Cisco, Rivals Confront the Commodity Crunch - TheStreet

Networking-industry leaders are about to pay a steep price for their success.

A decade of innovation has created a thriving communications-gear business centered on the Net. Leaders such as

Cisco

(CSCO) - Get Report

have amassed mighty fortunes charging premium prices for the equipment that kept the Internet rolling smoothly, even as usage boiled higher.

But investors know technological achievement comes with a cost. The more robust and widely accepted a given standard, the faster prices will fall as competitors flood the market. Tech watchers call the process commoditization.

And that's the prospect facing Cisco and its peers in 2004: As tightfisted big companies and telcos opt for cheaper, simpler gear, networking outfits will have to decide whether to fight the onrush of low-cost competition or flee to other niches.

"We are at the beginning of the second major wave of change in the industry in the past 40 years," says Blaylock & Partners analyst Gabe Lowy.

Aptly enough, the first wave was driven by the PC -- another business radically remade by commoditization -- and the need to connect computer systems. The second phase, says Lowy, will shift emphasis away from underlying infrastructure and toward the delivery of services.

Now efficiency-minded outfits like

Dell

(DELL) - Get Report

,

NetGear

(NTGR) - Get Report

and

3Com

(COMS)

, the last in partnership with China's

Huawei

, are driving hardware commoditization directly into Cisco's once-untouchable market. And analysts, including Lowy, say other parts of the telecom market are likely to see similar challengers coming up through the lower end of their markets.

"I wouldn't be shocked if Huawei partnered with someone like

Ciena

(CIEN) - Get Report

or

Tellabs

(TLAB)

," says Lowy, who has a sell on Ciena and no rating on Tellabs.

You can blame the Internet for dishing up a simple new protocol to displace the competing and incompatible standards that formerly dominated telecom networks. Yesterday the Internet brought us the breakthrough innovation of connecting computer systems; today it has largely become our plain-vanilla communications network.

Take, for example, the sudden rise of voice over the Internet, or VoIP. Net calling bypasses the old-line phone network and the taxes and fees that go along with it. It is so much cheaper that all the large phone companies have plans to use it, though some skeptics would say mostly as a

political demonstration.

Because the Internet's information traffic flows in a common language, the basic plumbing consists of many interchangeable routers and switches. Most of the gear serves as glorified mail sorters, helping the network more effectively connect users and deliver packets of data.

"What the Internet did to networks was to take everything out of the middle, and put all the great stuff at the ends," says industry strategist David Isenberg, of isen.com.

Cisco's rise to glory in the '90s was fueled by the company's ability to develop highly compatible networking devices that connected any number of computer systems. As PCs spread and computing became more distributed, the big iron outfits like

Wang

vanished and

IBM

(IBM) - Get Report

was forced to retool.

Now it's Cisco that faces a difficult decision: Fight the commoditization or flee to new growth areas.

"Right now, Cisco's trying to do both, but they've been smart about it," says Isenberg, who lists Cisco as a client. Earlier this year, Cisco bought consumer home-networking gear maker Linksys in an unexpected plunge into the low-margin consumer electronics business. But Isenberg says Cisco has wisely kept Linksys as an independent entity.

Instead of trying to pull Linksys up into its higher-margin market, Cisco actually could push some of its lower-end gear down into the Linksys unit, where operating costs are considerably lower, say Cisco watchers.

Meanwhile, Cisco continues its efforts to push into big new markets like phone systems, network security and data storage, to name a few.

Outfits such as

Lucent

(LU)

and

Nortel

(NT)

, which are still wed to their conventional-phone gear sales, have a great deal at stake in this transition. To try to keep up, both companies have shed numerous product lines and vowed to focus more closely on the types of equipment their big phone company customers are asking for.

But it might be too late.

"I see Lucent getting left behind," says Blaylock's Lowy, who has a hold rating on the stock. Others like Tellabs also fall into the legacy group that the others are breaking away from, says Lowy, who has no rating on Tellabs.

The companies breaking away in tech's second wave, according to Lowy, are Dell, Nortel and Web switch maker

F5 Networks

(FFIV) - Get Report

. All are rated a buy by Lowy.

As for Cisco, the company managed to increase its market share and image after the bust. The big question now, says Cimi Corp. analyst Tom Nolle, is what's going to happen beyond next year. 3Com and Huawei will start growing much faster than Cisco in 2005, he says.

"This new distributed computing framework could offer Cisco a chance to create some feature differentiation," says Nolle. But "if they don't find it, their distribution channels are ripe for others to come in who can offer a better margin."