Managing the downturn, the 3Com way
CRN editor Paul Briggs talks to 3Com chief executive Bruce Claflin.
CRN: Although most IT executives are reluctant to lift their head above the parapet to predict the course of the recessional economy over the next few months, especially after the terrorist events of September the 11th, could you share your views on market recovery?
Bruce Claflin
: There are obviously implications to business and you can't really talk about those implications unless you go back to the conditions before September 11th. I guess the best place to start is that after six years of unprecedented growth in technology, it all came to a rather abrupt end around the November, December (2000) time frame.
The first symptom was the telecommunications sector principally in the US, but also elsewhere, which saw a massive slowdown. The enterprise sector followed thereafter. It's without question that the current slowdown is the broadest and the deepest that the technology sector has ever faced.
At a recent analyst meeting I showed about six or seven charts where I showed how I had tracked the stock price of leading companies in various sectors of technology: semiconductors, PCs, software, systems, networking, and just to keep the analysts honest I had the analysts' stocks. As you might imagine, all of the stocks were down to the right, and my point was that if any one of these sectors would have had this profile, it would have been news in the past; but to have every sector down is unprecedented.
I think to understand this slowdown you have to understand why was it so robust before then. I think there were probably three or four factors. As I have said, there was six years of unprecedented buying opportunities and they were triggered by three events.
In 1996 there was the US Telecommunications Deregulation Act which was intended to create a more competitive telecoms structure, particularly at the local exchange; and as that act was passed, new capital poured in, new entrants popped up overnight and they bought technology to deliver services. While this is a US statement there was similar deregulation activities around the world that saw the same: new capital; new companies; technology.
Then in 1998, the Y2K phenomenon was coming to a head. At the time, most companies choose not to fix their old systems but rather to replace them. So again, unprecedented buying as people upgraded their hardware as well as their software.
As soon as Y2K was finished, there was the 'e' phenomena where the view was that business-to-business [B2B] and business-to-consumer [B2C] would disintermediate people's supply chains and value chains. Therefore, to stay competitive, the view was that you had to invest in the underlying technologies that could allow you to enable new business models B2B and B2C.
So here we saw three events, just about two years apart from each other, that created unprecedented buying. Added to that you had easy money, easy money. Interest rates were low, capital was widely available, and investors' patience was almost endless. It almost didn't matter for a while if you were profitable, so long as you appeared to have growth.
The last factor, in my opinion, was excess hype. I think the industry over-promoted what technology could do in the near term. The general media, trade media, financial analysts, amplified this. All of us were guilty.
The aggregate of all this was an enormous bubble of buying that then popped, starting with telecoms and moving to the enterprise sector.
If that's what built it up, why did it stop?
In the telecommunications sector, many of the new entrants that were created four or five years earlier were running out of money and they needed to go back to the capital markets to survive. But the climate had changed, and now capital was dear; investors wanted returns, patience was limited, and in the US, interest rates had risen dramatically.
So these companies found they could not get the capital they needed to survive, and they collapsed. We have since seen bankruptcies of about 85 per cent of those companies created in the last five years. So not only did these companies that were either a) bankrupt or b) running out of cash stop buying, they also had all this technology which is now excess, unused.
The enterprise sector had a similar reaction. It had all this build-up of technology to deliver the advertised value that was not being delivered. The value propositions, the benefits, were just not there. Again capital was dear, investor patience was tight and it too collapsed.
All of this happened as the industry was gearing up to enormous capacity to meet demand. So in this scenario you have the worst of both worlds - every sector of technology went into rapid decline just as the industry was at peak capacity, and that's what created this deep, long downturn.
I know recent events have perhaps skewed previous forecasts, but compared to the last recession when interest rates were a lot higher than they are now, do you think we are entering a U-shaped recessional curve or more of a V-shaped, where recovery will be a lot quicker?
The first move (in a slowdown) is to rationalise your capacity. If a company built capacity for X kind of revenue and it is now faced with a smaller Y figure, companies like 3Com and others have had to downsize, exit unprofitable business, reduce employment, cut discretionary expenses, sell real estate and consolidate. These are all the things you do to get your cost/expense structure much lower. All companies have been doing this.
All of this was going on as we approached September 11th. Although nobody really knows, my guess was that we were already pretty much at the bottom of the technology downturn before the events of that day.
My personal view at the time was that there wasn't going to be any rapid recovery and we would just bump along, with marginal recovery as the markets suggested. But post-September 11th, I don't think we are at the bottom. I think there is more softness in the economy because the events have made things worse, not better. It will mean technology will get hit further before it stabilises.
But I believe there is a higher likelihood of a more rapid and higher slope recovery. If I had to venture a guess, I would say that the US will be the first to turn around, in part because of the economic stimulants flowing into the economy right now, and also because companies have had to rationalise capacity so aggressively in the US.
Why is that?
Well, pressure on interest rates is even greater now, and interest rates in the US are at near record lows. The bias of the fed [Federal Reserve] is to drop them even more.
There are also enormous economic stimulus packages being introduced in the US. While none of it has been done yet, the estimates are anywhere from $75bn-100bn - new expenditures without any tax increase - and that's an enormous stimulant even in economies as large as the US.
One could argue that the events of September 11th, while harmful in the near term, could in fact be a stimulus for recovery. This is hard to call, and against this backdrop, if you are running a company, the real answer is you don't know what's going to happen. So in the face of this you will see 3Com being very cautious on our near term investments, conserving cash and being very careful not to buy too much inventory: you won't see us building plant, property and equipment.
It's very, very tight. But you will also see us, and other companies, continue to invest for the long term. I know of no-one in the IT industry who believes that the fundamental demand drivers have changed. I know of no-one who believes that technology is no longer a growth market opportunity, and so all of us are investing in technologies that we think will pay dividends for the long term, while cutting off the near term expenditures such as the transactional kind of activities.
Conserve cash, manage your balance sheet, but invest in those bets you think will pay off over the long haul. That's what we think we, and our competitors, are doing.
So in the current climate will we see more bankruptcies than acquisitions? Do you think competitors will survive just by cutting costs and downsizing? Who will be left?
If you are an acquiring company there are two things you don't want to do: you don't want to buy too soon before companies hit rock bottom on price, and you don't want to buy if you think your own business is unstable.
You may think that with a cash-rich position ($4.5bn) we are in a position to buy. I can assure you we are not going to buy in the short term until I am comfortable that I know where bottom is on the market and I know that I am balanced. I believe every CEO is roughly in that shape.
But once we get to this point, long before we see robust recovery, we will see consolidation. This is because as the bad companies are falling, the good, but not great companies are stable but not thriving, and the really good ones are confident enough that they will go ahead and buy.
I do believe there will be a period of consolidation in the industry. I don't think it's going to happen right now. Another quarter or two, and we will begin to see it happen as markets and companies begin an upturn.
To put a different spin on things: I know you have, as of the last quarter, a $1.45bn cash position, and cash is king in a recession, with a) the telecomms market being saturated, and b) you predicating flat revenue growth for your [carrier business] CommWorks. Instead of looking for acquisitions to plug gaps in your portfolio, would CommWorks be a likely acquisition target? Would you sell it?
As you know, this is always a hard question to answer because the chief executive of any public company is obligated to do whatever is in the best interests of the shareholders. If this means sell the company, then he has to do it.
You hate to say that to people like you because it will get reported that we are thinking about selling the company and I will get hate mail from all my staff.
So it's quite simple: we are up for sale every minute of the day; that's why we are a public company, and if someone came in and made an offer that created more shareholder value than anything we could do in our internal plans, then yes, we'd sell.
But that's not how we are running our business. We are not running it to sell, we are running it to build a business.
So do you see the tornado markets being serviced by divisions such as CommWorks?
CommWorks is an interesting story. Here's the telecommunications sector, with the greatest, the fastest and the deepest slowdown, and probably the hardest to turn around. But if you look at where we did and didn't make cuts last year, our CommWorks business was relatively untouched. We continued all of our major R&D efforts, we didn't cut any of them.
This links back to my earlier statement that in near term investments we will be very pessimistic, but in the long term we believe the service provider market will be a good one, and we believe it will be very attractive. So we kept our investments very high in that area.
CommWorks has the potential to be the greatest shareholder-value unit. By this I mean highest growth, highest returns. The segments they are targeting, even in the slowdown, seem to be very attractive and have very little of what I call our legacy business - old business in declining markets. Everything is new, high growth and high margin. So one of the big bets we made was that that segment, even with the pressure it is under now, will be attractive if we continue to fund CommWorks on a relative basis more than any other part of the company.
Let me give an example of the trade-offs we have had to make in this decision. Back in the good times, i.e. last year, we decided to go after a new market, the consumer market. Principally this was in the US but we planed to expand this strategy if we were successful.
Very quickly it became clear that the consumer market was not going to materialise the way we thought and was not going to be profitable, so we killed it. Although CommWorks was also not making as much money as planned, we decided that its future was better than that of the consumer area.
In terms of restructuring, redundancies and cost cutting, is this now as far as you can go, or can you go further?
There are lots of things we can do to be more efficient. For example, we have implemented an ERP system from SAP and the intent was that that would be a system to replace legacy systems; we still have 23 ERP systems inside our company. I think we can get more efficiency there, and as we do, I think we will get savings.
We can also look at outsourcing. If we have a mission that is important but not critical to our success or value proposition, then we'll look to outsource it if we can.
Let me give you an example: there is a fellow who works for me who looks after all of our business development and strategy, mergers and acquisitions. I doubt I'll outsource that job because it is absolutely core to who we are and what we are going to be.
At the other end we have people who cut the lawns in our campuses. They're outsourced. It doesn't mean they are not important. In fact, if the lawns don't get cut I'll get more complaint letters than I ever would about the strategy guy, but it's not core to our value proposition.
So we are constantly looking inside saying: what work do we do that, while it's essential, is not essential to our core, to the value proposition, and can it be done better on the outside. I view this as normal efficiency.
The last six months were wholesale company-wide blunt-instrument-type reductions; what we are doing now is more in line with the normal business of pruning, getting more efficient and hiring at the same time, and sure, we can do a lot there. Second half we will probably have continued reduction in net employment, although at a much more moderated rate over what it is today.
Does this mean that 3Com will be following Cisco's lead further down the outsourcing route? How can you minimise getting caught out, especially holding lots of inventory, by using greater outsourcing practices?
I don't envisage massive company-wide reductions where we make a company-wide edict that we are going to take manufacturing out - that I don't see. But we can be more efficient, do work in better ways, reduce costs, and we are going to continue to drive those like crazy.
Outsourcing does not eliminate risk but in some cases it can minimise risk. Take manufacturing: all outsourcing contracts basically say that the responsibility for inventory is that of the outsourced manufacturer, unless your inventory falls outside a profile in which the burden transfers back to you.
No outsourced supplier will take inventory risk. So if I go to our outsourced supplier and say that my demand is X and it comes in at half that, and they bought in the parts, that liability transfers back to my books. The responsibility to manage your supply chain rests with you as a company, even if it's outsourced.
Cisco fell into the trap, like many companies, of believing that the industry would continue to grow. Remember a year ago the industry had a supply problem and it took enormous steps to lock up supply to build in long-term committed contracts; when the industry turned down, it exploded on them. So it's an interesting phenomena that a company without inventory like Cisco has $2.5bn of written-off inventory.
What are your views on the proposed Hewlett-Packard Compaq merger
My customers never make mistakes. We have very good business with HP, we have very little business with Compaq. So perhaps it will be good for us and we will try to make it good for us.
When you withdrew product from the enterprise market, you stepped on a lot of resellers' toes. You are now reinserting into this market, but some analysts are saying that you while you are focused on the SME market with your channel, you are not communicating this message well enough to enterprise partners. How far do you think you have to go to win back the hearts and minds of these people?
We did step on toes. But I want to draw the distinction between the effects of withdrawing from product category, which can be negative, and not confuse that with withdrawing from a market. We exited very high-end chassis products, core routers, core switches. These products went up against Cisco's strongest segment. We had three and four per cent market share, Cisco had 60 to 70, and it was very unlikely that we were going to build a winning business there.
Now if you were the channel and you happened to be selling that product, you would be impacted, and out of 60,000 remarketers, about 500 sold those products. If you were a customer or partner caught in this, and Europe was our best penetration for this product, you were mad.
I do believe it was a disproportionate pain to customers and partners in Europe. When we did it, we were the only one in town doing it. Now everyone is retrenching.
VARs have welcomed your stackable products in terms of product differentiation when going to market, but they do want more from you guys to help them sell it to the market.
I think you're right. If you look at what we're doing, we have moved our product line into higher functions but it is not at the chassis: it is what we call modular.
The point is, we know that our customers want to have much higher levels of capacity and performance, but we want to try and deliver that in a form factor and a system that is far easier to design, store and configure than the complex chassis products. We think our value proposition is that of functionally rich but radically simple. And so as we move up into higher function products, we are doing it from a much simpler design for an install operator to maintain.
And that is a differentiation of what we were doing before and what Cisco is doing today. I think this plays well to the channel because of the less complex sale: they can do all of the selling and the service as well.
Last month, 3Com said it had shaved $25m off the channel inventories from its Business Connectivity Company. Most of this was in Europe. You also took a charge of $19m for the elimination of surplus kit. How bad was it, what shape is it now?
It wasn't bad ever. If we look at Europe, where most of our inventory was, we were running at something like five and a half weeks of inventory and that's not ugly. But the channel said this is tough times, we want to conserve cash, so they said: "I want to cut it [inventory] to four/three and a half weeks." So they were doing exactly what we were doing, cutting inventory, cutting costs.
So it wasn't that we were running our business out of line of normal, it was just that normal didn't apply any more. So we had to bleed off channel inventories, take care of our own inventories and it cost us some, but it didn't cost us as much as others who I think made wrong decisions in the period of high demand.
With capacity and inventory you have to imagine you are the captain of a ship and you have to sail out to sea in a storm. But you have to sail between two islands. One is a rocky island and the other is a sandy one; you don't want to hit either island, but if you hit the rocky island you put a hole in your boat and sink. If you hit the sandy island, it's not good but you can float away. The rocky island is too much inventory, the sandy one is too little inventory."