By all accounts, Cisco has won the enterprise networking market by a landslide. With revenues in 2001 totaling $22.2B, 75% (or $16.65B) of which comes directly from the enterprise market, no other company comes close. Nortel´s 2001 estimated enterprise revenue is $4.375B; Avaya and 3Com were at $2.8B each. Next comes Enterasys at $1.07B and the switch companies, Extreme and Foundry, at $491M and $311M, respectively. If you look at the difference in market cap between these vendors, the distance between first and second gets even wider.

So the question is, who will be the number 2 player in enterprise networking? Is our industry destined to take the shape and structure of the software industry, where there´s Microsoft, then everyone else? Are we at the same point in enterprise networking? Case in point: I know one company who recently changed from Nortel to Cisco due to the instability and uncertainty of Nortel´s financials. Is this type of thinking the tip of the iceberg that will make Cisco the Microsoft of networking? It´s hard to argue against Cisco´s prowess.

Jim Harper, Cisco´s Analyst Relations manager, gave me an ear full recently on how powerful Cisco is. His points are: Cisco has $21B of cash and equivalents in the bank, with no debt, and they are profitable - while 75% of IT concerns are not. Cisco dominates the enterprise router market with over 80% share. And, yes, it looks like Cisco is taking share from others in both the enterprise and service provider segments. They boast of having 10,000 IP engineers. To keep those engineers busy Cisco plows 17% of revenues into R&D. True, the world is moving to IP and, yes, most CIOs will tell you that they will layer voice and video over an IP network, but only when it delivers service beyond best effort. This trend fits Cisco´s strategy perfectly.

So what can go wrong for Cisco? Well, for starters, the $21B in the bank. For comparison, in 1990 Digital Equipment Corporation had the best balance sheet in IT with a similar cash position. By 1995 it was all gone. Moral of the story; having that much cash doesn´t mean you are safe forever. Cisco is only a two-product category company in the enterprise space; a down turn in either one can spell disaster. Switches and routers represent 80% of enterprise revenue, with each category contributing to nearly 40%. True, Cisco has little to no debt, but it still has some questionable loans out there in telecom land, which may eat up a chunk of that $21B war chest. Its market cap is huge at $110B and so is its P/E at 99. I´m no stock analyst - never was, never will be - and I don´t own any publicly traded securities. But if the S&P has an average P/E in the 20+/- range, what is it about Cisco that its price to earnings is five times greater then the S&P? Even Jim Harper says, ?¬¢‚Äö?ᬮ??¨We just want to grow 10% above the available market growth rate?¬¢‚Äö?ᬮ¬¨??. If the market growth rate is about zero now, then why such a premium for Cisco if its only promising 10%? Maybe some of those big analyst brains on Wall Street know something I don´t, but to me, Cisco is an $8 stock at best.

Now for the kicker: what happens if corporate IT capital spending falls only half as bad as the telecom market? A lot happens. IT delivery is structured around storage, computing, networks and applications. IT spending has been large enough to support different companies providing products and services in these categories. If the spending pie shrinks by some 20%, could the industry afford this structure or will it foster consolidation between storage, computing, networks and applications? In short, do we start to revert back to the IT models of the 1970s and 1980s, when there was Big Blue, AT&T and everyone else? Is the consolidation in the computing industry with Compaq and HP just the beginning of this cycle? Could available revenue shrink to the point that the only way to profitably deliver IT services to enterprises is through large concerns providing storage, computing and networking? Roll up IBM, Cisco and EMC and you may have a much more efficient way to deliver IT. There are many combinations that could work and are being explored in the case of a major IT spending downdraft. Remember what we have learned over the past 24 months: IT spending is discretionary, not mandatory. But we´re getting ahead of ourselves. The question we´re trying to answer here is who will be number two in enterprise networking. While Wall Street may cut Cisco´s market cap lead with a correction in valuation, what will really narrow the gap between number one and two is voice. The winners and losers in enterprise networking over the next business cycle will be governed by their success in IP voice. Voice will determine who the data winners are.

Fact, there are no more TDM or circuit switch PBXs being built. It´s a dead technology. So, over time, every enterprise will move to IP voice simply because there is no other solution other than to keep your antiquated circuit switched PBX that will cost you more and more every year to maintain. There will be a point in time when it will cost you more to maintain that PBX than to change it for a new IP voice solution. For the vendors, this is all about shifting Gross Margin (GM) between product categories. At Avaya and Nortel the GMs on their PBX systems are north of 60%, while routers and switches are in the 40-50% range. IP Voice will drive switch sales as IP voice end devices plug into Ethernet networks, while voice packets are transported over switched and routed IP infrastructure.

As open systems increase competition and allow Moore´s Law to work on the $30B PBX market, 60% GM will shrink. Avaya and Nortel have acknowledged that. Applying open systems and Moore´s law to the PBX market will cause the revenue potential of this market to shrink from $30B to who knows what. That´s the $30B question that no one knows the answer to.

For 3Com and Shoreline a shrinking PBX market is fine, since their share of the PBX market is incremental to their revenues. For Cisco this is true, too, but Cisco is a lot bigger and requires a larger share of this market to feed its growth engine. To grow 10% Cisco needs $2.2B or 7.5% of the current PBX market. Cisco will need a bigger and bigger share of a shrinking market to satisfy Jim Harper´s stated Cisco growth goals. For Cisco, if VoIP shrinks the PBX market size and GM too much, it may actually lose by winning in the voice game. It could lose by committing its resources to attack a market where revenue and GM disappoint
shareholder growth expectations.

Nortel and Avaya know what´s at stake all too well. GM will shift from the voice/PBX group to the Ethernet switch/IP group. If Nortel can ever get out of its 2 year financial crisis mode, then it may have a chance of being number 2. It has a wide product portfolio and a large installed base in enterprise voice systems. But they´ve turned their back on the enterprise while the service provider market was red-hot. It´s only now that they are trying to re-establish relationships and beef up products like the Passport, Contivity, and their PBX-to-VoIP transitional product, the CSE MX. The problem for Nortel is that it may be too late. They have lost so much credibility and it will take a long time to rebuild trust. They don´t own the channel to the enterprise and have undergone so many cuts that the people who are left are running ragged.

At Avaya, their financials are stable and are not a distraction like so many others. This allows the company to focus on running the business. Spinning off the enterprise group as Avaya, could have been one of the smartest moves Lucent made. Avaya has a lot going for it. For example, it owns the enterprise voice customer and associated channels. This is the highest barrier to entry in the VoIP market, excluding call management. Their Ethernet switching group alone is bigger than Extreme Networks! They are either number one or two in the call center/CRM and PBX markets. Their new ECLIPS product provides the transition from DEFINITY to its VoIP solution. If Avaya can manage the product, customer and channel transition from DEFINITY to Cajun, then it will have a solid shot at being number 2.

Enterasys, the spin-off from Cabletron, finds itself in a similar position as Nortel. With a market cap of $208M and revenues in 2001 of $1.07B, you know something serious is wrong here. Enterasys is mired in financial problems, sucking resources away from the business of building networks for enterprise customers. True it has switches, intrusion detection, VPN, routing and wireless solutions, but it lacks any voice expertise and products. It´s this lack of a VoIP solution and its financial nightmare that cause me to put Enterasys´ chances of being number 2 low to very low. 3Com has great brand and owns the small to medium size business (SMB). It has none of the financial problems of Nortel and Enterasys allowing Bruce Claflin and company to keep their eye on the ball. 3Com has a wide product range including wireless LANs, Ethernet switching, IP PBX, VPNs, broadband access and carrier class VoIP. It’s a responsible corporate entity as well. When it did exit from the high-end enterprise market it did so with grace and a transition plan that didn’t leave customers in the lurch. 3Com is the best at simplifying networking and reducing cost out of products. If VoIP turns out to be a low gross margin play then it may very well play into 3Com’s hand. 3Com is well positioned for the recovery. It’s SMB customer base will be the first to emerge from the spending slump fueling its business with cash and momentum. 3Com is the sleeper here and may very well surprise the industry if it makes a move up market. It has everything to gain.

Extreme and Foundry are niche players and don´t have a voice game. They are single product companies and, without a VoIP solution, they will find themselves further and further behind their larger system vendor competitors. Their value proposition of being faster and cheaper will not cut it any more in this new business cycle. As Cisco, Avaya, Nortel, 3Com and Shoreline move VoIP into the enterprise market, it will be their switches, not Extreme´s or Foundry´s, which will benefit.

There are other wild cards as well, such as Alcatel, and potential entrants, such as Juniper/Unisphere. Time will tell if they can make a difference in the enterprise market. My assessment is that Juniper lacks the motivation while Alcatel lacks the channel.
So, who will be number 2 in Enterprise networking? There are a lot of ?¬¢‚Äö?ᬮ??¨ifs?¬¢‚Äö?ᬮ¬¨??.

If Avaya can execute, then it has a good shot. If 3Com moves up market and leverages its´ service provider side to deliver enterprise value, it too has a shot. Nortel and Enterasys have to get their house in order before they can be taken seriously. Extreme and Foundry have to add VoIP solutions and channels. Shoreline, a VoIP pure play, has to beef up its channels and be relentless.

So who´s going to be number 2? We´ll see.

Posted 2 June 2002 at 6:40 pm under Lippis Report. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.