In his book One Up on Wall Street, Peter Lynch warns investors to watch out for "diworsifications," misguided attempts by a company to boost its slowing business through expensive acquisitions. More often than not, the acquisitions fail to pan out, forcing the company to go through a period of restructuring to undo the damage.
To see a case study in misguided acquisitions, just take a look at Cisco Systems' (Nasdaq: CSCO) failed attempt to enter the consumer-electronics market.
The shopping spree
Cisco's diworsification began innocently enough, when the company purchased the home-router company Linksys in 2003. On the whole, this move made sense. The acquisition allowed Cisco to move into consumer products without straying too far from its bailiwick.
Unfortunately, Cisco didn't stop there. In 2005, it bought Sipura Technology, a maker of VOIP hardware, and Kiss Technology, a maker of networked DVD players. It followed these purchases up by acquiring the No. 2 set-top cable-box manufacturer, Scientific-Atlanta, in early 2006. Shortly thereafter, Linksys announced that it would form a new business unit focusing on home entertainment and then proceeded to release an unbroken string of flops over the next four years.
It seemed that every device Linksys brought to the consumer market after Cisco acquired it was either rendered unnecessary by some other product or was simply a bad idea. For example, the Linksys Media Center Extender played DVDs and also streamed media from a windows PC over Wi-Fi. Sounded great, but the Microsoft (Nasdaq: MSFT) Xbox360 offered the same features, along with the ability to play games, rent movies, and stream Netflix. The Linksys iPhone, which was specifically for VOIP services such as Skype (and had no relation to that other iPhone), quietly transitioned over to a line sold by Netgear (Nasdaq: NTGR). Finally, its multi-room music system died -- because multi-room music systems have failed to interest the public since the 1960s.
The poor consumer-products choices eventually spread beyond Linksys to Cisco proper. The company's acquisition of Flip, a company that made handheld camcorders, quckly floundered after smartphones such as Apple's (Nasdaq: AAPL) iPhone 4 began offering HD video. Umi, Cisco's grossly overpriced home-teleconferencing system, had no chance against the free alternatives offered by Skype, Apple, orGoogle, or even lower-priced offerings from Logitech (Nasdaq: LOGI).
Meanwhile, the company began to lose market share in its core businesses as new competitors such as Hewlett-Packard (NYSE: HPQ) and Juniper Networks (NYSE: JNPR) entered the market. Investors started wishing that Cisco would leave consumer gadgets to Apple and return its focus to its core business. This past April, CEO John Chambers had to admit it was time to change course.
Restructuring and ramifications
In a message sent to Cisco Employees, Chambers outlined the company's main priorities as "leadership in core routing, switching and services; collaboration; data center virtualization and cloud; architectures; and video." Consumer products failed to make the cut. The company killed its Flip video camera and shifted Linksys' focus back to selling home-networking equipment. The Umi seems to have survived in some form, but only because Cisco plans to integrate it into its Business Telepresence line.
Although I believe that Cisco's forays into consumer electronics were somewhat boneheaded, I don't think they did much long-term damage. For all of its missteps, the company has remained profitable and generated a five-year average return on equity of 20.2%. Its trailing-12-month return has dropped to 15.3%. Now that Cisco has come back to its senses and is focusing on fixing internal organization issues that kept it from competing effectively, I expect the downward trend to reverse -- that is, unless the company decides to go on another spending spree.
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