The Network Effect

By Karl Taro Greenfeld

For most of us, the stock market is usually a blur, a swirl of statistics, charts and CNBCNNfn commentators telling us somestockweown or somestockwedon't is up or down. For a few hours last week, however, everything came into focus, and it seemed our (new) economy was clearly moving in the direction indicated by one company: Cisco.

At NASDAQ's close last Monday, the San Jose, Calif., Internet router maker emerged as the most valuable company in the world, with a market capitalization of $555 billion, more than $13 billion ahead of the reigning cap king, Microsoft. This shifting of the tech-tonic plates represents more than just Cisco's success and uncertainty over Microsoft's legal problems. In fact, it provides a pretty good road map of the post-PC landscape into which our economy and volatile stock market are heading.

Previous turnovers of the market-cap champs, such as 1998's passing of the belt from General Electric to Microsoft, were useful indicators. Microsoft's emergence bespoke information technology as the driving force in our economy, supplanting consumer goods, aerospace and financial services as the sectors that investors most expected to outperform the rest of the market. The same point could have been made in 1993, when GE surpassed Exxon (consumer goods trumped oil), or a hundred years ago, when John D. Rockefeller's Standard Oil was a monopolistic market bully and trust-busting wasn't even a slogan for Teddy Roosevelt.

That's because stock prices are based in large part on expectations. The emergence of a new leader or leading sector reveals not necessarily which companies have been more profitable--even today General Motors makes more money than Microsoft--but which are likely to have gaudy earnings in the future. That's why technology, Internet and biotech stocks--the new economy--have been soaring the past few months. But that's also why last week, when investors felt that expectations had got out of hand in the face of higher interest rates, the new-economy stocks sold off heavily, Cisco among them.

Cisco finished the week behind Microsoft--the difference between them was about $2.40 on Cisco's share price--and no one knows what last Saturday night's breakdown of settlement talks will do to Microsoft's stock. But none of this alters a fundamental transformation as we move from a computer-based economy to a communications-based economy--one in which you don't need PC power at your fingertips anymore because you can reach it instantly via the Web. "Many years ago people had trouble understanding what drove political issues," says Cisco CEO John Chambers. "It was the economy, stupid. Today people are asking what's driving the economy. Well, it's the network effect, stupid."

Chambers credits the network effect for U.S. productivity increases from the stagnant 1980s level of 1.5% annually to last year's 3%. And he should know. His company pioneered business on the Web, doing 33% of the world's e-commerce in 1997.

Cisco's rise signifies a new phase of the technological revolution. Microsoft ruled the first phase, marked by decreasing microprocessor costs and cheaper data storage, which made the PC a household appliance. That confluence of technologies resulted in cell phones, game platforms, pagers and a host of other smart devices that are now in place.

The phase we have entered--and where Cisco reigns--is one in which all those PCs and devices are getting linked to a free network, the Internet. The costs of data transmission are dropping even faster than Moore's Law is increasing processor speed. How much did you pay to send your last e-mail? Cisco, as the maker of the gear that runs the network, has been ideally positioned to capitalize on this trend. "We are the center of this Internet firestorm," says Don Listwin, Cisco's executive vice president.

CEO Chambers is fond of saying the Net has become "a home game" for Cisco, but the company's success is also due to another trend that is part of the new networked economy. From the start, Cisco has supported open Internet-protocol standards like TCP-IP (protocol is how servers talk to each other) rather than proprietary standards like Microsoft's closely guarded Windows source code. "Open standards are what unleashes the power of the Internet ecosystem," says Listwin. "IBM let only IBM build on its computers. Microsoft let only a few thousand build on its platform. The Net lets billions build on it." He has a point. The most widely used Web server program, Apache, and the most widely used e-mail application, Sendmail, are either free or open-source.

Certainly, Cisco is unique among today's MVCs (Most Valuable Companies) in that most people, including many shareholders, can't tell you what it makes. For the record, the Cisco equivalent of Windows or the Big Mac is the Catalyst 6000 family of routers and multilayer switchers. These are the souped-up computers that enable data--your e-mails, video files and MP3s--to whiz around the fiber-optic networks that are the Internet. "The fiber is the railroad tracks, and Cisco makes the trains," explains Hal Varian, dean of the School of Information Management at the University of California, Berkeley. "There's been a lot of investment putting fiber into the ground. If you want to use that fiber, you need Cisco routers."

Cisco's lean corporate culture--top execs fly coach and work in cubicles--signals a break with the perquisite-laden past of many of America's industrial-age Goliaths. Much of what is taken for granted at Web start-ups and tech firms originated at Cisco--open offices, free sodas, the hazy divide between work and play. But Cisco and Chambers rarely lose focus, maintaining a state of readiness reminiscent of a nuclear submarine on tactical alert. "They are one of the few companies that really live it," says Virginia Brooks, an analyst with the Aberdeen Group. "Given the kind of pressure they are under from the shareholder community, it's like they've done it backward and in high heels with the whole world watching."

This is a company that remains on the prowl--for new technologies, partners and especially acquisitions. Cisco has made acquiring and integrating other companies a house specialty, having done it 55 times since its inception and seven times already this year. Again, unlike Microsoft, which maintains a strong Bill-centricity that leaves acquired companies feeling like outlanders, Cisco has made it a central strategic tenet to integrate its bought talent. "When we acquire, all I'm acquiring is people and next-generation products," says Chambers. "I pay between $20,000 and $20 million per employee of a firm. If I lose the people, I'm in trouble."

All of which helps explain how Cisco got here. But will it continue to grow at a 50% annual rate? It took just 10 years for Cisco to go from start-up level to most valuable company in the world. That alone is a commentary on the pace of change in today's economy. The Internet has grown from a $5 billion business five years ago to a $500 billion one today, with annual growth rates of 50%. And in some sense, Cisco is the beneficiary of a virtuous cycle, so to speak, in which the very innovations that make its own products faster and increase the supply of bandwidth also supercharge demand for bandwidth, as faster computers mean we will want to download more video, more music and more of everything--all through Cisco-powered networks. "The user is the slowest link in the chain," says Varian. "We're limited by our biological perception--we can only read so fast, music only makes sense at a certain speed. But in terms of computers and routers, they can handle any speed."

Chambers likes to talk in terms of dog years. One human year is equal to seven Internet years. Even the folks at Cisco admit that in this technological revolution they will have to maintain a state of perfect paranoia to stay ahead. Cisco is facing tough competition in the telecom-equipment business, where longtime powerhouses Lucent and Nortel enjoy established expertise and relationships with key customers. "It's one thing to build a network the size of a corporation," says a skeptic, Nortel ceo John Roth, "but it's another to build one the scale of a whole nation."

The big prize awaits the dominant player in the voice-over IP business, in which voice is transmitted the same way as data--via the Net. Stealing a march on the competition, Cisco on Monday unveiled a new IP telephone that will allow corporations to use their data backbones for voice communication. Wireless networks loom as the next important phase of the Web. And then there's biotechnology, in which all these new systems are being applied to the natural sciences. And what about nanotechnology, with its tiny self-replicating machines? So, who will be the market-cap kings in 10 years? One thing you can be sure of--you haven't heard of them. Yet.