Cisco Fractures Its Own Fairy Tale Once upon a time a star called Cisco soared with the rising stock market. But when the economy slowed, Cisco's managers didn't know what to do.
By Stephanie N. Mehta Reporter Associates Julie Schlosser, Paola Hjelt

(FORTUNE Magazine) – On Monday, April 16, Cisco Systems CEO John Chambers embarked on a journey to visit telecommunications companies that use his company's gear in their networks. Chambers had just told investors that Cisco would post an unprecedented 30% decline in sales from the previous quarter, but the trip was planned months ago, and he decided to stick to his schedule. By Thursday night he had met with executives from ten phone companies in six cities. "Our progress and positioning with the service providers is extremely good," Chambers, reached on an airplane somewhere in the Mountain Time Zone, reported in a spirited voice. "There was no concern about our strategy or direction."

Chambers also found time in his travels to meet with employees and talk about the 8,500 jobs Cisco is cutting--the first mass layoffs in the company's history. He acknowledged that the firings are personally difficult for him, yet he still managed to put a happy face on things. "We've communicated actively with our employees," he said. "I would say probably well in excess of 95% of the voicemail and e-mails--and I've had a ton of them come in--have been extremely positive, even by those people who have been affected."

If this cheeriness sounds out of keeping with the times, that may be because everything about Cisco seems that way right now. On the way up to a stock market value of half a trillion dollars, everything about Cisco seemed perfect. It had a perfect CEO. It could close its books in a day and make perfect financial forecasts. It was an acquisitions machine, ingesting companies and their technologies with great aplomb. It was the leader of the new economy, selling gear to new-world telecom companies that would use it to supplant old-world carriers and make their old-world suppliers irrelevant.

Over the past year, every one of those characterizations has proved to be false.

Yes, we all know the numbers by now: Besides the drop in revenues, the company is taking a massive $2.5 billion write-off for excess inventory. According to its executives, Cisco was blind-sided by the suddenness of the economic slowdown and by the way demand for its equipment just up and disappeared. "This is a macroeconomic and decline-in-capital-spending challenge for our industry," insists Chambers. Indeed, many competitors, including Nortel and Lucent, are struggling too.

But as dozens of conversations with customers, past and present Cisco executives, competitors, and suppliers reveal, Cisco has made its own mess. It made some bad technology bets. It exhibited a cavalier attitude toward potential customers. It signed long-term contracts with suppliers at just the wrong time. And a few of its products just weren't very good.

Those looking for someone to blame can start with a CEO who didn't seem able to turn off the spigot of his own optimism. That pink-slipped employees are pitching woo at their soon-to-be-ex-boss says a lot about Chambers, 51, and the fervent devotion he effortlessly inspires. Few executives deliver a rap more hypnotically. And in an economy dominated by a stock market that thrived on positive news, few companies offered more of it than Cisco or had greater mastery over the numbers that told the story. For 13 quarters in a row during the bullish '90s, when its sales grew 75% a year, Cisco beat analysts' per-share profit expectations by exactly one penny. In April of 2000, when FORTUNE put Chambers on its cover and asked, "Is he the best CEO in the world?" the company had just hit a remarkable milestone: It had achieved a market value of more than $550 billion, surpassing Microsoft and General Electric, for a time, as the company holding the title of World's Biggest Market Cap. (See "My 'Dear John' Letter.")

Basking in such a culture of confidence, Chambers and his managers seem to have had difficulty anticipating bad news and forecasting lower demand for their company's products. In the heady days of last summer, Cisco's rosy outlook prompted the company to build inventories as part of a strategy to speed up shipments to customers. As recently as early December, Chambers was offering investors an upbeat view of Cisco's prospects, despite the demise of dozens of companies that were Cisco customers, particularly dot-coms and telecom upstarts. By then several securities and industry analysts had published reports warning of flat spending in 2001 by telecom companies of all sizes. Yet despite Cisco's heavy commitment to this market, Chambers didn't change his tune. Instead, he offered a variation on one of his common themes: "Cisco does better during the tough times."

But demand did indeed slow, and new technologies failed to take hold. Investors who bought into Chambers' pronouncements are likely to be singing the blues. Cisco shares have tumbled 65% since the beginning of December, and today its market value hovers around $115 billion.

Nowhere was Cisco's swagger more apparent than in the company's bold move into the telecommunications-equipment market, which was dominated by such powerhouses as Nortel, Lucent, Siemens, Alcatel, and Fujitsu. The runaway leader in equipment for corporate data networks, Cisco began looking for new markets to conquer in the mid-'90s. As large companies began using the phone system to carry data traffic between their facilities instead of building their own data networks, the divisions between corporate and public-phone networks began to blur. Telecom companies ogled the massive amounts of traffic that corporate data networks could handle and started wondering if similar systems could efficiently run public networks.

Meanwhile, deregulation of the U.S. telecommunications industry, enacted in 1996, coupled with a robust stock market and the boom of the Internet, prompted the creation of hundreds of new companies, all eager to build new networks and swipe business from established players like the Bell telephone companies, AT&T, and WorldCom. Telecom spending, which had been growing at single-digit rates for much of the '90s, exploded and began rising 14% to 17% annually.

Cisco strode cocksure into this conservative and somewhat stodgy world and declared a revolution: Internet Protocol--the digital language of the Web--would rule the world. Telephone calls would be chopped up into data packets and delivered free--via Cisco equipment, of course--and anyone who didn't understand this was pathetically old-economy or, worse, a dinosaur headed for extinction. Chambers quickly became the poster child for the Internet and promised to meld it with the public telecom network. With his patient speaking style and West Virginia drawl, he made Internet Protocol, or IP, seem somehow less intimidating. When he called rival telecom-gear makers "old world" companies, his tone was never mean-spirited. Rather, it was almost as if he felt sorry for them. (This, by the way, was even more infuriating to competitors.)

Cisco's assuredness bordered on the naive. In pursuing customers Cisco had its greatest luck with its spiritual compatriots--new service providers that didn't have old-world networks and attitudes. At first the fit seemed perfect. The new carriers and Cisco were united in their desire to outgun their old-economy counterparts. Like Cisco, these carriers were stock market favorites for a time. Investors figured each of these newcomers would be the next MCI, which thrived by taking long-distance customers from AT&T. Many of the upstarts had raised plenty of money to spend on Cisco's "next generation" telecom gear. Others were able to borrow the funds, and then some, through Cisco's structured finance program. Though the upstarts accounted for roughly 25% of U.S. telecom spending in 2000, by last summer Cisco got about half of its telecom revenues from them.

As it turned out, Cisco had made a big bet on the wrong segment of the telecom market. Many of the new telcos were poorly managed, had weak business plans, or failed to meet their earnings targets. Today these companies aren't simply slowing their capital spending. Many have gone under, and others will crash soon. Those that are hanging on face a cash crunch.

It's no surprise, then, that telecom accounts for a disproportionate share of Cisco's woes. Sales to telecom companies make up about 40% of Cisco's revenues, but telecom gear and parts accounted for 70% of the inventory write-down. And telco revenues declined an estimated 40% in the most recent quarter, vs. 20% for sales to corporate customers.

Cisco wasn't alone in pursuing the newbies. Some of Lucent's gambles on new carriers, for example, have fared poorly. (See "Hear No Risk, See No Risk, Speak No Risk.") But unlike Lucent or Nortel, Cisco can't fall back on deep relationships with established phone companies. "Cisco totally underestimated the importance of the embedded carriers," sniffs one telecommunications executive. "Maybe we are dinosaurs, but dinosaurs lived for a hell of a long time." Chambers says alternate carriers contributed about $500 million a quarter to Cisco's revenue a year ago. "It has dropped to a small fraction of that," he says.

Yet Cisco apparently is still chasing upstarts. In March Cisco announced a handful of contracts with carriers that would be deploying its equipment. Only one, Swedish phone company Telia, is a brand-name phone company. Other customers include no-names like DataVoN, which had $11.4 million in sales last year. DataVoN confirmed that Cisco was providing financing for its purchases. Asked to comment on why Cisco is making deals with such small fry, Chambers replied, "You want to think of alternative service providers as disrupters to the market; they push the traditional players to move faster."

Just as damaging as its pursuit of the newbies is the way Cisco alienated many of the giant old-world phone companies that now seem likely to survive the current downturn. In the fall of 1998, at a gathering of some 100 service providers in Monterey, Calif., Chambers made his famous statement that "voice would be free," leaving telecom executives either indignant or bemused. Chambers wasn't just attacking their cash-cow voice-calling business; he was taking a shot at the 100-year-old phone network, legendary for its reliability.

As a consequence, many of the established phone companies eyed Cisco with suspicion. Like Chambers, most Cisco executives didn't disguise their frustration with the telcos' hidebound traditions and multiyear timeline for evaluating new suppliers. And the telcos didn't trust a builder of corporate Internet systems to touch their networks; this was the late '90s, when tales of intranet crashes abounded.

Cisco's sales tactics irked some phone companies too. Rather than making their pitch to engineers and procurement officers in charge of buying network gear, Cisco's salespeople often approached their counterparts at phone companies with a proposition: Buy Cisco gear and we can introduce you to our corporate customers--customers you desperately want to serve. This was appealing until phone companies started to realize that Cisco was promising every telco access to the same handful of potential customers.

Phone companies have also been reluctant to embrace Chambers' vision of delivering free voice calls over Internet Protocol networks. According to Synergy Research, last year phone companies spent some $35 billion on equipment for so-called circuit-switched voice networks--the stuff built by old-world manufacturers like Lucent. They spent less than a billion on voice-over-IP gear.

The slow uptake isn't just a case of phone companies' dragging their feet. They have invested billions of dollars in their circuit-switching gear, which creates a dedicated circuit between two parties for every phone call. Circuit switching isn't very efficient, but it provides excellent sound quality, which telco executives don't want to sacrifice. Telcos are also looking for suppliers that will help them make a gradual transition to new-world packet networks. Yet Cisco has always seemed to advocate ripping out old networks and replacing them with new ones. "The larger, established carriers tend to view Cisco skeptically," says Paul Sagawa, an analyst with Sanford C. Bernstein. "By no means do they view Cisco as a partner."

Cisco did score victories with the larger carriers--its routers are staples in AT&T's and WorldCom's data networks, for example. Some of its successes, though, have come at a price. Cisco pushed hard to supply telephone companies with gear to support high-speed digital subscriber line, or DSL, service. But a few telecom companies grumbled to FORTUNE about the quality of Cisco's DSL equipment. At least one carrier said it had to replace some of Cisco's broadband equipment with newer Cisco gear because the original shipment wasn't up to snuff. A Cisco spokeswoman says, "If a customer has an issue with a product, Cisco will do everything possible to resolve the problem quickly."

Even worse for Cisco is the way it misread demand for the equipment, which contributed to the enormous inventory write-off. A little over a year ago, the Bell telephone companies--and some of their DSL competitors, like Covad and Rhythms--set aggressive targets for deploying high-speed Internet access to consumers and small businesses. Cable operators, too, were rolling out fast cable-modem services. Demand for Cisco's broadband equipment was very high.

Yet when Cisco's customers started to cut back early this year, Cisco was caught in a bind. The company had been worried that long lead times--customers sometimes had to wait months for a product--were hurting sales. So it entered into long-term contracts with suppliers and manufacturers to assure the availability of customized components for its products, including broadband gear. As much of that inventory was coming in, however, demand started to slow. In DSL, for example, giant SBC announced plans to cut back its deployment of high-speed lines, citing the need to shore up its Ameritech purchase. The competitive DSL providers are all but wiped out. And the lack of competition from telcos has provided the cable operators breathing room to deploy cable modems at a more leisurely pace. Chambers says, "When your run rate on certain products such as DSL or cable goes from 150% to flat to down, you end up with more capacity than you need."

Nevertheless, the size of Cisco's inventory stockpile is astounding, and the way the company has accounted for it has raised eyebrows as well. Cisco says that its policy is to write down anything it won't use within 12 months. Without the $2.5 billion write-down, the value of Cisco's inventory for the quarter ending April 28 would be about $4.1 billion--64% higher than for the quarter ended January 27. Some accounting experts have suggested that Cisco might try to use some of this written-down inventory in the future--CFO Larry Carter said some of this inventory will be placed in a "secured area"--if demand picks up again. Products sold using inventory with zero cost would show some very nice margins, leading to the suspicion that Cisco may be taking a big hit now (in a quarter that was going to be bad anyway) in order to look better in future ones.

Cisco claims that the excess inventory will be obsolete within 12 months because manufacturers keep improving their components--a scenario affirmed by some suppliers. If that's the case, though, the question becomes, Why hadn't Cisco written down some of its inventory in earlier quarters? By the end of the January quarter, inventory levels had reached $2.5 billion, up $1.2 billion from a year earlier. Yet the company didn't disclose any write-downs, which implies that Cisco expected to be able to use the gear. How did so much of it become impaired in a three-month period? The Securities and Exchange Commission has recently expressed concerns over the timing of such write-offs. A company might know it was holding impaired inventory, so the worry goes, and fail to share this information from investors. Cisco says that the size and timing of the write-off came as a result of "a precipitous drop in demand."

For now, Cisco is taking steps to raise its standing with important telcos. In late April, Senior Vice President William Nuti revamped Cisco's telecom business to dedicate more sales and technical support staff to a smaller number of customers. The aim is to help phone companies develop the kind of value-added services that their own corporate customers want. Nuti says, "We're going to get back to basics in terms of listening to our customers and responding to what their needs are."

That may be a touch of humility you hear--but it isn't necessarily shared by all of Chambers' managers. Asked if he felt any regrets about Cisco's "we do well during the tough times" mantra, strategy chief Volpi didn't hesitate: "I think that's true," he said. "This is an opportunity for Cisco. All our competitors are hurting, and when they hurt they'll retrench. We can gain much more share now than in the past." Volpi might want to check the latest market-share numbers from Synergy, which show that Cisco's rank in the communications-equipment market in the fourth quarter slipped from second place to fourth.

Despite its woes, Cisco still has many fans. "The real story on Cisco will be told six months from now, when things normalize," says Rand Blazer, CEO of KPMG Consulting, which is 10% owned by Cisco. "You are still dealing with one of the strongest companies in the world." Despite the free fall of its shares in the past year, investors who bet on Cisco when it went public in 1990 would be better off than if they had invested in the S&P index. The company has gear in 85% of large U.S. corporations, and analysts point out that in the telecom market, Cisco is only an acquisition or two away from becoming a dominant player. It certainly has the means. Its market cap still dwarfs that of its rivals, it has $17 billion in cash and investments, and its balance sheet is debt free.

Yet Chambers has always been loath to acquire mature companies--the sort that could make Cisco an instant contender in a new market. He doesn't want to risk the culture clash, analysts say. Potential acquirees, meanwhile, may be reluctant to take Cisco's battered stock. And not all of Cisco's deals have gone so well. While it seems to be getting mileage from its $7 billion acquisition of optical networking gear-maker Cerent, which recently won a contract from BellSouth, some other attempts to buy into that market have been flubs. Cisco has scrubbed a product developed by acquiree Monterey Networks that aimed to route waves of light in fiber networks. Cisco says the product was ahead of its time; analysts say customers rejected it. The analysts expect Cisco to axe other lackluster products too. Its acquisition of Pirelli's optical-systems business has also been a disappointment. Once the leader in a technology that increases the capacity of fiber-optic networks, the Pirelli unit has fallen far behind rivals Nortel and Ciena. Cisco says Pirelli is developing new products.

Acquisitions, forecasting, technology, and, yes, senior management--all have failed Cisco in the past year. To some extent, the same fate has befallen the company's competitors. But Cisco's stumbles are fascinating because Chambers promoted the company as a new breed of behemoth--one that was faster, smarter, and just plain better than the competition. "I expect to be held to a higher bar than others," Chambers concedes.

But don't think that this CEO is depressed. He's already talking about a return to 30% to 50% growth, though he admits he doesn't know when. "As a business leader, you have to plan for the future...and share that with employees so they can plan for everything from manufacturing to facilities," he says. "And if you don't share that with your shareholders, you have a disclosure issue."

Chambers stops a minute to catch his breath. There are so many drivers of growth to talk about: e-learning, video on demand, overseas markets--he almost doesn't know where to begin. "There's not a single customer we called on that didn't think we have an excellent chance of breaking away from the pack," he says. It's the kind of optimism that got Cisco where it is in the first place.

REPORTER ASSOCIATES Julie Schlosser, Paola Hjelt