FORTUNE MAGAZINE - CISCO's Worst Nightmare (and Sun's and IBM's and Nortel's and...) 2/4/02 Monday by Julie Creswell "Tec's big guns are waging ware with a new foe: used-equipment sellers"

The deal had hit a snag--a big snag called Cisco. Late last summer John Lynch's company, Asset Recovery Center, in Eatontown, N.J., was on the verge of selling 59 used Cisco routers to New York brokerage firm Credit Suisse First Boston for $1.3 million. Then Cisco got wind of the deal. "Cisco threw up tons of roadblocks to try to stop the sale," says Lynch. The router maker's sales representatives told CSFB that the used equipment wouldn't work, and even if it did, CSFB would be unable to get service contracts for it and would be left hanging if it broke later on. Only after convincing CSFB that the equipment was in perfect condition did Lynch land the deal. "Cisco probably lost out on a $4 million order," says Lynch. "Better yet," he adds, chuckling, "I got the equipment certified as new. If CSFB plugs the routers in and they blow up, Cisco has to go in and fix them."

Lynch is a denizen of high-tech's gray market, a realm of fast-talking smoothies who buy leftover routers, servers, and other networking gear for pennies on the dollar and resell them at a profit. On the surface, a company like Asset Recovery, which expects to have only around $30 million in sales this year, would seem no more than a blip on the radar screen of an equipment-making giant like Cisco, which, according to analysts, will have revenues of about $19 billion for the fiscal year ending in July. But 2,000 scavengers just like Asset Recovery--twice as many as a decade ago--are out there feasting on equipment from dead or ailing corporate customers that no longer need it. With businesses cutting capital spending and a glut of nearly new equipment for sale, the market for used IT gear has swelled to $20 billion a year. Cisco and competitors like Sun, IBM, and Nortel are feeling the squeeze on their prices and profit margins, and watching their chances of recovery recede into the future.

Just as troubling as the size of the gray market is the sort of customer shopping there now. Not long ago the typical transaction would be a mom-and-pop business buying a server on eBay from a busted dot-com. These days, more and more of the buyers are Fortune 500 companies discovering that last year's model of a Cisco router or a Sun server at 70% off list price suits their needs just fine. The used-gear business is better financed now too. Asset Recovery, for example, may soon hire a brokerage firm to raise money from private investors for more equipment purchases.

That's grim news for the big gearmakers. As CIBC World Markets analyst Steve Kamman says, "For those who are looking for a rapid turnaround, the tremendous overhang in excess equipment is just another reason for this to be a depressed year."

In a chilly warehouse about an hour south of New York City, Lynch moves past row after row of shelves piled 30-feet high with boxes bearing names like Nortel, Sun, IBM, and Compaq. Tightening a wool scarf around his neck, he takes a right turn and spies a quartet of four-foot-tall StorageTek data-storage units. He runs his hands over their gray metal surface. "AT&T gave these to us. It cost us about $2,200 to truck them out of the facility they were in," says Lynch with a satisfied smile. "I'm going to get $25,000 apiece for them.

Lynch is the new economy's used-car dealer, spinning tales of how cheap this server or that router was and how much someone is going to pay for it. His partner, company founder Mark Magee, is a lanky, soft-spoken lawyer who ran AT&T Capital's used-gear operations until 1996, when the unit was shut down. Magee founded Asset Recovery just before the tech boom of the late 1990s. The gray market was pretty anemic then, as corporate America spent gobs of money on new equipment to get ready for both Y2K and the expected boom in broadband demand. After Y2K passed and broadband fizzled, business in the secondary market picked up sharply, Asset Recovery took off, and Lynch signed on.

Combative and fast talking, Lynch, 46, is the perfect foil to his tweedy colleague. "He digs them up, and I stab them," Lynch says, as his cell phone rings for the umpteenth time with yet another bargain hunter on the line. He's not above using gamesmanship to make a sale. When he goes to meet clients Lynch leaves his $100,000 Mercedes SL 500 at home, driving a beat-up Ford Bronco truck instead. And though he's really the CEO, his business cards identify him as a marketing director. "It makes me seem like I'm the low man on the totem pole and have to get any deal okayed by my boss," says Lynch, laughing. (Of course, that trick may be played out now.)

Cisco may not like it, but Lynch and his ilk aren't going away anytime soon. With more gear from bankrupt companies likely to hit the market--Enron alone could have $350 million of broadband equipment to sell if it is liquidated--and continued softness in telecom, resellers expect the glut of networking gear to persist through 2004. Used-equipment brokers are better organized now too. ITParade.com, for instance, runs an auction site where corporate customers post ads for equipment they no longer need, and brokers bid to buy it. In the past year, says founder Robert Davie, the number of brokers using the service grew from 200 to 500. While the first wave of gear on the site came mostly from defunct dot-coms and telecom startups, recent sources include established retailers like CVS and big telcos looking to dump gear they had bought for their broadband networks but did not install. "We're seeing huge quantities of brand-new product that has never been taken out of the box from some of the big telecommunications carriers," says Davie. "There's also a heck of a lot of Sun servers coming out of hosting companies."

Many buyers turn to the gray market after traditional suppliers give them sticker shock. Sherri Stetten, an e-project manager for Chicago printer ComGraphics, was distressed last year when she found out what Compaq was going to charge for gear the firm wanted for its e-business. "We needed 30 pieces of equipment, and the price we were quoted for one item--$152,000 for a data-storage unit--would have blown our entire budget," Stetten says. She went to the used market and got almost all of what she needed from Lynch for the same price. "Some of the equipment worked just great when we plugged it in, and other pieces needed tweaking. But you have the same issues with the new stuff," says Stetten. She has given Lynch a wish list for more gear.

Not surprisingly, equipment makers are fighting back--with what some resellers call questionable tactics. "They're throwing tons and tons of FUD--fear, uncertainty, and doubt--in front of the buyers," says James Davie, the younger brother of ITParade's Robert Davie and a partner in Atlanta reseller Optimus Solutions. Davie claims the equipment giants tell buyers that they won't maintain used hardware, or they'll charge hefty fees to certify that the equipment is in good working order and eligible for warranties. But all that makes Davie's sales pitch simple, he says: "We ask the customer if they want to work with somebody who's going to coerce them to buy, or if they want to work with someone who's going to save them money."

Peer 1 Network CEO Geoff Hampson faced the wrath of Cisco last year when he went shopping in the used market. Enticed by attractive financing terms, Peer 1 had bought new Cisco routers and switches in 1999 to build its Canadian data-communications backbone. But when Hampson went back to Cisco to expand the network, the story had changed. Cisco's newest routers were much more expensive, and its financing terms were much more stringent. "They wanted guarantees from the principals of the company to make us personally responsible for the debt," says Hampson. "And while there had been minor improvements in the equipment, there hadn't been enough to justify the higher prices." Hampson found the gear he needed at Asset Recovery for a fraction of the cost, but somehow the Cisco sales rep discovered that Hampson was in the gray market and tried to talk him out of the deal. The rep told him that the equipment wouldn't work and that the warranties wouldn't be valid. "I can't have my network go down, but a new router costs $265,000, and I was getting a used one for $40,000," says Hampson. "So I bought a backup. It was cheaper to buy two used routers than one new router." A Cisco spokeswoman says, "Customer satisfaction is the core value of Cisco's culture. Any behavior that does not support this value is unacceptable."

While publicly Cisco and other equipment manufacturers pooh-pooh the impact of the gray market on their businesses, they're clearly spooked. Last September, Cisco banded together with 3Com, Compaq, and other gearmakers to form the Anti-Gray Market Alliance. The group's charter is to inform consumers about the risks of buying used gear. Without question, the gray market is a domain where the buyer must beware of unscrupulous resellers dumping lemon circuitboards and switches. But in an interview, David Colton, executive director of the alliance, describes resellers in general as having little compunction about saddling unwitting buyers with inappropriate gear. "Equipment whose electrical system is customized for China is ending up in New York City," says Colton. "When it doesn't work, the user turns to the equipment maker to get it fixed." He also implies that buying in the gray market can be unpatriotic, suggesting, rather cryptically, that some resellers may be fronts for "groups that are not only extranational but that are perhaps not in the best interest of the U.S."

Matters of national interest aside, not all manufacturers see the gray market as the realm of evildoers. Some are even opting to join what they can't beat. Sun claims that it is the biggest reseller of its own equipment and that its "like new" division has seen a surge of buyers. "The secondary market is a substantial opportunity for Sun," says vice president John Tucker. "We don't feel threatened by [resellers]. They're competing with us; we're not competing with them." Some manufacturers are cashing in even when customers buy used gear from somebody else, charging fees of $650 to $3,000 per piece of equipment to recertify it, and then selling annual service contracts that can run about 8% of the original purchase price. "It's a high-margin annuity stream that can last for three to five years," says Susan Kalla, an analyst at Friedman Billings Ramsey.

In the meantime, Cisco and other equipment makers will have to put up with Lynch. His aspirations aren't grand; he only wants a little piece of the pie. "We're just a couple of street guys looking for the fastest way to retirement," he says, smiling. No doubt the sooner they find it, the better for companies like Cisco.