Tag Archives: Cisco

Cisco (CSCO) Case Study; The Lord of Dark Matter


Next the statesmen will invent cheap lies, putting the blame upon the nation that is attacked (Syria), and every man will be glad of those conscience-soothing falsities, and will diligently study them, and refuse to examine any refutation of them; and thus he will by and by convince himself that the war is just, and will thank God for the better sleep he enjoys after this process of grotesque self-deception.” –Mark Twain

“When the rich make war, it is the poor that die.”–Jean-Paul Sartre

Case Study of Cisco:

CSCO Chart

Case Study on Cisco Third Quarterly Earnings  (includes 2012 for comparison purposes).  Instructions and questions in the document.

CSCO_VL   (for reference) CSCO March 2013 Qtr Report

Please explain what you see.

The Lord of Dark Matter

Fleckenstein:  “Probably anyone who listens to your wonderful interviews already understands that money printing can’t solve anything … Most recently the housing bubble led to the collapse in 2008/2009, and now we’ve got QE of biblical proportions being foisted upon us by the Fed, BOJ (Bank of Japan), Swiss National Bank, and probably the BOE (Bank of England) soon, etc.

The irony of it all is that 5 years into zero rates, and America alone (with) $5 or $6 trillion of deficit spending, the economy is still crummy.  No one ever says, ‘Why is that?’  Well, the reason is because money printing doesn’t work.”

….Everybody and his brother is bearish.  I get sent two articles a day about some knucklehead who’s bearish on gold.  Well, you know what?  They are all bearish for the same two reasons:  The chart looks bad, and the price is wrong.  Like they know what the price (should be).  How do any of us know what the price is supposed to be?  It’s just a price.

Click the link below to hear the twelve-minute interview:



Serial Bubbles: 



P.S. I have been a bit swamped with work, so I will post next week. Be well and BE CAREFUL!



Chapter 7: Production Advantages Lost, Part 3

All products become toasters in the end

Part 2: http://wp.me/p1PgpH-tC

Part 3: Explain the statement, “No matter how complex and unique products seem at the start, in the long run they are all toasters.”

Though they differ from one to another in functional and design features, one toaster is pretty much like another. But with no barriers to entry here, it is unreasonable to assume that any manufacturer is earning an exceptional return on its toaster assets.

How different is a complicated and expensive piece of network equipment—a router, smart hub, or Lan switch—from a toaster? Initially very different, but ultimately, not so different at all. The success of Cisco in its original business attracted new entrants, most of whom could not put a dent in Cisco’s performance without extensive technical and maintenance support. They were not sophisticated enough to mix and match communication equipment the way families do with household appliances.  Also, the need to develop successive new generations of software and hardware makes fixed costs a permanently large part of total costs, and they are a source of economies of scale. (In contrast, in CD manufacturing, plant, and equipment were a once-and-for-all expense. Economies of scale topped at a two million discs per year plant.) All these factors created competitive advantages for Cisco, and put up barriers to entry in its enterprise-class business.

But it seems clear that those advantages diminish over time. Equipment becomes more reliable and easier to use. Support and service costs decline. Compatibility across company product lines increases as equipment functions become standardized. Research and development costs decline as product lines mature. Customers become more confident in their use of equipment and more willing to try new, lower cost suppliers. Some of these changes have already affected Cisco. The trends identified above will ultimately eliminate Cisco’s competitive advantages entirely.

Technological change can be the enemy of the investor.

Our next study will be Chapter 8 in Competition Demystified.

Chapter 7: Production Advantages Lost Part 2

Part 1: http://wp.me/p1PgpH-ta and the original post on the case study is here: http://wp.me/p1PgpH-r2

Logan James, a huge contributor to this blog, continues his analysis….

Question 2: Why was Cisco able to dominate the router market in the 1980s and 1990s in a way that Philips was not in the compact disc market?

Answer: Cisco’s router and switch products were much more complex than Philips’s compact discs. Cisco’s customers, in the beginning, were businesses, government agencies and universities. These institutions required initial setup of router and switch networks as well as continual service to make sure that the networks were up and functioning properly. If you’re a business that runs a network, imagine what it would be like if your network went down and business essentially stopped? Who would you call? Probably Cisco first. You would also view Cisco as the expert in the router/switch markets and would rely on their advice in regards to servicing the network. If you want to upgrade your network equipment, they’re probably getting the first call. So you have captive customers combined with some economies of scale (maybe in R&D, advertising, manufacturing). Note: Would need to check to see if these advantages show up in the numbers.

Philips sold compact discs, which are not complex. The company was the first mover, like Cisco, but did not benefit from any competitive advantages. Why would a recording studio be captive to one maker of compact discs unless that company had patents protecting its products for a period of time? The purchaser of the CD does not care which company makes the CD, they just want the music. Note that Philips initially targeted a niche part of the music market but planned to take share away from vinyl records in the future.

Note that growth can harm companies that benefit from EOS + CC because it is easier for competitors to enter the market, take demand and achieve minimum efficient scale. Two examples where this did not occur are MSFT and CSCO.

My comments below are repetitive to Logan James but may reinforce concepts pertinent to this case.

Cisco managed to create competitive advantages for itself, which became stronger as its business grew. The advantages of economies of scale never became important for Philips because the CD market was large relevant to the efficient plant size of two million discs per year. Cisco, by contrast, because of the high software content and attendant high fixed costs for its routers, enjoyed economies of scale advantages. It managed this advantage brilliantly.

Cisco prospered by solving a problem that was widely shared. By removing the language barriers between computer systems, Cisco made networking throughout the enterprise a reality. A company that makes life much better for its customers gets handsomely rewarded, provided it can separate itself from competitors offering similar benefits.

Cisco’s market had two elements missing from the CD market–substantial customer captivity and economies of scale. Routers are sophisticated pieces of equipment, a complex fusion of hardware and software. A high level of technological expertise was required to install and maintain the systems, an expertise not widely available except for those customers with large and skilled IT departments. The others relied on Cisco or its competitors (3Com and Wellfeet). As they expanded their own internal networks, they naturally turned first to the vendor whose equipment they already owned, not wanting to incur the risks and costs of developing a relationship with a new supplier. This asymmetry of familiarity was abetted by another feature of routers that made it difficult for customers to switch: the routers themselves were not compatible. Customers were made captive by complexity.

Cisco’s pre-tax return on invested capital during 1990-2000 was 142%!

Cisco moved into the new market of telecommunications service providers. As an entrant into this market, Cisco was without the critical competitive advantages it enjoyed in the enterprise market. It has no captive customers; so far as established customer relationships are concerned, it was the outsider looking in. Without this kind of customer base, Cisco had no economies of scale in distribution or service support. Because Cisco was working on new products for new customers, it had no economies of scale advantages in research and development either.
Part 3: Next Post.

Analysis of Ch. 7 on Production Advantages Lost Part 1

 A reader, Logan, provided a thorough, intelligent analysis of the case study of Philips and Cisco (first mentioned here: http://wp.me/p1PgpH-sL) from Chapter Seven in Competition Demystified below. My comments are in Italics. Please do not hesitate to add your comments if you have additional insights.Question 1: Discuss first mover conditions that Philips might have considered in entering the compact disc and compact disc player markets. Consider: market growth, establishment of standards specs, patents, customer captivity, economies of scale.


First mover conditions:

Will Philips be able to have any sustainable/structural competitive advantages in this industry? Will we be able to develop and maintain any structural competitive advantages? If so, which ones? Proprietary technology? Patents/trademarks? Learning/experience? Demand? Economies of scale + Customer captivity? How sustainable will these advantages be? What will we be able to do in the long run that competitors cannot do?

The market for compact discs could be very large in the future. How large? In several years, perhaps 200 million units will be sold. Will growth in the market be good or bad for Philips? That depends on whether the company will have any structural competitive advantages and how sustainable those advantages are.

Supply: Philips will have no long-term supply based competitive advantages. There are NO patents protecting the CD technology (since it was developed at MIT in the 1950s). We are to assume that any competitors with available funds will enter the market and replicate the technology if they choose. One potential advantage Philips might have is an experience based advantage from being the first mover. We should try to quantify this.

Where was Philips going to make its money in the CD market? None of the record companies like CBS/Sony paid a royalty to Philips for its technology. Quite the opposite, Philips and Sony had to persuade them to take up the new product; they were not about to reduce their returns for the favor. No patents protected the technology. And the large record companies were the only players in the whole industry who were concentrated enough to wield some bargaining power. Philips was NOT in a position to coerce them. 

Perhaps it could prosper as a manufacturers of CDs. As the first mover into the field, might Philips been able to take advantage of its earlier start down the learning curve, producing the discs at a much lower variable cost than companies just beginning to learn the intricacies of achieving high yields by keeping contamination to a minimum. Although experience did help in raising yields and lowered variable costs, it was offset by the disadvantage of being the first to invest in a production line. Here, costs were lower for the latecomer, who did not have to pay the penalty for taking the lead.

The balance between these two forces would depend on how rapidly the market for CDs developed. On balance, then, Philips could expect to benefit from an initial learning curve advantage over new entrants. However, as an entrant gained experience and moved down the learning curve, this advantage would start to shrink and would disappear entirely once the entrant had procured a cumulative volume of 50 million discs. Because it was using later-generation equipment, its capital costs would be lower than Philips’s.

Demand: Demand for the new CD technology is dependent on the acceptance of the new format by the 5 major recording studios. In order for the technology to be a success, a few studios will need to adopt the format and cause the others to follow suit. Will the recording studios be captive to one supplier of CD technology? Habit? No. Switching/Search costs? No. The recording studios are essentially purchasing a commodity product and are not captive to one particular manufacturer of CDs. If Philips is the only game in town, the studios will be forced to use them. Since we know that there are no patents protecting the CD technology, entrants will flood the market (if they can) and at best they will compete based on price and “product differentiation.”

It will cost $25 million and take 18 months to build the first manufacturing line with a capacity of 2 million units. Internal projections show that the costs of equipment and time to manufacture new facilities will decline in the future. Therefore, entrants will have an advantage over the incumbents with older manufacturing facilities. Will higher volume offset the disadvantage of using older technology? In 3 years’ time, it is projected that Philips could be selling 10 million units. Variable cost per CD will be roughly $1.77 vs. $3.00 for an entrant in the 0-5 million unit output range. This is an advantage of $1.23. Using the older equipment, Philips fixed costs per unit at 20% cost of capital and 10 year depreciation will be $2.50 vs. $1.12 for a spread disadvantage of $1.38 per CD. Therefore, higher unit volume will be more than offset by the more efficient and productive new facilities.

Questions: What are the fixed costs relative to the size of the market? Can Philips focus on a niche? If so, which niche? What is the minimum efficient scale? Will competitors take customers and market share away from our company? Why would a recording studio use our products and not potential entrants?

Plants can be efficiently operated at a scale of 2 million units. Given that demand is projected to reach 200 million in the next several years, companies will enter the market since customer captivity is very limited. In order to reach minimum variable costs per unit, a competitor would need to reach 50 million units per year. If Philips could enter the market and CREATE customer captivity, it could potentially control a large enough share of the market to make entrance by competitors prohibitive. But we have observed that customer captivity is going to be VERY limited.

How will the establishment of standards specs impact the industry? If you develop the standard that everyone decides to use AND you have some structural competitive advantage (supply, demand, or EOS+CC) then you can benefit from being the company that manufactures the standard (think MSFT). If competitors can copy the standard and you do not have captive customers or patents, you will be competing on a semi-level playing field (you might have some advantages in terms of know how). Since you are first mover and create a new product, you can benefit in the short-term potentially from learning and experience. Over time, competitors will gain the knowledge and experience (do it themselves or hire your people away) so as to make this advantage dissipate. Question: Apple has created several product categories. In the long-run, how do you assess whether Apple can continue to create new products and that competitors will not catch up?

If the CD market exploded to 200 million or more units per year, then at least some new entrants could rapidly reach a cumulative output of 50 million. It is unlikely that Philips would benefit from customer captivity, since its important customers were the large, sophisticated and powerful major record companies. Thus, Philips ‘s cost advantage would last for less than two years. Paradoxically, the only condition that might sustain Philips’s learning curve would be a SLOWLY growing CD market, so that it would take years before competitors could reach the 50 million cumulative milestones and complete their passage down the learning curve.

From this perspective, the problem with the market for discs was not that it would be too small; it would be TOO LARGE. Even if it had a head start, Philips was not going to sustain an advantage based on being first mover for more than a few years. Unless it achieved some measure of customer captivity, there was no reason to think that Philips could keep current customers from taking their business elsewhere. And since plants could be efficiently operated at a scale of only 2 million discs per year, economies of scale in production would both be a deterrent to entry. Without captive customers., durable production advantages, or relative economies of scale, Philips would benefit from no competitive advantages as a producer of CDs.

It might have been better off if CDs had been restricted to a niche market in which it would have had the field to itself for perhaps five to seven years. During this interim period, it might have been able to earn above average returns, maybe enough to compensate it for its initial development expense.

In the CD market, Philips never had the kind of honeymoon that Cisco enjoyed. It never established customer captivity; its customers were large and sophisticated, and its product did not require significant support. It also never benefited from economies of scale. Distribution and service support for raw, unrecorded CDs accounted for a tiny share of the costs, and while the original development costs may have been high, continuing R&D expenditures were negligible. Learning curve related advantages, Philips’s only remaining hope of competitive advantage, were undermined by the rapid growth CD market, which allowed its competitors also to move quickly down the experience curve. Philips confronted a world without competitive advantage–a “toaster” world.


Part 2 Tomorrow

Questions on Chapter 7: Production Advantages Lost: Compact Discs, Data Switches and Toasters

If it’s a penny for your thoughts and you put in your two cents worth, then someone, somewhere is making a penny.” –Steven Wright

Chapter 7: Philips and Cisco in Competition Demysitified

The questions are on Chapter 7 (pages 137 to 159) from Competition Demystified. Also, read: An Open Letter to Warren Buffett Re: Cisco Systems http://www.capatcolumbia.com/Articles/Reports/Buffett.pdf and Philips Case Study: http://www.scribd.com/doc/81400135/pcd

Question 1: Discuss first mover conditions that Philips might have considered in entering the compact disc and compact disc player markets. Consider: market growth, establishment of standards specs, patents, customer captivity, economies of scale.

Question 2: Why was Cisco able to dominate the router market in the 1980s and 1990s in a way that Philips was not in the compact disc market?

Question 3: Explain the statment, “No matter how complex and unique products seem at the start, in the long run they are all toasters.”

We will follow up by the end of the week.