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Routers to Riches

By laying down the tracks of the Internet, Cisco has become the railroad of the New Economy. And the phone business may ensure it's not at the end of its growth track.

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One reason Cisco Systems is so popular among Wall Street analysts -- a whopping 38 of them cover the stock, each and every one with a buy rating -- is that it makes their jobs so easy. In its 40 quarters as a public company, Cisco has been almost tediously predictable, meeting or slightly exceeding earnings expectations every time and growing an average of 77 percent a year over the past decade. When the technology-heavy nasdaq index goes up, Cisco leads the pack; when the index comes down, as it did recently, the San Jose networking firm solidly stands its ground. And at a time when the market's mood seems set permanently to "nervous," one analyst recently predicted it could be the first company worth more than $1 trillion. You can read that as "bigger than Microsoft."

Considering its incredible success, Cisco is in the unusual position of being underappreciated, in the sense that many people -- even those who own some of the stock -- have little idea what the company does. Everyone knows GE makes lightbulbs, Microsoft makes Windows, and Intel makes "Intel inside" stickers and the microchips that go with them, because they can see -- and buy -- those products. But few people have ever knowingly laid eyes on any of Cisco's networking equipment, let alone understood what it was for. I saw an actual Cisco product once -- a nondescript gray breadbox tucked into a dark, refrigerated back-office closet -- and fled the scene. (That said, I currently own the stock.)

If you think of every bit of Internet traffic as a piece of mail, Cisco sells postal workers -- remarkable, untemperamental ones. More than 80 percent of its revenue comes from two types of equipment: routers and switches. Routers are the postal supervisors, the specialized computing devices whose processors determine how to direct and handle the data packages coming in from dozens of sources. Switches are the mail sorters, the less computational circuitry that speedily executes the instructions the router hands down.

But despite Cisco's reputation as a hardware company, it's actually the company's proprietary operating system, IOS, that makes both its products and its balance sheet work so well. At 20 percent or better, Cisco's net profits are consistently higher than the networking norm because it's partly a software outfit that enjoys that business's low cost of goods. Another factor is that Cisco's customers rely on the company's equipment for critical tasks, so they're not all that interested in saving a few bucks along the way. "If a bank doesn't make the Fed closing at the end of the night, it costs them millions in interest," explains Carlos Dominguez, Cisco's vice-president for the Northeast, who says he has more than 90 percent of the city's financial firms as clients. When it comes to big jobs, "there's just not tons of people who have built thousand-router networks."

In fact, Cisco is so good at that part of what it does that its rivals are literally abandoning the large-enterprise market, as 3Com did last week. But that dominance presents it with both a short-term boon and a long-term question. Its sky-high valuation -- way over 100 times next year's expected earnings -- assumes the company will keep growing at its current annual pace of about 40 percent for years to come. But the company is about to run into an economic principle known as the Law of Large Numbers. Years ago, that 40 percent rate used to call for a few billion in additional sales; now maintaining that growth rate requires adding tens of billions -- and Cisco has already conquered its natural market.

"Considering its incredible success, Cisco is in the unusual position of being underappreciated, in the sense that many people -- even those who own some of the stock -- have little idea what the company does."

There are several ways of combating the problem. Microsoft has tried sustaining its growth rate by expanding into other businesses, like media and finance. But Cisco might not have to stretch into another industry, because another industry -- a very large one -- is stretching toward Cisco. The really big opportunity Cisco faces, the tens-of-billions-a-year opportunity, has to do with a sea change in the kind of traffic the Net will soon be carrying -- and hence the size of the market Cisco will get to address. We're talking telephone. As the "voice data" business changes over from atoms to bits, phone calls, which Cisco used to have nothing to do with, are becoming Internet-ready data packages. More packages means more postal workers. According to Cisco's own estimates, spending on Internet-based telecom will dwarf traditional data networking: The voice-related gear-and-services business is already worth a quarter-trillion dollars, and it's growing faster than even Cisco's optimistic projections.

Not that Cisco doesn't have work to do. Nortel and Lucent, its two main competitors, are well entrenched in the telecom world with excellent technology. There are also technical hurdles: Internet connections of the kind Cisco peddles are not yet as reliable as old-fashioned but dead-stable PBX phone networks. Then there's sheer scope. For Cisco to grow as fast as it wants to, it will have to hire 2,000 new employees per quarter for the foreseeable future.

A target like that would seem overambitious coming from anyone but Cisco CEO John Chambers. Among the most revered figures in the technology industry, Chambers humbly chalks up his company's success to being in the right place (the networking business) at the right time (when the Internet took off). But it's more than luck. Chambers's vision of how to run a company that's both large and nimble is reflected in his perpetual shopping spree: In the past seven years, he's purchased 52 next-generation networking and communications firms, essentially as a method of outsourcing R&D spending. And when he buys the technology, he gets the brains that invented it -- a much rarer commodity -- as part of the package. Even more crucially, the imported tech talent tends to stay put: Chambers told Business 2.0 last year that only 6 percent of acquiree managers and engineers leave each year -- a fraction of the industry norm. He also has a well-deserved reputation for delivering what he says he'll deliver, and what he says he'll deliver is a $50 billion-a-year company (up from $18 billion) by the year 2004. Credit Suisse First Boston's Paul Weinstein, the analyst who made the trillion-dollar prediction, thinks he'll make his $50 billion goal by 2003.

Cisco's admittedly high valuation is a vote of confidence in the future of an Internet that will be more than an e-commerce mall. That's significant, because the market may be about to witness a wave of Web washouts that could call into question the fate of the networked economy as a whole. But any near-term Net sell-off will be about the delirium from which we all know certain stocks have benefited, not about a mistaken view of the big picture. And with phone service -- and after that, video -- set to dissolve into the matrix of the Internet, Cisco will be way too busy to miss a few dear, departed dot-coms.


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