Today almost 40% of Cisco's revenue comes from the sale of switches, the basic movers of data packets through electronic networks. Routers-the brainy parts of a network, which control and direct traffic chip in a bit more than 20%. Around 20% comes from new technologies like Internet telephony and video, on which the com panyis pinning much of its hopes for future growth. Services account for the remain ing 15%. Total revenue topped $28 billion in fiscal '06 and is expected to rise to $33 billion in the current fiscal year.
A few years back, Cisco's router sales flattened when Juniper Networks (JNPR) seized the high end of the market with powerful routers designed for the core networks of telephone-service provid ers like Verizon Communications (VZ). The competition forced Cisco to spend $500 million to develop a new router,the CSR-1, which could carry 100 times more traffic than Juniper's. Since its launch in 2004, the CSR-1 has stormed the market, forming the core of new networks at Sprint (S), Comcast (CMCSA), British Telecom (BT) and Japan's Soft- Cisco Product Segments bank BB, while Juniper has strug- Past five quarters: sales in billions gled to come up with a response. Ac cording to the Dell'Oro market-re search group, in Redwood City, Ca lif., Cisco now enjoys about a 60% share of the router market for such customers.
The development of the CSR-1 helped place Cisco once more on the ground floor of a revolution, this one involving the delivery of multiple services over a single network. Un til now, telephone, cable and satel lite television each has been deliv ered via a different network technol ogy. Now, companies in all three in dustries are gearing up to offer cus tomers a "triple play" ofvoice, high speed Internet and television service-and, before long, wireless and wireless TV -over a single network that uses the Internet Protocol technology that is Cisco's forte.
Similar efforts are unfolding abroad, where upstarts like France's N euf and Ita ly's Fastweb are challenging their coun tries' former telecom monopolies. CEO Chambers says Cisco designed products like the CSR-l with a vision of the coming convergence. "We did not build the CSR-l to do a billion phone calls," he says. "We built it to do 100 million videos."
Suppliers of traditional telecommunica tions equipment, such as Lucent Technol ogies (L U) and Nortel Networks (NT), have seen flat or falling demand from their phone-service customers in recent years. But spending on Internet equipment by phone and cable operators is growing by 17% a year, says Mike Volpi, who runs Cisco's router and service-provider busi nesses. Volpi views his business unit as the arms merchant in a war of competing com munications companies. But unlike the net work spending of the 1990s, which was fi nanced by stock sales, today's outlays are funded by these companies' copious cash flow.
The Spending iH likely to increase.When Verizon began instralling its FiOS fiber-optic network in Massachusetts last year, Comcast countered by boosting the download speed of its cable-modem ser- vice. That required the cable company to upgrade its routers.
Volpi is encouraged by Cisco's win rate so far. "When we do a goodjob as a vendor, we get 80% ofthe business and the second source gets 20%," he says. "When we don't do a good job, it's 50/50."
In the triple-play race so far, cable com panies have had great success selling tele phone service. They can charge a low fixed price because they run calls over Internetstyle routers, most provided by Cisco. Within about six months, Volpi says, Cisco routers also will incorporate digital-video technologies. Internet Protocol-based tele vision, or IPTV, is the delivery technology of choice for new providers of TV service like AT&T, Verizon and Italy's Fastweb.
The technology also will enable Cisco to bring the home-alarm industry into the dig ital age. Indeed, the company thinks it could create a billion-dollar market for gear thattransmits video from your baby's crib to your cell phone, or from a break-in to the local police station.
Best of ail, the "data packets" carrying video are bigger than other kinds of net work traffic, and would require networks to upgrade their switches and routers. High-definition video conferencing, for in stance, might use 10 times the network bandwidth of other network traffic. "The more bits, the better for Cisco," Volpi says.
To beguile enterprise customers· with the virtues of video, Cisco soon will unveil a sophisticated high-def video-conferencing system. Companies such as Polycom (PLCM), Radvision (RVSN) and Nor way's Tandberg have been selling video conferencing products for years, but Cisco could quickly become the market leader. Bob Hagerty, CEO of Pleasanton, Ca lif.-based Polycom, guesses there have been around a million video-conferencing systems installed around the world, about half sold by his company. In May Polycom introduced its latest $250,000 video-confer encing set-up. In coming months it will up grade its product to high-definition.
Competing with a high-def product of its own will be Fair Lawn, N.J.-based Rad vision, whose video-conferencing gear has been sold under the Cisco label. Video transmission over Internet-protocol net works means video calls no longer need be a luxury for CEOs only, says Radvision's chief executive, Boaz Raviv. His company created a consumer video-calling product for Fastweb that uses the living-room television as the conference-calI's video monitor. With Cisco and Northrup Grum man (NOC), Radvision is building the world's largest video-conferencing, by linking 1,500 meeting locations for the U.S. Defense Department.
Cisco's Chambers has used current-generation video-conferencing products to confer with other execu tives, such as IBM's Sam Palmisano. Chambers says he can barely tell who's who on the TV screen, and that he'd never use itto talk to customers.
But next-generation products are an other story, capable of delivering a - 0.5 "telepresence."
"It's video conferencing and data conferencing and IP telephony con ferencing,"says Chambers. "You can play Texas Hold'em with three other groups at the same time in different locations, as if you were all at' the same table."
Time permitting, you could also get some work done, and Chambers believes collaborators would work 20% to 30% more productively. He's got a credible record in productivity improvement; Cisco pulls in more than $700,000 in revenue for each em ployee, triple its nearest competitor.
Cisco will roll out its telepresence prod uct to its 70 sales offices next year, and esti mates it will break even on the investment in less than nine months. It expects to save an annualized $100 million in travel ex penses by year-end 2007.
Cisco's video plans are but a piece of a larger ambition to lead in all forms of com munication. In the same way that a phone company can run ail communications over a single Internet-Protocol network, a large business now can use one IP network to unify its various systems for e-mail, in stant-messaging, project collaboration, physical security and PBX phones. Cisco believes the annual market for "unified communications" solutions will reach $10 billion within three to five years.
The company's first communications products have been successful. In just a few years, Cisco grabbed the lead in the market for PBX [private branch ex change] internal phone switches, winning a 23% market share with its Voice-over-Internet-Protocol systems, according to fig ures from Synergy Research Group. In the July 2006 quarter, Cisco shipped more than a million VoIP telephones. For a branch office or a medium-sized business, getting a PBX can be as simple as adding a card to Cisco's Integrated Services Router, a Swiss Army knife-style product that also can become a network firewall and a Wi- Fi network base station, also by inserting new cards. Video surveillance soon will become another add-in feature.
Cisco sells tens of thousands of ISR routers every quarter; the ISR ramped to a $1 billion annual sales rate within its first year, faster than any other Cisco product.
Voice-over- Internet-Protocol solutions have dominated the PBX market with Sill' prising speed, forcing incumbent vendors like Avaya (AV) to revamp their product lines. In 2002, VoIP products were about 15% of all PBX phone lines sold, says Avaya CEO Lou D'Ambrosio. This year, he expects IP products will be 60% of PBX in dustry sales. The computer-like IP-PBX systems save companies money by letting them use cheap Internet links, instead of expensive trunk lines. They also allow third-party software writers to invent clever new applications. At the Wynn Las Vegas resort, for example, an Avaya IP phone lets guests use many ofthe casino's services from their night tables.
D'Ambrosio concedes that Cisco enjoys an advantage in selling IP products, as most large organizations own Cisco switches and routers. So PBX incumbents like Avaya and Nortel strive to compete on the quality of their software applications. Many customers want their mission-eriti calphone systems to remain separate from their networks, says Avaya's CEO.
The University Hospitals Health Sys tem in Cleveland, Ohio, is not one, however. The hospital complex has hired Cisco to re place its existing PBX, cable TV and com puter networks with a grand, unified net work, in an 18-month project costing tens of millions of dollars. The hospitals' phone center will feature triple-redundant sys tems, says the system's chief information officer Ed Marx. Medical records will be ac cessible instantly to authorized people any where. Intercom announcements of the "Code Blue, Unit 5700" variety will be a thing of the past as the network wirelessly summons the required doctors and nurses.
The Cleveland system did not solicit a network vendor other than Cisco, satisfied with the company's promise of a certain level of network peIformance, with finan cial penalties if the service fell short.
Indeed, many Cisco customers make just that one call, instead of soliciting com petitive bids. In a survey of 500 informa tion-technology buyers conducted in March by SG Cowen, 35% of respondents indicated they planned to move more of their network spending to Cisco, while only 4% expected to shift more to competi tors. Customer satisfaction is one reason why strong challengers, such as China's Huawei, have yet to crimp Cisco's 67% gross profit margins.
If Cisco is leaving most of its traditional networking rivals in the dust, there's anew competitor looming: Microsoft. The Red mond, Wash., software behemoth (MSFT) has its sights set on the same unified-com munications market that Cisco is target ing. In June Microsoft announced several products planned for late 2007 that would handle VoIP phone calling, instant messag ing and video conferencing. Microsoft plans to take advantage of its huge in stalled base by bundling some of the new communications features into its ubiqui tous suite of PC applications, Microsoft Of fice, while adding other features to its popular e-mail-server software, Microsoft Exchange. There are more than 400 million users of Microsoft Office and over 100 mil lion workers with mailboxes on an Ex change server.
Communications is a natural next step for Microsoft, says Anoop Gupta, a vice president of the company's unified commu nications group, "What are the key pain points that information workers have?" he asks. "Twenty years ago, it was creating documents and spreadsheets. Today, it's how worldwide partners can collaborate."
At the June announcement, Mi crm\oft demonstrated how a worker on the road could phone into the Exchange e-mail server and tell it to read aloud from the text of freshly arrived e-mail messages. A writer could click on a per son's name where it appears in a Word document, and instantly be able to phone or e-mail that person. A video conference demo featured a tabletop gadget with a 360-degree camera at the top of a six-inch stalk. This "Round table" video-conferencing device sends a panoramic view of everyone assembled, and can zoom in on any speaker.
But apart from devices like the Round table camera, the Microsoft unified commu nications solution is all software -with soft ware's attendant economies. "In om' ap proach, there is no PBX," says Gurdeep Singh Pall, another Microsoft VP. "It's a to tally distributed architecture."
If Microsoft sees communications go- I'. ing from computer to computer, Cisco foresees communications functions run ning on its network gear. One Cisco I advantage is its head start; it has been , selling communications products for a l1 few years, and can deliver solutions that work out of the box. Microsoft plans to start selling its software around the middle of 2007, and its third party hardware and software partners may need more time to get everything working. Microsoft and Cisco products may compete with each other, but at least they'll be able to talk to each other; the two companies say they'll work to ensure compatibility. Gupta says it's a huge market they're both chasing: perhaps as large as $40 billion in annual sales.
While these new technologies are giv ing Cisco's current customers reason to up grade, Cisco also is seeing growth of nearly 50% a year in its sale of networking systems in emerging markets like Saudi Arabia. That growth results from sales in vestments Cisco made in the past couple of years, just as it had done previously in In dia and China. A large sales force of Cisco representatives is now making the case for oil-rich nations to invest in networks as a way to improve health care in those coun tries and create high-value jobs. Today such countries represent 10% of Cisco's sales, but Chambers thinks they will con tribute 30% to 50% of future growth.
If Cisco revs up its sales growth with products for unified business communica tions or consumer quadruple plays, its gross margins should remain in a range of 64% to 66%, says Dennis Powell, the company's chief financial officer. That's because the value added, in most Cisco products, is software, whether it's embedded in com puter chips or part of the company's net work operating system.
Cisco generated free cash flow of $7 billion in its July 2006 fiscal year. Financial chief Powell says the company wants to give shareholders the cash it isn't investing in new ventures or acqui sitions. Since September 2001 Cisco has shrunk its shares outstanding by about 25% through $35.4 billion in stock buy backs. It still has $4.6 billion of fire power left under its share-buyback au thorization. Sooner or later, Powell expeets Cisco will start paying a dividend, but there has been no groundswell of shareholder demand yet. When Cisco does initiate a dividend, Powell would like it to be more meaningful than the token 1.5% yield paid by Microsoft (not including its special dividends).
Investors probablyvvill be happy to con tinue betting on John Chambers and his team. "We were $1 billion in sales when I took over, ten years ago," he says. "We now move into new markets and do $1 billion in each of them. No company in the history of IT has ever done that in more than a couple of product and we're doing it repeatedly. We're in the right spot at the right time, and we're trying not to mess that up".
Chances are, it won't.
