Exclusive Interview: CEO John Chambers reveals his plan to break away from the pack

First of two parts

He calls it the “breakaway,” and John T. Chambers rates his chance of success at an astounding 70%.

The Cisco Systems CEO and president says those are the odds that his company will build an unbridgeable lead over the rest of the pack vying to build the backbone of the Internet.

But that’s not all.

In an exclusive interview with InvestmentNews, Mr. Chambers, 51, laid out a broad vision of Cisco’s future in which he unabashedly predicted that his company would take away market share enjoyed now by competitors in an industry that he says will far surpass all expectations.

a global player

That market should drive earnings and growth for years to come, and Cisco, because of its size, proficiency and positioning, is poised to execute an endgame strategy that will allow it to dominate the Internet-driven “second industrial revolution.”

Cisco, he says, grew at 66% in the last quarter, double the 33% growth rate that Wall Street predicted earlier this year when the company was the darling of Wall Street and its stock was trading for as much as $82 a share.

At its current share price of about $52, Cisco trades at a price-earnings ratio of 98 based on the past year’s earnings.

But its p/e is 65 based on the Wall Street analysts’ consensus earnings estimate of 79 cents per share for Cisco’s fiscal year ended July 31, 2001.

Cisco has promised Wall Street growth in the range of 50% to 60% for this current fiscal year or 71 cents to 81 cents per share.

“Now you’re growing it twice as fast, and all your engines are hitting in each area, and you’re just scratching the surface in terms of what this productivity could mean,” Mr. Chambers says. “Logic would indicate this is a breakaway.”

Mr. Chambers’ remarks during a wide-ranging interview at the company’s San Jose, Calif., headquarters are in marked contrast to recent articles in Barron’s, The Wall Street Journal and a slew of financial websites.

The conventional wisdom these days is that Cisco can’t grow fast enough to sustain a p/e that hovers near 100.

“Trees don’t grow to the sky,” says Thomas G. Donlan, the editorial page editor of Barron’s.

Mr. Donlan’s May 8 article in Barron’s, titled “Wanna Buy a Bridge?” painted a bleak portrait of Cisco that sent shares of the Internet blue chip plummeting. It has yet to fully recover.

Some Wall Street analysts like Paul Sagawa of Sanford Bernstein have downgraded its shares for the first time in years, and mutual fund managers are now lumping the company with other big, slow-moving tech blue chips like Microsoft Corp. and IBM Corp.

“These are the Procter & Gambles of tech, and Cisco is one of those,” says Donald Lufkin, CEO of MetaMarkets.com, a San Francisco mutual fund that owns no Cisco shares.

If Cisco is now a glorified soap company, it will be a blow to hundreds of money managers and other investors who watched their Cisco shares appreciate almost 80% a year on average for the past decade.

Of the 20 mutual funds with the greatest stakes in Cisco, eight of them are managed by Fidelity Investments; the Fidelity OTC Fund holds 12.55% of its assets in the company, according to Morningstar Inc., the Chicago fund tracker.

There is logic to the conclusion that Cisco can’t grow at 50% annually past a certain point without virtually owning the world.

But when Mr. Chambers, perhaps the most credible executive in the history of business, makes a bet, it’s hard not to take his odds.

After all, he has earned his sterling credibility by making predictions for high and sustained growth levels both for his companies and the markets into which they sell. Those predictions have been uncannily correct.

“So who you going to bet on?” he asks.

“By the time the majority are in sync, it’s probably too late. That’s true in terms of market transitions, and it’s true in terms of the stock,” he says.

“By the time the majority was completely united in March, and everybody agreed this was the stock to have, and maybe that was the time the stock did get ahead of itself. Now may be the opportunity.”

Jack Harrington, general partner with Advanced Technology Ventures in Palo Alto, Calif., agrees.

“I don’t know another market like this,” he says. “I don’t know what to compare it to. I’d think that if you believe this is going to hold then Cisco needs to be one of your core holdings. Are they too big a multiple [of earnings]? Who cares?”

calling the market

The foundation of Mr. Chambers’ “breakaway” strategy is that Cisco can dominate the greatest market in the history of the world – a market that hardly exists yet but most certainly will.

That’s because the power of computer networking has reached a threshold where it offers startlingly high returns to those most capable of paying – multinational corporations.

In effect, those corporations can form what Mr. Chambers calls “networks of networks” in which 30 companies are wired together to achieve the power and efficiencies of a single large one.

During the 1980s, annual productivity – the magical efficiency of manufacturing that allows companies to produce more goods and products without spending more resources – grew 1.5% on average.

That improved to only 1.6% by the mid-1990s even though capital expenditures on information technology doubled to 30%, from 15%.

But because of a paradigm shift in business practices brought about by improved data exchange that he calls the “network effect,” productivity is now zooming ahead at 5.6%, and information technology spending represents 55% of capital expenditures for U.S. companies, Mr. Chambers says.

“You could say, `John, you’re making a call on the market,”‘ he says. “I absolutely am.”

Suddenly, IT spending is becoming the top item on a CEO’s desk because it represents a way to increase revenues rather than a way to pare costs.

Those productivity advances will never relent for complacent companies.

“The thing people don’t get,” Mr. Chambers says, “is that everything will get cheaper forever. That creates incredible pressure on the top line in terms of revenue. So unless you’re driving your productivity up, you’re not going to make profits.”

With the size of the corporate pie growing at triple its previous rate and with the corresponding open-ended IT budget allocations for computer networking, Cisco is ready to pounce.

Brendan W. Mills, CEO of General Bandwidth Inc. in Austin, Texas, and a Cisco employee until last year, says those claims of dominance are not so far fetched.

“I really see it that they’re distancing themselves from their competitors,” he says. “These guys are hyperaggressive people, and they know what’s got to be done. Cisco’s just got the mind-set that they’re open to a new business model,” he adds. “It’s ingrained in them.”

Game over

Also ingrained in Mr. Chambers’ mind is the need to dominate the market for every link in the networking chain.

It is the `bigger-is-better’ philosophy that has fallen out of favor on Wall Street.

Lucent Technologies’ fall from grace and the eye-popping initial public offerings of startups like Corvis Corp. of Columbia, Md., and Silicon Valley’s Juniper Networks suggest that smaller, more nimble players will dominate.

But Mark Lutkowitz, an optical networking analyst with Communications Industry Researchers in Charlottesville, Va., says the pendulum may already be swinging back.

“Cisco is a potential powerhouse,” he says.

“We’re going to gradually move back toward `bigger is better.’ World-class companies like WorldCom want a single box to install anywhere in the world and get service worldwide. Only the big guys can pull that off.”

Mr. Chambers says size also saves his company from ripples in the economy and actions of competitors. Cisco has 12 business segments each selling more than $1 billion in products.

“Cisco, I believe, is the only company in the industry that controls its own destiny,” he says.

“We are not controlled by economics or competitors.

“If we execute right, it’s `game over.”‘

Much of that execution involves continuously making purchases of companies with complementary technologies.

Mr. Donlan of Barron’s called Cisco’s strategy a “house of cards” in his pivotal May 8 article, and many of Cisco’s critics agree.

Not only is the integration of so many people and technologies draining on management resources but it is getting exponentially more expensive. Whereas Cisco used to buy companies for millions of dollars, it now has to pony up billions of dollars for the best technology start-ups, he argues.

Mr. Chambers says that analysis is flawed.

Cisco is able to make acquisitions far more easily today than ever before, he says.

When Cisco made its first 10 acquisitions, Mr. Chambers says, he was involved with the integration up to his eyeballs. Now, he says, he receives an executive summary, and that’s almost his entire involvement.

Meanwhile, Cisco has no trouble courting companies and making deals.

“On the average day, we get offers to either acquire technology or companies – probably from 10 or 15 companies,” he says, which compares to “three years ago when we were only getting one opportunity every two weeks.”

Companies join up with Cisco for more than the money.

“The great news is that Cisco is looked upon as a white knight,” he says.

Another criticism of Cisco is that it has grown so big that it’s no longer nimble in developing technology.

“It’s not on the leading edge of anything,” says Mr. Lufkin.

“I’d take Juniper in a heartbeat.”

But Johna Till Johnson, chief technology officer of Greenwich Technology Partners in White Plains, N.Y., a consultancy that advises clients on what technology to install in their networks, says this is more perception than reality because of isolated incidents.

“Has there been a major brain drain, and has the technology dropped below par?” she asks. “I’d say no. They have a significant portion of the intellectual capital in the technology space. In putting together a project, your greatest asset is not smart people but smart people who have been around the block.”

Still, Ms. Johnson says, Cisco must lie awake at night wondering about how it will fare in optical networking and high-end routers – two markets where it faces real competition.

Larry Lang, vice president of service provider marketing for Cisco Systems, says Cisco’s vulnerabilities to router maker Juniper Networks in Sunnyvale, Calif., and optical networking leader Nortel Networks of Brampton, Ontario, are overblown.

He says Nortel’s optical networking equipment is “jimmied” voice-carrying equipment that is hardly ideal for tomorrow’s networks, which will need to carry primarily Internet traffic.

Mr. Lang adds that optical networking is but one link in the communications chain that has caught the imagination of the public.

Mr. Chambers says that with its Cerent box, Cisco’s optical networking sales will soar from $1 billion during the year ended July 29 to between $3 billion and $7 billion in current fiscal year.

Mr. Lang also notes that Juniper has only about 20% of the market for high-end routers and that it may never again see such growth.

Much of its revenues are derived from service providers who are following their own rules to purchase equipment from two vendors, he says.

Though Cisco executives refuse to believe that technology itself will prove to be a stumbling block, Mr. Chambers sees potential pitfalls for his juggernaut.

“How do you scale quickly enough? How do you double your leadership team? How do you keep your hunger?” he asks.

That is why Mr. Chambers’ prediction that his company will blow doors off the competition, and economic history itself, comes with a 30% probability of failure – a prediction he promises is not a red herring.

“Anyone who doesn’t think that can happen is wrong,” he says. “Nothing teaches you that like laying off 5,000 people. I laid off 5,000 people with Wang myself. You let down your customers. You let down your shareholders. You let down your employees. I’m never going to let that happen again in my life. Never.”

Next week: Cisco chief John Chambers makes clear that he is playing hardball with his competitors. Needless to say, his competitors take a few swings at that.