets so large and it has such a giant investment in incumbent technology," asks
money manager Don Luskin. "It becomes extremely difficult to stay on the leading edge," said Luskin who has no position in Cisco, but was recently short the stock because of its lack of optical leadership.
But Redfield takes issue with the notion that Cisco is willing to rest on its previous router glories and watch its rivals capitalize on the new opportunities.
"We do not protect old legacy technologies. We do not protect cash cows. We will eat our own young -- as the saying goes -- before the competition does," says Redfield.
"'Do or die' is sort of dramatic, but we have been living do or die for better than a decade," says Redfield. "We will do what our customers demand or we know the competition will eventually do it. That's what drives this company
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