What Went Wrong at Cisco in 2001

Cisco Before was CFO Larry Carter writing in April’s Harvard Business Review about the San Jose, Calif.-based company’s “virtual close” software. “We can literally close our books within hours,” Carter boasted in the article. “More important, the decision makers who need to achieve sales targets, manage expenses and make daily tactical operating decisions now have real-time access to detailed operating data.” Cisco’s decision makers possessed a godlike ability to peer into every nook and cranny of the business, 24/7, which Carter says allowed the company to forecast a slowdown in Japan’s economy and garner half of the switching market there. Cisco After was CEO John Chambers, admitting to The Economist that same month, “We never built models to anticipate something of this magnitude.”

That something was what is now inelegantly referred to as the recent economic downturn. It created a major earnings surprise for the manufacturer of switches and routers?the company’s first negative quarter in more than a decade. In the third fiscal quarter of 2001, sales plunged 30 percent. Chambers wrote off a mountain of inventory $2.2 billion high, and 8,500 people were laid off. On April 6, Cisco’s stock sunk to $13.63. Thirteen months earlier, it had been $82.

Chambers surveyed the wreckage and compared it to an unforeseeable natural disaster. In his mind, the economy?not his company’s software nor its management?was clearly to blame.

But other networking companies, with far less sophisticated tools started downgrading their forecasts months earlier. They saw the downturn coming. Cisco did not. Other companies cut back on inventory. Cisco did not. Other companies saw demand declining. Cisco saw it rising.

Even more troubling, there’s ample evidence that the company’s highly touted systems contributed to the fog that prevented it from seeing what was clear to everyone else. Cisco executives may have been blinded by their own good press. What’s clear is that overreliance on technology led the company down a disastrous path.

CIO Peter Solvik defends his company’s systems. He insists that without the forecasting software, that third quarter would have been even worse. He says that once executives realized there was a crisis, the day-to-day, near-real-time data helped Cisco quickly hit the brakes. It was just that “the speed of the swing caught everyone by surprise,” Solvik says.
Of course, surprise was exactly what Cisco’s software systems were supposed to eliminate.

The Growth Bias

MOST CIOS ARE FAMILIAR with the virtual close. Cisco has aggressively marketed it?and the rest of its internal software?as a huge competitive advantage. In numerous news accounts, CFO Carter was quoted as saying that these systems made the company both huge and nimble, Goliath’s brawn with David’s agile sling.

CIOs were envious, competitors fearful. No one came away from a virtual close demo without high praise, like Fortune: “Cisco uses the Web more effectively than any other big company in the world. Period.” Or Business Week: “It should mean zilch-o earnings surprises.” Cisco was also a perennial CIO-100 award honoree.

But not everyone was so impressed. Fred Hickey, editor of the High-Tech Strategist, notable for his hype-free, dogging assessments of networking companies, calls the power of the systems “bogus.” Frank Dzubeck, president of Communications Network Architects, a networking consultancy in Washington, D.C., who has worked with Cisco, calls the infrastructure “overrated and incomplete. There was a lot that wasn’t real with [Cisco’s] supply chain, with the inventory management,” Dzubeck says.

“For the last year, Cisco and John [Chambers] have said over and over again how their information systems make them so efficient and so on the ball,” says Jeffrey Young, author of Cisco Unauthorized (Prima Publishing, 2001), which details Cisco’s long climb and the beginnings of its return to earth. “You couldn’t go anywhere without hearing that if you weren’t trying to be like Cisco, you were falling behind, their systems are so brilliant. I’m sorry. It’s clear it’s not the case.”

What Cisco’s systems didn’t do was model what would happen if one critical assumption?growth?was removed from both their forecasts and their mind-sets. If Cisco had run even modestly declining demand models, Chambers and Carter might have seen the consequences of betting on more inventory. But Cisco had enjoyed more than 40 straight quarters of stout growth. In its immediate past were three quarters of extreme growth as high as 66 percent. The numbers the virtual close presented to the eye of the beholders?the Cisco executives?painted a picture of the present as lovely and pleasant as a Monet landscape. According to many observers, Cisco’s fundamental blunder was to rely on that pretty picture to assume the future would be equally pretty.

The Inventory Buildup

CISCO’S HISTORY is like Mount Saint Helens. Its explosive success blew the side off the old economy rules of slow, steady growth.
Cisco rose above a crop of small networking companies through two strategies: outsourced manufacturing and growth through acquisition. From the time it went public 11 years ago, Cisco was never not growing. Sometimes its growth was staggering. Its stock split 12 times in the ’90s. Its revenues went from millions to billions to tens of billions as fast as the Internet would let it. At its height?say, May 2000?44,000 people worked at Cisco, and thousands of them were millionaires. For a New York Stock Exchange minute, Cisco topped GE as the most highly valued company in the world and earned a half-trillion-dollar market capitalization. If growth continued at the same pace for another decade?and why wouldn’t it??Cisco would be as big as the U.S. economy. Without a hint of irony, analysts suggested Cisco might be the first company to have a trillion-dollar market capitalization.

In May 2000, Fortune put Chambers on its cover and asked if he was the best CEO in the world.

At the same exact time, a few components for Cisco’s networking equipment were rumored to be in short supply. Privately, Cisco was already twitchy because lead times on delivering its routers and switches were extending. Eventually those lead times would reach nearly six months on some products. Not having the components could push those delivery dates out even further. So Cisco decided to build up its components inventory. Doing that would accomplish two things: It would reduce the wait time for its customers, and it would give the manufacturers of Cisco’s switches and routers a reserve to draw on if components makers ran out.
Of course, everyone else wanted those components and the manufacturing capacity to build the networking devices too. So in order to get both, to make sure they would have them when they needed them (and they knew they’d need them; the virtual close told them so), Cisco entered into long-term commitments with its manufacturing partners and certain key components makers. Promise us the parts, Cisco said, and we promise to buy them. No matter what.

“Our forecasts were still dramatically high,” recalls Selby Wellman, a retired Cisco executive. A self-proclaimed outsider, Wellman retired last summer, for reasons he says are unrelated to business. Some of his last meetings at Cisco were about the components shortage of summer 2000. “We wanted to make sure our growth was strong, so we ordered up big time,” he says.
That seemed to work. Year-over-year growth was robust, 55 percent for the last quarter in 2000, and then a whopping 66 percent in the first quarter of 2001. As late as September, Cisco looked at its virtual close and saw plenty of bookings. It also had the pleasant problem of not being able to deliver products to customers fast enough. Combined, those numbers were enough to convince executives who literally had never seen a down quarter that everything was fine.

But some Cisco suppliers were not so sanguine.

“People see a shortage and intuitively they forecast higher,” says Ajay Shah, CEO of Silicon Valley-based Solectron Technology Solutions Business Unit, a company that manufactures parts for the networking industry and for Cisco. “Salespeople don’t want to be caught without supply, so they make sure they have supply by forecasting more sales than they expect,” Shah explains. “Procurement needs 100 of a part, but they know if they ask for 100, they’ll get 80. So they ask for 120 to get 100.”

Demand forecasting is an art alchemized into a science. Reports from sales reps and inventory managers, based on anything from partners’ data to conversations in an airport bar, are gathered along with actual sales data and historical trends and put into systems that use complex statistical algorithms to generate numbers. But there’s no way for all the supply chain software to know what’s in a sales rep’s heart when he predicts a certain number of sales, Shah says. It’s the same for allocation. If an inventory manager asks for 120 when he needs 100, the software cannot intuit, interpret or understand the manager’s strategy. It sees 120; it believes 120; it reports 120.

Furthermore, there’s a growth bias built in to the business of forecasting. If there’s a rule of forecasting demand, it’s to err on the side of needing more, not less. Be aggressive, because you don’t want to end up like Sony did in 2000 with its PlayStation 2 video game system: 100 people clamoring for three units. When that happens, 97 empty-handed customers might go buy a Nintendo. Hence, if demand is dropping off, it can be hidden behind overcommitment. Financial systems say sales are strong today, which managers who have never seen a bad quarter take to mean that sales will be strong tomorrow. So they forecast high demand. Everyone’s forecasting high demand, which in turn means it’s time to build up inventory.