FOOL ON THE HILL
Cisco's Successful Strategy

The annual CEO letter to shareholders offers an underutilized way to become familiar with a company's big-picture story. In the case of Cisco, CEO John Chambers' letters from 1997 to 2002 offer a high-level view of the strategies that have led the company to its undisputed leadership position in the networking world.

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By Matt Richey (TMF Matt)
December 5, 2002

This is round three of looking at companies through the lens of the CEO's annual letter to shareholders. So far, I've been dazzled by Amazon (Nasdaq: AMZN), put off by Elite Information Group (Nasdaq: ELTE), and today I'll offer my impression of Cisco Systems (Nasdaq: CSCO).

How bad a year has it been for Cisco? Well, in the company's most recent annual report (for the fiscal year ended this past July), CEO John Chambers called fiscal 2002 "the most difficult environment Cisco Systems has ever faced."

So it was a horrible year, and yet Cisco consistently generated around $1.5 billion per quarter in operating cash flow -- its highest ever cash flow from operations in a single year (and without the help of tax benefits from employee stock options, which amounted to only $61 million for the year). When a company earns record operating cash flow in its "most difficult" year ever, you know you're looking at a great company.

Another sign you're looking at a great company: The CEO actually writes about cash flow in his annual letter to shareholders -- as did Chambers:

Our positive cash flow from operations continues to average between $300 million and $500 million per month. And while this will vary from quarter to quarter based on large cash outlays, such as tax payments and end-of-year compensation payments, we were pleased with our average positive cash flow for the year from operations of $1.5 billion per quarter.

How does Cisco do it? Here we are in an IT spending slump, and its cash profitability is running at peak levels. This feat becomes all the more impressive when compared to the likes of Lucent (NYSE: LU), Nortel (NYSE: NT), and Juniper Networks (Nasdaq: JNPR). Stacking these competitors side by side reveals the magnitude of Cisco's lead in terms of raw cash profitability:

                  CSCO     LU      NT     JNPR
Revenue ($M)     19,312  12,321  11,496    542
Op. Cash Flow     6,270    -756    -393    -19
Margin            32.5%    -6.1%   -3.4%   -3.5% 

As you can see, especially in the margin comparison, the numbers here are so lopsided in favor of Cisco that one wonders whether the word "competition" even applies to this industry anymore.

But again, how does Cisco do it? What strategies have allowed it to become the runaway leader in networking? That's the question I sought to answer as I read and studied its past six annual letters to shareholders. Between Chambers' sometimes overly grandiose philosophizing about the Internet's potential, I discovered three components to Cisco's long-term strategy that differentiate the company from its competitors:

1. A networking guinea pig
One of the common threads in Chambers' letters is that Cisco doesn't just sell networking gear; it sells itself as a model of networking's productivity-enhancing potential.

At the end of the 1997 letter, for example, he invited readers to dig into the annual report for examples of "the compelling business advantages that networks are delivering each day." One of these examples was the company's own website, which was then known as "Cisco Connection Online" (CCO). The following stats may seem routine today, but in 1997, they were mighty impressive to its customers and potential customers, the majority of whom were still trying to figure out what the Internet even was:

With nearly 70,000 active registered users from around the world, CCO is accessed approximately 700,000 times each month, making it the primary vehicle for delivering responsive, around-the-clock customer support. Customers rely on CCO to answer questions, diagnose network problems, provide solutions, and receive expert assistance worldwide. In fact, over 60% of Cisco's technical support for customers and resellers is delivered electronically, saving Cisco over $150 million annually and improving customer satisfaction.

Over the next three years, he updated these increasingly impressive stats in each of his letters: In 1998, "[M]ore than 64% of our orders and nearly 70% of our customer inquiries were handled via the Web." In 1999, "80% of our orders and more than 80% of our customer inquiries were transacted over the Web." And in 2000, "90% of our customer orders were transacted over the Internet."

By 2001, he had every right to toot his own horn about the impressive efficiency gains being created by Cisco's internal network:

Over the last several years, cost savings from our Internet-based applications have averaged increases of over 50% each year, exceeding $1 billion in savings. Two applications in particular, e-sales and e-learning, are currently having a dramatic impact within Cisco. Today, our sales team has better access to sales statistics, real-time bookings, and customer news, as well as a more efficient process for tracking overall sales efforts. Sales & Marketing Management magazine recently rated Cisco as the "best-trained sales force" in the United States across all industries. This was largely due to Cisco's use of e-learning applications. We achieved a 40% to 60% cost savings through increased use of e-learning over instructor-led training in our fourth quarter alone.

This is more than mere boasting, more than mere "eating our own dog food." When it comes to selling customers on the promise of networking, Cisco's in-house success has provided it with an important marketing advantage: credibility. Without this credibility, customers would be leery of taking networking advice from a company who's trying to sell them networking gear. Instead, though, because of its demonstrated in-house networking expertise, clients look to the company as a strategic advisor for their own networks.

2. Striving for technology leadership, not technology dictatorship
Given that Cisco is widely viewed as a technology company, you might be surprised to discover how little space Chambers devotes in his letters to whiz-bang networking innovations. When it comes to networking technology, his attitude seems to be, "Whatever works best for customers -- and if we don't have the best technology, we'll acquire it." As he wrote in 1997:

Our goal has always been to provide solutions for our customers without imposing a particular technology as the only "right" answer. Cisco continues to deliver the products that best address our customers' requirements through the innovation of our engineering teams, complemented by our alliances, acquisitions, and minority investments.

From 1993 to 2000, it acquired 65 companies as part of its aim to own the best technology. Critics accuse the company of waste in some of these acquisitions, but no one can argue with the results: In 2001, Chambers reported that Cisco held the No. 1 or No. 2 position in all 21 of the product segments in which the company competes.

This position of technology leadership is what will allow Cisco to pursue its vision for the future, as stated by Chambers in the 2002 letter:

CIOs and technologists will decide on which type of infrastructure they implement, and Cisco will be the company to deliver the networks that provide the greatest productivity gains, regardless of network type.

3. Training tomorrow's networking engineers -- around the world
Perhaps the most unconventional and most interesting component to Cisco's long-term strategy is its network engineer training program. Launched in 1997, the Cisco Networking Academy was started as a way to prepare high school and community college students -- both here and abroad -- for networking careers. Chambers explained the program in his 1999 letter:

... this program is our way of increasing the pool of qualified IT professionals and ensuring that business and government work together on their common goal of preparing students for the future.

The Cisco Networking Academy was an immediate success. By 1999, the program had already grown to more than 2,500 academies in 39 countries. A year later, more than 81,000 students were enrolled in 83 countries. By 2001, there were over 8,000 academies in more than 130 countries. And in October 2002, the program celebrated its five-year anniversary, with 9,900 academies and 263,000 students.

In my view, Cisco's Networking Academy represents one of the finest examples of strategic philanthropy in all of corporate America. This isn't just a give-away of shareholders' money, but rather an investment in Cisco's long-term potential. Not only does Cisco build goodwill with foreign heads of state, but also it lays the educational fabric necessary for its products to be demanded around the world.

Conclusion: great company, good letters, pricey stock
As I alluded to at the outset, I believe Cisco is a great company, and I believe it shows in both its financials and the CEO's letters to shareholders. These letters are best in terms of their high-level strategic content, which is why I presented the material I did. The letters aren't perfect, though. I especially fault Chambers for glossing over 2000's billion-dollar inventory charge. All in all, though, I credit him for the professional quality of his letters -- full of examples and supporting facts -- which reveal much about what makes Cisco great. 

As for the stock, I don't see a margin of safety at the current price of 40 times earnings. Perhaps at 30 times earnings, I'd begin to get interested. And at 20 times earnings, I'd give the stock serious consideration.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. For Matt's best Foolish stock ideas and in-depth analysis that you won't find anywhere else each month, check out our newsletter, The Motley Fool Select. The Motley Fool is investors writing for investors.