New rivals take aim at Cisco's networking mkt

CHICAGO: Cisco Systems Inc. reigns as the biggest seller of machines used to direct Internet traffic, but new rivals want to eat into its meat-and-potatoes business with lower prices -- cutting into fat profit margins. Computer maker Dell Computer Corp. and China's largest telecom equipment maker Huawei Technologies Inc. are hitting the marketplace with their own networking gear, driving down prices.

"Dell has the right channels of distribution and that scares the hell out of Cisco," said Frank Dzubeck, a strategy consultant and president of Communications Networks Architects. "And if Cisco had one global worst nightmare, it's Huawei."

Other technology markets, such as data storage and personal computers, have been radically changed as Dell and others moved in to compete on price -- taking aim at market leaders such as EMC Corp. and Hewlett-Packard Co.

For now, Cisco shrugs off the intense price competition on its switches and routers, and most industry analysts and executives agree the immediate impact on Cisco is minimal. In fact, Cisco's profit margins hit an all-time high of 69 percent last quarter. "I wouldn't go out and short Cisco (stock) tomorrow," said Shawn Campbell, analyst with Northern Trust Corp.'s asset management arm, which owned 52.7 million shares in September.

However, analysts and investors say in the long run low-price rivals could hurt Cisco and force the giant to change tactics. Some customers are already buying the cheaper gear. Restaurant chain Dave & Buster's Inc., which spends up to $5.5 million annually on technology, started using Dell's switches because they offered savings of 50 percent.

"If I get the same product or I get something where the two products are extremely similar, obviously the next thing would be to go to price," said Matt Leipsner, assistant vice president of information technology at the Dallas company. Dave & Buster's was not a former Cisco customer.

Cisco executives say it is rare for customers to choose on price alone. "Price is still not the key issue in the marketplace," Cisco Chief Executive John Chambers said in November after the company reported its fiscal first-quarter results. "It's your ability to really help your customers be successful." Cisco strategy includes offering features, such as security and voice functions, in its switches to differentiate them.

Other advantages Cisco sports are its huge embedded base of customers and a $3.3 billion research budget that dwarfs rivals', analysts said. It also is pushing into new markets, including storage, security and Internet voice transmission.

Dell launches another price war?

Dell has a history of rolling into markets with big profit margins, building products at low enough costs to drastically undercut rivals on price while still eking out a profit. "We have done this across many markets and we are now moving very assertively into networking and particularly into switching," Dell networking chief Kim Goodman told Reuters.

In the fall of 2001, it began selling entry-level Layer 2 switches, which are used on the edge of computer networks and account for two-thirds of all switches. Dell so far has carved out 1 percent market share with about 100,000 switches sold. The Round Rock, Texas-based company plans in 2003 to offer more sophisticated Layer 3 switches. Layer 3 switches, which actually determine best paths across the Internet, have higher profit margins than Layer 2 versions.

Cost conscious small- and medium-sized businesses are the bulk of the Layer 2 customers, offering Dell an opening as it already sells many of them desktop computers and servers, analysts said. On the other hand, the Layer 3 market is mostly large corporations, where Cisco has a stronghold.

Dell also is eyeing the router market, which can command still-higher margins. Switches accounted for 42 percent of sales in Cisco's latest quarter ending in October. In the third quarter, Cisco held a dominant 69 percent share of the combined Layer 2 and Layer 3 switch market, which totaled $2.7 billion in sales, according to market research firm Dell'Oro Group. No one else had more than 5 percent.

Despite the competition, Cisco believes its share can rise above 70 percent. Cisco has already picked up a lot of business from smaller rivals whose customers, burned in the implosion of the technology industry, seek out suppliers with futures.

Cisco rivals, such as telecom equipment maker Juniper Networks., hope Dell proves to be more than just a nuisance to the market leader, forcing Cisco to spend its hordes of money. The company has more than $21 billion in cash and generates about $1 billion every quarter.

"It's not a David-Goliath kind of thing. It's Goliath-Goliath," Juniper Vice President Christine Heckart said. Smaller switch makers such as 3Com Corp., Extreme Networks Inc. and Enterasys Networks Inc. may be more vulnerable to Dell's model, which uses direct sales and low cost manufacturing in Taiwan, analysts said.

Cisco signaled its views on Dell in August by ending its reseller agreement with its newest rival, a move echoed by 3Com. HP, which also makes switches, ended a similar arrangement after Dell started selling computer printers.

Huawei may have impact like Toyota

As much as Dell is a U.S. threat, Huawei, which makes all the same gear, worries Cisco overseas, especially in Asia, analysts said. And it wants to build its presence in the United States. "Huawei may have the same long-term impact on the networking market that Toyota and Honda had on automobiles," CIBC World Markets analyst Steve Kamman said, adding however, that it will take time for the Chinese company to gain a significant U.S. foothold.

Kamman, who recently visited China, does not own Cisco stock and CIBC does not do banking work for the company. Founded in 1988 by a former officer in the People's Liberation Army, Huawei expects 2002 sales to rise almost 25 percent to $3 billion, thanks partly to growing exports outside of Asia.

"This is a time for Huawei to enter developed countries. At this time the economy has slowed down," company Executive Vice President Fei Min said recently at its Shenzhen headquarters.

(Additional reporting by Doug Young in Hong Kong)

© Reuters