Why Cisco Chose Buy Over Build

The “buy versus build” analysis is a business school staple. Armed with a set of variables, students are asked: Is it better to pay top dollar for an established widget company or start fresh and beat them at their own game?

In recent months, executives at Cisco Systems engaged in a similar exercise, only the products, takeover target and risks weren’t hypothetical.

The San Jose, Calif., company, which made its fortune selling equipment to telecom carriers, Internet service providers and large corporate customers (all of whom have been watching spending), wanted to reach down into the home networking market. And for good reason. Consumers spent $3.7 billion on gear such as wireless routers and access points last year, a figure that is expected to double over the next three years, according to the Dell’Oro Group.

It was complicated calculus, but in the end Cisco went the ready-made route, announcing last week that it would pay $500 million in stock for industry frontrunner Linksys Group of nearby Irvine, Calif.

The deal ranks among the top 10 acquisitions in Cisco history, a noteworthy fact given its voracious appetite for high-priced, high-profile optical deals in the late 1990s. And interestingly, buying wasn’t its first impluse.

“When we first started looking into this we thought it was something we would do in-house,” said Charlie Giancarlo, Cisco’s senior vice president and general manager of product development.

To be sure, Cisco engineers could have designed products allowing home users to access the broadband Internet connections and interconnect computers, printers and other devices on a local area network. The company didn’t get where it is without top-notched engineers.

But just because it’s technically feasible doesn’t make it good busines. Even with Cisco’s immense resources, it would take a year, maybe two, to design, test and market the offerings.

In the meantime, the company would fall further behind Linksys, D-Link and Netgear, making it harder to gain traction. Also, there was the fact that Cisco wasn’t alone in noticing the market. In November, Microsoft jumped in and there was always the threat of Cisco’s traditional rivals, Lucent and Nortel, making a buy and leapfrogging Cisco while its products were still on the white board.

Besides time-to-market, production costs were a concern. Building the systems at Cisco plants was not an option because of higher labor and material costs.

Manufacturing for Linksys’s line, which includes 70 distinct products is outsourced to Asia-Pacific designers and manufacturers, mostly in China and Taiwan. The realtionships, cultivated over several years, allow the company to keep prices down — around $200 for the average home wireless set-up.

“We understood full well that we would need an operating model that took advantage of talents in China and we went to many businesses (there) to attempt to learn the business before starting,” Giancarlo said.

But Linksys’ connections were hard to beat. Similarly, Linksys had a sales pipeline, both direct and through resellers, to the consumer and small office/home office market. It also had a customer support call center, where one in four customers dial in for help free of charge. To compete, Cisco would have to hire and train its own sales and help desk staff, further driving up the costs.

Besides impediments to builing its own system, Cisco also sees synergies in a Linksys acquisition. The privately held company had tallied $429 million in revenue last year most in North America. Cisco believes it can energize the company’s sales overseas.

“Cisco can help with international distribution, sales teams and international retailers,” said Dan Scheinman, Cisco’s senior vice president of corporate development. “The combination of the two brands will make the (international rollout) quicker and more powerful.”

Though praising the use of off-the-shelf silicon and promising not to touch the pricing of the basic Linksys offering, Cisco may incorporate some of its components to enhance the performance of some products, which would raise prices, and presumably margins. A Cisco spokesman declined to elaborate.

While initially surprised that Cisco is courting the consumer market, Zeus Kerravala, an analyst and vice president at the Boston IT research firm Yankee Group, said the decision to buy Linksys rather than build its own system was the right one.

“Linksys has a good consumer brand name and very well-baked products,” Kerraval said.

Cisco’s purchase of Linksys can easily be adopted into a B-School case study. But whether professors agree with Kerraval and use the deal as an example of a smart pickup or as a cautionary tale remains to be seen.