guiding light for growth, optical networking, is fading fast.
More than a year ago, Cisco placed a huge bet on optics as it
sought to crack the lucrative telecom market. But in the wake of a crippling industrywide spending slowdown and a series of unsuccessful acquisitions, Cisco's sputtering optical unit, with only one healthy product line to its credit and a number of flops, heads up the list of problems at this onetime highflier.
Now, facing steep earnings and revenue declines for the first time, Cisco either must renew its efforts to compete in optical networking or be content with meager output, say investors and analysts. With the telecom industry in decline and its stock worth less than a quarter of its peak value, Cisco must confront the fact that resuming its former growth pace won't be easy, no matter which course it chooses.
"The question now is, does Cisco accept its current position in the optics market or do they make another effort to build a broader beachhead?" asks
CIBC World Markets
analyst Steve Kamman.
With its 1999 buy of
, an edge-of-the-optical-Internet gearmaker, Cisco sharply changed course. Cisco had long dominated the business of making routers that direct traffic over computer networks, but growth in that business was expected to decline. Meanwhile, sales of optical gear to telecom service providers were expected to surge. (Optical networking uses laser beams to transport bits of information at far greater speeds than conventional electronic-based networks. To answer the call of the Internet boom, service providers turned to optics to make networks more capacious and more efficient.)
With the $7 billion Cerent buy and the subsequent, smaller purchases of
, Cisco began assembling a suite of optical products to offer big telecom outfits like the
But just as it was attempting to bring its optical shop up to speed, Cisco ran
full steam into a wall. Rising telecom sales projections were predicated on the continued good health of the emerging telecom industry. Yet by CEO John Chambers' own estimates, Cisco's service-provider customer list shrank by 95%, to 150 from 3,000, over the past year. Worse yet, observers say Cisco never mastered the business, in either product or relationship terms.
"Cisco has had an uphill battle with the service providers," says a Boston-based hedge fund manager who is long Cisco. "A very large percentage of their service provider revenues have come from the weaker players. And it has not been easy for them to gain the trust or develop the relationships with the larger telcos. A weak product portfolio doesn't help."
Ultimately, the rush of telecom sales never materialized, as evidenced by the $2.2 billion pile of inventory -- 70% earmarked for telecom gear -- that Cisco wrote off in the most recent period, leading to its first-ever loss as a public company.
"Optics was going to be their big growth area," says Kamman, who rates Cisco a hold and whose firm has no underwriting ties to Cisco. But other than Cerent, Cisco's optical purchases failed to live up to expectations, the analyst says. Indeed, last month, Cisco killed the optical switch it acquired with last year's acquisition of Monterey. The Monterey switch was going to be the linchpin of its optical business, and the core of the 674,000 square-foot optical manufacturing facility it
opened in October.
Cisco didn't reply to repeated requests for comment on its optical strategy. On a conference call with analysts Tuesday, the company said it had killed the Monterey switch because it was essentially a product ahead of its time.
But Kamman chalks the Monterey project's failure up to competition, not poor timing. "People wanted to buy CoreDirector," the analyst says, referring to
At a Crossroads
Given the problems at the optical unit, Cisco could resume the buying spree that brought Cerent and Monterey into the fold, or it could trim its offerings and focus on what's working, analysts say.
Signaling a willingness to cut its losses, Cisco said Tuesday that it has pulled out of six businesses, including optical switching, unified messaging and consumer products for broadband wireless.
Credit Suisse First Boston
analyst Lissa Bogaty says that perhaps culling losing efforts isn't such a bad idea.
"I think it's a positive because they are more focused in the areas where they do compete and at least it's areas where their margins will hold up," says Bogaty. The downside is that "obviously this shrinks the size of their market, which translates into a lower growth rate for the company, more like 20% vs. their projected 30%," she continues. Bogaty's firm has no underwriting ties to Cisco.
That said, "You are looking at a decline in
the telecom service market for at least the next 12 months for everyone," says CIBC's Kamman. "In that environment, it's going to be pretty tough to see significant growth."
Indeed, avoiding new stabs at telecom might not be a terrible situation for Cisco, at least for the time being. After all,
equipment spending could get much worse before it starts to get better. And with its stock well off its highs, Cisco will be hard-pressed to get back in the acquisition game using its favorite currency, its once-highflying stock.
"They will have to be more selective as they choose new markets," says CSFB's Bogaty. Ever the optimist, Bogaty says any new killer application or hot product could reverse the current declining growth scenario. She sees opportunities aplenty in emerging tech areas that Cisco has already dipped a toe in, such as Net-phone equipment, storage networking, wireless infrastructure, network security, virtual private circuits, metro Ethernet and content-aware switching.
So plenty of opportunity. But so far, no new guiding light.
As originally published, this story contained an error. Please see
Corrections and Clarifications.