Kevin Kennedy

Everyone likes to take potshots at No. 1. The problem for Cisco Systems is it barely had time to check out the view from the top of the telecom mountain before a confluence of factors led some to question whether the company even had the right to be there.

As Kevin Kennedy, senior vice president of Cisco's service provider business, tells it, the ascent of Cisco from “data guys” to telecom supplier was moving along just fine until November 2000. The Nasdaq was in a freefall and Cisco's stock was plummeting, but the demand for services — particularly from competitive carriers — was in full force, and the company was still selling plenty of boxes. At the same time, though, the investment community began to demand profitability from companies that weren't set up to turn cash flow positive for several more years.

“There was a sudden thing, which was the demise of venture capital and hence the CLEC world,” says Kennedy. “There was an anticipation that many of those people would become the property of other operational companies. But it happened so fast that they ended up just going bankrupt and going out of business.”

The decline in that market hit Cisco particularly hard. Not only did the company lose a big chunk of potential customers who were spending heavily, its bottom line was marred by a series of vendor financing deals with companies that have since filed for Chapter 11 protection. Through the quarter that ended January 29, Cisco had committed around $2 billion in vendor financing — though customers have used only about $675 million of that.

Among the companies Cisco lent a lifeline to were ICG Communications ($180 million) and Rhythms NetConnections ($125 million). The company also offered to pony up $500 million to Winstar Communications but made it conditional, and nothing was drawn by the carrier before it filed for Chapter 11 protection.

And though Cisco maintains that it is keeping a tight grip on the generous financial terms it once offered emerging carriers, it continues to loan money to some, including a $100 million commitment to Looking Glass Networks in February.

“That became a double impulse factor,” says Kennedy of the downturn in vendor financing. “Less financing meant there were sales that people might have been thinking about that we were not going to pursue under those terms and clearly some of the customers we had before this were not there.”

Moreover, as the market continued to falter through the end of last year, Cisco had a huge buildup of inventory from a downturn in sales combined with a flood of “gently used” equipment from carriers that had gone belly-up. All of which combined to sink the company's bellwether shares and give it less leverage.

Despite the streak of grim news, Kennedy is upbeat about Cisco's position in the carrier market, drawing an analogy between it and Northern California weather. “The climate's great, but the weather's been pretty ugly.”

In the short term, it may get even uglier, according to John Chambers, president and CEO of Cisco. Speaking to 3500 resellers in April, Chambers said the recession hitting technology markets is going global and will have a rebound effect in the U.S. where it all started.

“We might not get hit in the first wave, but we will in the second,” he said. “The short-term will be more challenging than any of us probably imagined.”

Just how challenging was confirmed a couple weeks after Chambers spoke to the resellers, when Cisco officially acknowledged the first layoffs in the company's history.

Longer-term, though, Kennedy says the company is on the right side of the market. “Because the Internet is something that TDM switching can't handle well, anybody that's in the data world is living in a great place.”

Based on the service provider group's own survey of 114 local exchange carriers, fewer than 40% are buying new TDM switches. “We think that's going to continue to accelerate with every couple of quarters,” says Kennedy. “Anybody that makes money out of packet switching is in good shape.”

Assuming packet switching is profitable.

Over the course of the last several months, some are rethinking the path to packet switching while others are suggesting that the steps needed to get to wide-scale packet switching in the public network don't make economic sense right now.

“We feel the level of investment to maintain a standalone media gateway program in conjunction with a softswitch is a very expensive undertaking with a relatively short market life,” said Brian Jackman, president of global systems and technology for Tellabs, which shelved its Salix packet product in April.

According to Chris Hartman, an analyst with Probe Research, the path to packet switching is still a good one, but some companies that are focused on the current wave of gateways are going to be left behind. “One of the problems with the softswitch model is it relegates the gateway guys to commodities and they don't want to be commodities.”

Indeed, if there's one criticism consistently thrown at Cisco, it is that the company lacks vision and is more interested in selling commoditized boxes to make quarterly numbers. It's an analysis that Kennedy rejects, noting that the company has enough “boxes” that service providers can create a pure Cisco network from end to end. More important, the company's architectural vision sets it apart from true “box players” like Juniper Networks and Sycamore Networks, Kennedy says.

“We are very much an end-to-end architecture player,” he says. “It's one of the things that differentiates us against our competitors like Juniper, or even our competitors at the edge.”

At the same time, after being somewhat obsessed with large traditional telecom vendors, Kennedy doesn't even see them as Cisco's chief competition any more.

“We've been very fortunate in our success in the carrier market, and I think Lucent has struggled to an extent that when we go to an account they seldom are a competitor we most worry about,” he says. “From a financial position, Lucent and Nortel are struggling over the transition from a large TDM base.”

According to Kennedy, one of the signs for a telecom turnaround he'll be looking for is a surge in orders around June, which will indicate carriers are preparing for their traditionally busy back-to-school season.

“We are going to be keenly asking, ‘Have people decided what TDM projects they are not pursuing in lieu of packet projects, and do we see them getting energized over those periods? Some are, and for some it's too early to tell.”