Does Cisco need consumer electronics?

Apparently not...

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Does Cisco really have any desire to enter the consumer electronics business, as many analysts, and Cisco itself have been saying of late?

We've put some numbers together, and don't think it does. The acquisition of both Kiss and Scientific Atlanta, which was approved by shareholders this week, have led to lots of rhetoric about how internet attached consumer devices may make a good new market for Cisco, but does that add up financially?

We've ranked three types of companies against Cisco to give Faultline readers an idea of how such deals appear from the lofty heights occupied by CEO John Chambers, as he looks at acquisitions. They are consumer electronics companies, four of the largest in the world, plus TiVo plus Apple; two handset makers, three traditional telecoms suppliers and its recent acquisition, Scientific Atlanta. The ratios we have chosen to look at are, along with free cash flow, among the most important that Wall Street analysts use to examine what a company is worth.

It is easy to see why analysts have recently got in a funk about Cisco potentially buying Nokia. Nokia has the second highest revenue per employee of all these companies, after Apple. These are the ONLY two companies that are generating more dollars for each employee they have, than Cisco. Nokia is also growing faster than Cisco, but it still doesn't have its margin and buying such a large company, apart from all the cultural and other issues, would dilute its margin far too much.

After Cisco, it's a long fall to first Motorola and then to TiVo with revenue per employee of $541,000 and $501,000 respectively. Sony is the first real consumer electronics company that enters the rankings on this statistic and it's number is roughly two thirds that of Cisco. We are not suggesting that Cisco is being lined up as a buyer of Sony, even though Cisco has sufficient market capitalisation that it could theoretically afford to buy any of these companies, but our point is that there are few that it would ever want to own. And there are few whose business it wants to enter.

Having lots of employees, albeit cheap Chinese and Asia Pacific employees, would just weight down Cisco's management processes so don't expect it suddenly to buy into one of the smaller Asian CE firms either, because it shares financial statistics similar to Sony and Panasonic. Lower revenue per employee also says a lot about the type of employee you have, and culturally they would tend not to fit in with Cisco's working ethos.

Manufacturing staff don't sit too well with programmers and vice versa, and both need very different environments. But overall net margin, something Cisco cannot dilute too aggressively, would also be dramatically effected by entering some of these businesses however it entered them.

When it first acquired Linksys, the famous Cisco margin took a while to recover. How long would it take to recover from owning something the size or Thomson or Sony? Or even a smaller competitor. It's just not in the nature of Cisco to want to be any of these beasts.

What Cisco is really saying is that it is tempted to enter these markets on the back of the Scientific Atlanta and Kiss purchases, and on the back of the Linksys retail brand. But anyone who wants to go into the market for selling directly to consumers, has to expect no better net margin that Apple's and Philips' current 9 per cent plus.

Cisco would need to enter these markets with a margin that is 2.5 times the industry average, for it to be entirely comfortable. In Scientific Atlanta it is buying a company that is 20 per cent of its total workforce, so more easily digested by its HR department and management. It is acquiring a company that will make half as much profit margin, but only on 7 per cent of the total combined revenue. That makes the dilutive effect on income just $230 million, an amount that can be saved by HQ combinations and component purchasing efficiencies.

But then Scientific Atlanta (SFA) isn't actually in the consumer electronics business at all. SFA sells set tops, in the main, to large cable operators. It has perhaps 80 per cent of its business among its 5 top clients. In other words, it sells like Cisco sells when it is addressing Telcos. True consumer electronics businesses sell via retail, to consumers, as Linksys and Kiss do.

SFA had already shown that it can land some of the big IPTV supply contracts to major US telcos, with the AT&T deal. So suddenly traditional Cisco telco customers (the other main source of Cisco revenue being major enterprises) can suddenly be of service to Scientific Atlanta. The Cisco sales process can pull through more SFA product, which is why it makes sense as a deal. But it’s more utilitarian than visionary.

But where else in the consumer supply chain can Cisco realistically do that? Effectively making more sales from the same sales force? Well, it is possible that Telcos and cable operators may move out of simply supplying set tops and go on to become important in any home network which works with a set top. This would include networked TVs, DVRs and even portable devices. This is because they will need to interact with the set top, so it may end up being safer to buy these from your TV operator than from a store. That process would then drive CE companies to whomever held the set top technology (for instance the DRM) in order to make their devices work alongside them.

DRM will become a key part of this play and, Cisco needed an anchor in the home with which to manage encrypted content. SFA provides it with that in the US. But it may also need something similar outside of the US before that type of control is really worth having, but there is no automatic candidate in both DRM and set tops in Europe with a decent market share.

But once a set top is in Cisco’s hands it can drive Cisco APIs and decryption techniques onto other devices, which it doesn’t have to make, but which it can charge some intellectual property for. Portable players, DVD players, DVRs and home networks MAY be made and provided by Linksys and SFA, but they might just as easily be controlled from the SFA boxes and a Cisco home networking architecture may emerge.

In that scenario Cisco has no need to get into the consumer electronics business at all. Cisco should be jealous of Apple growth rate of 68 per cent, but it is not in the nature of the Cisco sales process to be at the beck and call of fads and fashions, in devices, which is Apple’s strength, so we hardly see it chasing that.

Instead, expect a vision from Cisco of using SFA to extend control and influence through partnerships which will reach into the operator dominated entertainment gizmo market. Because at least there the financials add up.

Copyright © 2006, Faultline

Faultline is published by Rethink Research, a London-based publishing and consulting firm. This weekly newsletter is an assessment of the impact of the week's events in the world of digital media. Faultline is where media meets technology. Subscription details here.

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