“From Innovation to Financialization: How Cisco Became Focused on Its Stock Price

and Lost Its Way”

Bob Bell, University of California, BerkeleyMarie Carpenter, Télécom Ecole de Management, Henrik Glimstedt, Stockholm School of Economics, and William Lazonick, University of Massachusetts

Ford Foundation ConferenceFinance, Business Models, and

Sustainable Prosperity,

Ford Foundation, New York City, December 6-7, 2012

• Buyback team • Motorola• RIM • Nokia • Cisco

NEBM & finance & strategy…Telecom equipment and stock repurchases

• Non-buyback team • Ericsson• Huawei• Apple • Google

(Motorola)

Good team to be on in the 90s, 2000s…

Better team to be on in the 2010s…

• Buyback team • Motorola• RIM • Nokia • Cisco - $76.7 bn: FY2002-FY2012

• Non-buyback team • Ericsson• Huawei• Apple • Google

(Motorola)

Good team to be on in the 90s, 2000s…

Better team to be on in the 2010s…

NEBM & finance & strategy…Telecom equipment and stock repurchases

Cisco, employees, sales, and profits, 1989-2012

A story of unbridled success or a warning tale?

A story of unbridled success…….• In the 1990s Cisco Systems was the world’s fastest growing company.

• From $70m. in revenues and 254 employees in fiscal 1990 (year end July), its IPO year, Cisco grew to $18.9b. in revenues and 34,000 employees a decade later.

• In FY2011 Cisco had record sales of $49.2b.and record employment of 71,825.

…or a warning tale?• Yet on Apr. 5, 2011, after “disappointing the market” for two quarters, Cisco CEO Chambers

told employees: “we have lost the accountability that has been the hallmark of our ability to execute consistently for our customers and our shareholders.”

• What Chambers did not say was that from 2002 to 2011, Cisco expended $71.9b., 126% of net profits, on stock buybacks in an effort to boost its stock price.

• But on Apr. 5, 2011, Cisco’s stock price was just 51% of its post-2001 peak (Nov. 6, 2007). Its buybacks over the decade were 1.66 times its R&D expenditures.

• We seek to uncover the real long-term cost of Cisco’s obsession with its stock price by analyzing its failure to succeed in certain key technology areas for future growth:

• optical networking, its most sophisticated segment, where it had acquired productive resources in the 1990’s,• Mobile backhaul, where it failed to develop the engineering capabilities • Data centers, where it appears more successful at levering enterprise networking competencies

“From Innovation to Financialization: How Cisco Became Focused on Its Stock Price and Lost Its Way”

5/12/2012

“Oops! Five CEOs Who Should Have Already Been Fired (Cisco, GE, WalMart, Sears, Microsoft)”

1.Steve Ballmer, Microsoft2.Edward Lampert, Sears Holdings3.Mike Duke, Walmart4.Jeffrey Immelt, General Electric5.John Chambers, Cisco Systems

“Mr. Chambers appears to have been great at operating Cisco as long as he was in a growth market.  But since customers turned to cloud computing and greater use of mobile telephony networks Cisco has been unable to innovate, launch and grow new markets for cloud storage, services or applications.  Mr. Chambers has reorganized the company 3 times – but it has been much like rearranging the deck chairs on the Titanic.  Lots of confusion, but no improvement in results.”

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Cisco Systems: enormous run-up in stock prices in 1990sbut stagnant and volatile stock-price performance in the 2000s in line

with the NASDAQ Composite Index

Stock-price movements, NASDAQ Composite Index, Cisco, and AppleApril 1990-April 2012

Cisco’s presentation of its financial operations

Cisco Systems: gains from exercising stock options, 1995-2012:When did gains come from innovation, speculation and manipulation?

• Cisco’s Origins• Founded in 1984 on campus of

Stanford University• VC of $2.5 million in 1987 from

Sequoia capital• Demand > supply• Don Valentine of Sequoia brought

in Don Morgridge as President and CEO

• Professional managers appoint• IPO on 16 February 1990• Founders, Sandy Lerner and

Leonard Bosack sell back stock to Cisco in Dec 1990 for ca. $170 m

• 1991: John Chambers hired as Morgridge’s future successor from Wang

From routers to switches to…• Dominant in fast growing market

• Excellent initial product with full interoperability

• “perfect market conditions”• Commitment to customer service • Wellfleet & Synoptics merged to create

Bay Networks

• 1990 – 2000: Aquisition and Development (A&D model)

• Turnover grew from $0.69 bn to $20 bn• First acquisition, Crescendo, = ‘grand slam’

• $95 million for company with turnover of $10 million

• Turnover grew to $500 million in 18 months• Rapid integation of acquisitions

• Small firms located close by, keep all employees• ‘VC’ model of acquisitions: 40-60% to ‘stay

afloat’, 20-40% failures and 20-40% whopping successes

Cisco Acquisitions in the 1990s1993 1994 1995 1996 1997 1998 1999 2000

Number 1 3 4 7 6 9 18 12Value ($m) 95 414 467 4714 569 1094 14597 10595% stock 100 71 100 96 70 87 99,8 99,9

Cisco’s Acquisition and Development (A&D) Model & Optical Beginnings

• Cisco’s Optical Beginnings

• 7500 Series launched with packet over SONET (Aug ‘95)

• Five-phase optical strategy (Apr ‘98)

• Optical SBU established 1999

• IP+Optical strategy in 2000• Acquisitive Behavior (1996-

2001), beginning with StrataCom to shore up optical expertise

Cisco is the world’s most valuable company: March 2000$541 billion capitalisation

Market capitalisation index, 100 = January 1998

Challenges with Optical Acquisitions (1995-2001)• Cisco and Service Provider Customers

– Historically, Cisco interfaced with enterprise - not SP - customers.– Cisco lacked SP customer expectations, offering less reliable data networking equipment instead of reliable

carrier-class equipment. Also, not used to– Telephone companies initially resistant to Cisco’s revolutionary voice over data packet offering instead graceful

evolution its competitors (e.g., Lucent/Nortel) offered.– Cisco bet on new telco carriers, some of which failed in the early 2000’s, instead of the incumbent operators.

• Competitive/Market Factors– Cisco had late start compared to its competitors (Ciena, Lucent, Nortel)– More nimble start-ups (Ciena, ONI) had manufacturing and “blank sheet innovation”– Inflated demand forecasts (long-haul optical) and 2000/2001 market slump

• Acquired products/business challenges– StratumOne with “virtually no revenues”– Monterey acquired with no revenue/customers. – Qeyton DWDM did not ship as of 2001.– Pirelli not a market leader, and its technology trailed Ciena, Lucent, and Nortel.

• Integration challenges– Staff (StrataCom sales force; Monterey and StratumOne founders left)– Geography (SkyStone– Ottawa, Canada; IEng – Ann Arbor, MI; Pirelli – Milan, Italy; Pentacom – Herzliya, Israel;

Qeyton – Stockholm, Sweden)

• One successful acquisition in metro segment– Cisco ONS 15454 (Cerent 454 Box) most successful optical product. Focused on metro optical segment and

eventually neglected long-haul.

2001: Telecom ‘bust’ and $2.2 billion inventory write-off

“Virtual supply chain” became very unvirtual!• Customers over-ordering to overcome shortages leading to over-optimistic forecasting• Guaranteed purchasing agreements entered into with suppliers in order to overcome

component shortages in boom-time

Stock price

Cisco’s Diminishing Optical Focus in downturnManufacturing divestments

– Pirelli DWDM manufacturing facility (Salem, NH) sold May/June 2001.

– Qeyton Swedish plant closes Oct 2002.– Fibercore (U.K.-based maker of specialty optical fibers),

acquired as part of S-A, divested February 2011.– Scientific-Atlanta Juarez, Mexico plant closes 2011.

Discontinued Products– Monterey optical cross connect discontinued Apr 2001.– Pirelli DWDM end-of-life announced August 2004.

Optical Staff moved– Dec 2005: 80 employees moved out of optical group

from San Jose, Richardson, and Petaluma sites.– Nov 2006: 40 optical staff in Petaluma (CA) moved out.– 2007: Cerent founder Ajaib Bhadare leaves after his

return in Dec 2005.

Decreasing Patenting Activity in Optical (starting in 2006)

Optical business moves to “Other Products” from advanced technologies (business potential for $1B), effective 1Q07. Cisco “hides” optical product revenue, splitting it among routing, switching, and “other” categories.

Market factors: focused on North American segment, which suffered from recession. Other competitors (e.g., Huawei) had foothold in APAC/emerging markets.

Source: USPTOSearch phrase (e.g., 2010): AN/cisco AND optic$ AND APD/1/1/2010->12/31/2010

Only 1 optical-related acquisition 2001-2010: • Scientific Atlanta’s optoelectronics (2006), in

support of video. • During this period, Cisco acquired 68 companies• Passed up on potential optical acquisition

targets:• Siemens networking division (merged

with Nokia Network Business) in 2006• Nortel’s Metro Ethernet Division (which

was acquired by Ciena in 2009).

Six growth businesses identified in 2004

• 70% of its turnover still from maturing networking business

• CEO John Chambers says. "Cisco fully intends to expand its current core markets, expand in service providers, and expand in advanced technologies“

• Six areas identified with potential to become “billion dollar businesses”

Cisco as a 20-year old company Six advanced-technology areas Enterprise1. Security2. StorageService providers3. Optical4. IP telephony5. WirelessConsumer products6. home networking

ON market share remains stagnant for Cisco but grows for Huawei, ZTE, Infinera, Ciena

Optical Transport Equipment Market Share (1998-2010)

Source: Dell’Oro

Huawei’s growth in optical market• Established 1988• R&D Investments

– In 2005, Research staff was 48.6% employee count

– 60% employees holding master’s/Ph.D. degrees.

– 10% revenue for R&D.

• Partnership strategy – Reluctance to focus on M&A’s for acquiring

technology – Joint ventures as vehicles for accessing new

markets.

• APAC-driven growth – Regional (APAC) and emerging markets that

drove global optical market growth– China to APAC to other emerging markets

(South America, Middle East) – To more developed markets outside North

America (e.g., 2001-2005 Germany, Spain, Portugal, Sweden, Netherlands; UK’s British Telecom in April 2005) to North America.

North American difficulties (2001-present)• US House intelligence committee investigation 2011:

Huawei, ZTE = security threat• Ren Zhengfei, Huawei founder, left PLA in 1984• Sun Yafang, chairwoman, worked for Ministry of

state security• “The Chinese are aggressively hacking into our

nation’s networks, threatening our critical infrastructure and stealing secrets worth millions of dollars in intellectual property from American companies. This jeopardizes our national security and hurts U.S. competitiveness in the world market.”Dutch Ruppersberger, committee member

Optical Market Rise– 2001: Number 1 in optical for China, APAC.– 2004: By Q4, 3rd place in world optical

market. – 2006: Number 2 spot in optical, behind

Alcatel-Lucent. – 2009: Surpassed Alcatel-Lucent in optical

market by Q3.

Infinera’s growth in optical market• Established 2001 in Silicon Valley, IPO 2007• Photonic Integrated Circuits, PIC, combines dozens of optical components onto 2 tiny chips• 1,200 employees, turnover $0.4 bn in 2011, losses $81.7bn• R&D Investments: 31% in 2011, 320 patents filed/granted

• Vertical integration: Plants in Sunnyvale CA, Allentown, PA• Tom Fallon, CEO of Infinera since 2010

Cisco : since 1993: Operations manager– 2001 - 2003: GM of Optical Transport Business Unit – 2003-2004 : VP of Engineering and Operations Infinera – 2004 - 2009: COO & VP of engineering and operations – 2010: President & CEO

What is most important advice you can give for someone who wants to run a telecom company? “My advice would be make sure you have a long view of the world. Investors can be shortsighted, and things can come along that are bright and shiny. The thing is to pick a technology path that is hard and big and that creates an opportunity for your customers to differentiate”. Tom Fallon

Light Reading January 14 2011

2010: Cisco’s renewed optical focus

• Since 2010, Cisco is increasingly focusing on commercial 100G long-haul optical transport, in part because of increasing cloud services driving traffic.

• CoreOptics ($99M) acquired May 2010 for for transition to 100Gbps transmission.

• Launches packet-optical transport system (P-OTS) Nov 2010.

• LightWire acquisition ($271M), Feb 2012, for optical interconnects (for 40, 100 Gbit/s transitions).

• Market share in 2012– Huawei leading– Alcatel-Lucent challenger– Ciena, ZTE, Fujitsu

• Sycamore, Nokia Siemens Network sold to private equity firm

• EMEA, Americas in decline

$15 bn Optical Market “challenging”Renewed focus on Optical

Mobile backhaul: --what are we talking about?

Services and switchingAggregate many towers and transport

Connectivity

Drivers of backhaul equipment markets

• Increasing numbers of mobile subscribers

• New mobile internet services begins to take off

• Demand for bandwidth• More cell sites

2003: Mobile backhaul projected to grow from $1bn to $6-8bn gobally by 2007

Who would win backhaul contracts?

Telecom-Centric Vendors• Voice (real-time)• Centralized control and

network intelligence • Control Quality of Service• High-cost scalablility• Incumbents with +100 years

of experience in selling telecom systems

Internet-Centric Vendors• Multimedia, Internet • De-centralized control and

network intelligence• Best effort• Low-cost scalability• New entrants with highly

scalable (read: cheap) technology

Cisco in mobile backhaul: Architectural Control

• IP as a potential disruptive technology – Cheap and scalable access to bandwidth – But decentralised and less control over data flows

• Architectural control and standards– Complex system integration dependant on architecture– Standardization controls architecture– Cisco outsider in standardization institutions

• Hybrid technologies mixed into existing infrastructure – For 3G backhaul technology, ATM was chosen by

incumbents• Control of service levels (data and voice)• Connects well with prexisting 2G copper and fiberoptical SONET

– Incremental techs (GPRS, EDGE etc) allowed to add bandwidth through mixing packet protocol with existing 2G voice technologies (TDM)

• Business Models and Organizational Capabilities– Cisco develops understanding of complexity and

hybrid technologies (MPLS)– However, to win customers Cisco would have had to

demonstrate hands-on experience and used-cases– Cisco had to rely on re-sellers to get business at all,

limiting ability to learn and build up a portfolio of used-cases

– Non-exclusive reselling contracts led to intense competition between Cisco and Tellabs

– Also, Cisco was a high-margin ’box-seller’ with little inclination of providing system integration services for free as part of the sales proceess

Cisco in mobile backhaul: Organization and Business Model

Has Cisco learned?

• Building a full service portfolio– Starent acquisition in 2009 for $2.9 bn– Strategic alliance with NEC for BH radio

technology

• Battles for control of architecture outside BH– Definitions of standards for software defined

networking in data center

Cisco and data centers• Internal development and acquisitions to bolster to networking solutions

into data centers– LAN network storage, switch and load balancers – Acquisitions –

• Andiamo acquisition in 2002 – storage area networking products• Actona acquisition in 2004• Topspin and FineGround Network acquisitions in 2005• Nuova systems acquisition in 2006• Reactivity acquisition in 2007

• Data Center 3.0 Strategy from July 2007– VMWare patnership for virtualization of server and network ceters – Green data center launched in 2011 at Allan, Texas– Tidal Software acquisition in 2009

• Unified computing system in 2009– Server business into data centers– Converged solution for data centers: networking, servers, storage and virtaulization – Head-to-head competition with Microsoft, HP (3Com acquisition), Juniper/IBM partnership– 10,000 customers by January 2012, global market leader (no. 2 NA, no. 3 global in blade server)

A Cisco success story?

Cisco and data centers• Key success factors

– Market transitions anticipated more easily as present from early 2000s– Acquire companies with complementary technologies – Familiarity with enterprise segment and high brand equity– Leverage core competencies in networking

• Next generation technologies – Software-defined Networking– Opensource software that shifts control of network from routers to an overarching

control centers allowing data center managers can thus control resources autonomously via new software layer

• Potential commoditization of routers

• Standardization battle– Cisco, HP & IBM in short-lived partnerhip in search of ’incumbent advantage’– Cisco judged the terms offered by others to be unreasonable and entered server

market– HP now clearly in head-to-head competition with Cisco for market leadership

A Cisco success story?

Cisco, employees, sales, and profits, 1989-2012

A story of unbridled success or a warning tale?

Tentative conclusions

Conclusions