Yves here. I’m old enough to remember when Cisco was the dominant Internet infrastructure company during peak dotcom. A falloff in Cisco’s orders was the sign the bust had started. Now it’s an also-ran.
By Marie Carpenter, Professor of strategy, Institut Mines-Télécom Business School. Vice-President, Academic-Industry Research Network, and William Lazonick, Professor of Economics, University of Massachusetts Lowell, President, The Academic-Industry Research Network. Originally published at the Institute for New Economic Thinking website
Cisco Systems: From Innovation to Financialization
Once the global leader in telecommunication systems and the Internet, over the past two decades, the United States has fallen behind global competitors, including China, in mobile-communication infrastructure—specifically 5G and Internet of Things (IoT). This national failure, with the socioeconomic and geopolitical tensions that it creates, is not due to a lack of US government investment in the knowledge required for the mobility revolution. Nor is it because of a dearth of domestic demand for the equipment, devices, and applications that can make use of this infrastructure. Rather, the problem is the dereliction of key US-based business corporations to take the lead in making the investments in organizational learning required to generate cutting-edge communication-infrastructure products.
No company in the United States exemplifies this deficiency more than Cisco Systems, the business corporation founded in Silicon Valley in 1984 that had explosive growth in the 1990s to become the foremost global enterprise-networking equipment vendor in the Internet revolution. In our Institute for New Economic Thinking Working Paper, “The Pursuit of Shareholder Value: Cisco’s Transformation from Innovation to Financialization”, we provide an in-depth analysis of the corporate resource-allocation decisions that have underpinned Cisco’s organizational failure.
Since 2001, Cisco’s top management has chosen to allocate corporate cash to open-market share repurchases—aka stock buybacks—for the purpose of giving manipulative boosts to the company’s stock price rather than make the investments in organizational learning required to become a world leader in communication-infrastructure equipment for the era of 5G and IoT. From October 2001 through October 2022, Cisco spent $152.3 billion—95 percent of its net income over the period—on stock buybacks for the purpose of propping up its stock price. These funds wasted in pursuit of “maximizing shareholder value” were on top of the $55.5 billion that Cisco paid out to shareholders in dividends, representing an additional 35 percent of net income. Besides absorbing all its profits over the 21 years, Cisco took on debt and dipped into the corporate treasury to fund these two types of distributions to shareholders.
In our INET working paper, we trace how Cisco grew from a Silicon Valley startup in 1984 to become, through its innovative products, the world leader in enterprise-networking equipment over the next decade and a half. As the company entered the 21st century, Cisco was positioned to build on its dominance of enterprise-networking equipment to upgrade its technological capabilities to become a major infrastructure-equipment vendor to service providers. We analyze how and why, when the Internet boom turned to bust in 2001, the organizational structure that enabled Cisco to dominate enterprise networking posed constraints related to manufacturing and marketing on the company’s growth in the more sophisticated infrastructure-equipment segment of the communication-technology industry. We then document how, beginning in September 2001, Cisco turned from innovation to financialization, as it used its ample profits to do massive stock buybacks to prop up its stock price. Finally, our paper ponders the larger policy implications of Cisco’s turn from innovation to financialization for the competitive position of the US information-and-communication-technology (ICT) industry in the global economy.
Cisco as an Innovative Enterprise
In 1987, Cisco’s co-founders Leonard Bosack and Sandy Lerner turned to venture capitalist Donald Valentine of Sequoia Capital for an infusion of cash and access to management expertise. Valentine then recruited computer-industry veteran John Morgridge to run the company. Morgridge led the process by which Cisco wrote enterprise-networking software for all existing protocols, giving the company a competitive advantage when, in 1993, the US government opened the Internet that it had developed to commercial uses. As Cisco expanded production in the early 1990s, Morgridge favored the practice of direct selling to customers so that Cisco engineers and programmers could design and implement software solutions for clients’ specific needs. At the same time, Cisco outsourced manufacturing of its enterprise-networking equipment to electronic manufacturing service (EMS) providers—a defining characteristic of the “New Economy” business model in the rapid growth of the ICT industry in the 1990s.
In 1995, John Chambers, whose career experience was in sales, took over from Morgridge as Cisco CEO. To enable the rapid growth of Cisco’s output of routers and switches, Chambers favored reliance on value-added resellers (VARs) to provide Cisco’s enterprise-networking equipment to customers (business corporations, government agencies, and civil society organizations), configuring and programming the Cisco boxes to these buyers’ particular requirements. In 1996, 62% of Cisco’s revenues came from direct sales and 38% from VARs. By 1998, revenues from VARs slightly surpassed those from direct sales, although in 1999 and 2000 direct sales saw a resurgence as Cisco entered the communication-infrastructure segment, in which service providers demanded that an equipment vendor such as Cisco provide implementation and maintenance services.
Within its own organization, Cisco was an exemplar in the integration of its personnel to serve the rapidly changing requirements of enterprise networking, thus limiting employee turnover in the hypermobile labor market for which Silicon Valley is known. To gain control over rapidly emerging enterprise-networking innovations, Chambers continued a practice begun under Morgridge of growth-through-acquisition. From fiscal 1994 through fiscal 2001 (years ending in the last week of July), Cisco made 71 acquisitions, gaining a reputation for its system of integrating the incoming employees into its organizational-learning processes.
In fiscal 2000, Cisco did seven optical-networking acquisitions, including Cerent ($6.9 billion), Pirelli Optical Systems ($2.0 billion), Qeyton Systems ($887 million), and Monterey Networks ($517 million), positioning the company to challenge “Old Economy” incumbents Lucent, Nortel, Alcatel, and Ericsson in the infrastructure-equipment market. As part of this move to become a major vendor of high-quality and complex equipment to telecommunication service providers, in May 2000 Cisco acquired a former DEC manufacturing plant on 110 acres in Salem, New Hampshire, to assemble and test infrastructure equipment. Cisco recruited senior managers and engineers from the nearby Lucent Merrimack Valley Works to lead the plan to employ 2,500 people at the Salem facility.
Cisco as a Financialized Enterprise
After listing on NASDAQ in its initial public offering in February 1990, Cisco’s shares became integral to Cisco’s growth. In the process of expanding from $70 million in revenues and 254 employees in 1990 to $22.3 billion in revenues and 38,000 employees in 2001, Cisco relied heavily on its stock as both a combination and compensation currency. The purchase price of Cisco’s 71 acquisitions from 1994 to 2001 totaled $34.2 billion, of which 98% was paid in Cisco shares. Especially in the last years of the 1990s to the end of fiscal 2000 (ending July 29), in doing acquisitions Cisco had the financing advantage of its soaring stock price. As for the compensation function, virtually all of Cisco’s employees were included in a broad-based stock-option program. With stock-market speculation becoming the key driver of Cisco’s stock price in the last years of the Internet boom, the estimated average realized gains per worldwide employee (not including the five highest-paid Cisco executives) from exercising stock options was $193,500 across 18,000 employees in 1999, $291,000 across 27,500 employees in 2000, and $105,900 across 36,000 employees in 2001.
For Chambers as CEO, the actual realized gains from exercising stock options were $120.8 million in 1999 and $156.0 million in 2000, representing 99% of his total compensation in those two years. The other four highest-paid executives named in Cisco’s proxy statements averaged actual realized gains from stock options of $24.9 million in 1999, $36.7 million in 2000, and $14.9 million in 2001 (97% of their total compensation). In 2001-2003, Chambers took $1 in salary and exercised no stock options. But, with the company’s stock price in a slump, Cisco’s board granted Chambers an abundance of new stock options at very low grant (i.e., exercise) prices, and in 2004-2007, he raked in an annual average of $55.1 million (96% of his total compensation) in actual realized gains from exercising stock options.
In March 2000, Cisco sported the highest market capitalization of any company in the world. In 2001, however, the company’s stock price collapsed as the speculation disappeared, even though Cisco’s revenues increased to $22.0 billion in 2001—up 18 percent from 2000. Subsequently, the company largely lost the advantage of using its stock as a combination currency, and since 2004 has used cash for most of its acquisitions. Cisco’s stock still functions as a compensation currency, but, except for 2007 when the average estimated gains from stock-based pay were $73,500 across 55,700 worldwide employees, these supplements to salaried compensation have ranged from a high of $32,800 in 2004 to a low of $3,200 in 2009.
From an all-time peak of $82.00 on March 27, 2000, Cisco’s stock price plummeted to $17.99 one year later and dropped as low of $11.04 on September 27, 2001—just 13.5 percent of its level exactly 18 months earlier. On September 14, 2001, with US stock markets closed after the 9/11 terrorist attacks, Cisco announced a $3.0-billion two-year stock-repurchase program, portraying it (as did many other US business corporations) as a patriotic response to prevent a stock-market collapse when the stock markets reopened. It soon became clear, however, that the purpose of Cisco’s buybacks was to give manipulative boosts to the company’s stock price.
In the decade 2002-2011, Cisco spent $71.6 billion repurchasing its own stock, equal to 126 percent of net income, while paying its first dividends in 2011. In 2012-2021, Cisco’s buybacks totaled $72.5 billion, 81 percent of net income, along with $47.0 billion paid out as dividends, another 53 percent of net income. In 2022, Cisco’s distributions to shareholders were 117 percent of the company’s all-time high net income of $11.8 billion, with $6.2 billion in dividends and $7.7 billion in buybacks.
As we document in detail in our INET working paper, over the past two decades, Cisco’s “financial commitment” has been to boost its stock yields, not to invest in its innovative capabilities. As the company ramped up buybacks from $1.9 billion in 2002 to $10.2 billion in 2005, it largely abandoned its previous investments in optical-networking equipment, including its manufacturing plant in Salem, New Hampshire. Instead of moving toward a direct-sales model, which would be required to compete in the infrastructure-equipment segment, Cisco increased its reliance on VARs, which accounted for more than 80% of the company’s revenues by 2008.
Many of Cisco’s acquisitions in the last half of the 2000s were in seemingly innovative technologies that quickly became commodities. One potentially cutting-edge acquisition was Webex in 2007, but in 2012 Cisco’s vice-president of corporate engineering, Eric Yuan, frustrated by Cisco’s failure to commit to the enhancement of videoconferencing, took more than 40 Cisco engineers with him to launch a startup called Zoom.
Socioeconomic and Geopolitical Costs of Cisco’s Financialization
Despite financialization, Cisco has grown over the last two decades because of the greatly expanded demand for enterprise-networking equipment. In 2022, Cisco had 2.3 times the revenues and 2.2 times the employees it had in 2001. In terms of employees in the United States, the increase was 1.5 times, up from 27,000 in 2002 to 39,900 in 2022. The company has been a job creator.
Yet, the dominance of financialization over innovation within Cisco Systems over the past two decades has had a negative impact on its capacity to develop the capabilities needed to compete as a systems integrator in the infrastructure-equipment segment of ICT. As a result, as is widely recognized, the United States has fallen behind China and the European Union as a locus of innovation in 5G and IoT. Particularly in the case of China, the home base for world leader Huawei Technologies, it is all too easy and convenient to blame unfair competition for the innovation deficit of the United States.
Cisco is not the only US-based communication technology company to succumb to financialization. In the late 1990s, Lucent Technologies, at the time the industry’s global leader, adopted Cisco’s growth-through-acquisition model, using its stock as a combination currency to acquire optical-networking capabilities. Lucent was unable, however, to achieve the organizational integration required to transform these acquisitions into innovations. Then, in the first half of the 2000s, Lucent lacked the financial resources to invest in wireless technology. In 2006, Lucent was acquired by France-based Alcatel, and in 2015 Finland-based Nokia acquired Alcatel-Lucent. Canada-based Nortel, which was more advanced technologically than Lucent in the late 1990s, with a large R&D footprint in the United States, suffered the same financialized fate as Lucent and went bankrupt in 2009, with its physical assets and intellectual property being sold off in pieces in its subsequent liquidation.
In 2005, when the United States still had innovative capabilities in communication infrastructure-equipment at the iconic Old Economy company Motorola and innovative New Economy companies such as Qualcomm and Ciena, Cisco CEO Chambers announced six new strategic “advanced technologies” to be targeted by the company with a view to attaining a number one or number two position in terms of market share. The objective of the diversification was to reduce reliance on the company’s core markets of enterprise routers and switches by taking advantage of future high-growth markets.
One of these “advanced” technologies was “home networking” and, as documented in our INET working paper, Cisco’s acquisitions in this line of business proved to be expensive and unsuccessful attempts to move into the consumer sector over the next decade. Three of the six technological areas—optical networking, IP telephony, and wireless—were, however, relevant to equipment for the service-provider sector.
In 2005, however, when Chambers announced Cisco’s plan to invest in innovation, the company had $5.7 billion in net income but did $10.2 billion in open-market repurchases. Had Cisco not been so focused on doing buybacks to boost its stock price, it might have joined forces with companies like Motorola, Qualcomm, and Ciena to build a US-based global competitor to Ericsson, Alcatel, and Huawei. But both Motorola and Qualcomm were themselves becoming highly financialized at this time, while Ciena, which had been founded in 1992, had only $427 million in revenues with $436 million in losses in 2005. Motorola’s infrastructure business was acquired by Nokia Siemens Network in 2010, and Qualcomm, the US pioneer in the CDMA wireless standard, focused on maximizing the return from its patent portfolio as a fabless chipset designer.
As early as 2006, Cisco removed optical networking from its group of “advanced technologies.” The company’s vice president and chief development officer at the time explained that this was because “optical is more of an access technology, where the market is not going to grow as aggressively as it had in the past.” Meanwhile, in 2009, the rising China-based company, Huawei, became the world leader in optical networking, which it integrated with wireless and Internet capabilities, succeeding in global competition, where Cisco failed. Despite numerous acquisitions in the area, Cisco’s focus on a radical ‘‘all-IP’’ solution combined with its lack of radio base stations and ‘‘account control’’ left it without the capability of becoming a systems integrator that could displace the incumbents and counter the growing competitive strength of Huawei.
More broadly, the impact of growing financialization in the sector has left the United States without the capability to innovate in the development of a communication-infrastructure network. While failing to recognize the role of financialization within the sectoral dynamics, US policymakers have chosen to respond to the US loss of competitiveness with aggressive protectionist measures against Chinese competitors and by attempting to introduce a new standard that will favor US, Japanese and Korean competitors without systems-integration capabilities.
During the 1990s, Huawei built on its domestic success to become a global leader in the industry. China-based ZTE also emerged as an important global competitor, but with only one-third of Huawei’s infrastructure-equipment revenues in recent years. In 2012, US policymakers concluded in an intelligence committee report that these Chinese firms were potentially open to influence by the Chinese government for “malicious purposes.”
Without the capacity to build a 5G mobile network and aware of the importance of the “Internet of Things” for future digitalization and competitiveness, the United States became much more aggressive under the Trump administration. Huawei was added to the “Entity List” in 2019, blocking US suppliers and their customers from selling machinery, components, and software to the Chinese company, thus halting its rapid expansion in the mobile handset market. William Barr, the US attorney-general (who, in that position, displayed scant capability in enforcing the law), even suggested that the United States should buy controlling stakes in Nokia and Ericsson to help build a stronger competitor to Huawei. Perhaps Barr’s perspective on how to attain global leadership in critical technologies was influenced by the demonstration by Cisco, among other US tech companies, of a “core competence” in purchasing their own shares on the market to manipulate their stock prices.
A RAND Corporation report suggested that counteracting the Chinese threat required a standardization body that could pioneer an alternative to the global standard that had emerged in the 4G era and facilitated the success of the new entrants from China. Cisco and Japanese firms, NEC and Fujitsu, have been actively promoting the alternative standard, OpenRan, as an opportunity to challenge the dominance of Huawei, Ericsson, and Nokia in the mobile-infrastructure market. By “opening” interfaces at certain points in the 5G mobile network, the new standard seeks to replace the vertically integrated model that has traditionally dominated in the sector and introduce more competition. The White House and the Japanese government began actively coordinating technology policy in this area with a view to promoting “a transparent and open 5G network architecture to support security and vendor diversity”. The extent of the challenge that operators will face to integrate multiple suppliers within the OpenRan standard is not yet clear, nor is it evident that a return to the fragmentation of the standardization landscape for mobile infrastructure will lead to cost savings overall for operators.
Deregulated by the Telecommunications Act of 1996, it took about 15 years for the United States to become a has-been and also-ran in a sector that is at the center of the ongoing technology revolution and that is critical for productivity growth, cutting-edge employment opportunities, and national security. Despite its original position as the country with the potential to foster global leaders in the converged communications landscape, US policymakers have found themselves scrambling to come up with a solution to the nation’s loss of sovereignty in a technology sector that is strategic to both socioeconomics and geopolitics.
Given its trajectory at the turn of the century, Cisco could have played a central role in an industrial policy aimed at maintaining and enhancing US global strength in this critical sector. Without additional capabilities in wireless and optical networking, it would not have been able to become a systems integrator. But such resources were becoming available in North America as other vendors struggled to overcome the fall-out of the bursting of the Internet and telecom speculative bubbles. Rather than suggesting the unlikely acquisition of European leaders in the 2020s, US policymakers could have recognized the need to develop these innovative capabilities in an era that one might now call America’s “lost decades”. A company such as Huawei did not impose this loss of global leadership on the United States. Hundreds of billions of dollars wasted on stock buybacks did.
Rather than accusations (often unfounded) against Chinese competitors and an alliance with Japan and Korea to counter the lack of US success in competing as infrastructure vendors in an era of global standards, US policymakers need to recognize the damage that has been wrought on this sector by financialization over the past twenty years. The future of communication-infrastructure equipment may be influenced by the success or failure of a new US-promoted mobile standard. Its success will only be possible if those firms that have contributed to them continue to maintain the necessary level of investment in productive capabilities to support their development. It is far from evident that Cisco will voluntarily favor investments in building technologies and markets rather than do massive payouts to shareholders.
Companies in the S&P 500 Index, including Cisco within the top ten, did a record of about $850 billion in buybacks as open-market repurchases in 2021 and in excess of $900 billion in 2022. The destructive and illogical ideology that, for the sake of economic efficiency, a company should be run to “maximize shareholder value” continues to cripple the United States in global competition in a range of critical technologies. The evolution of Cisco Systems from innovation to financialization is one extremely important case in point.