Light Reading

Cisco's Secret Franchise

Craig Matsumoto
News Analysis
Craig Matsumoto
9/6/2006
50%
50%

It's well known that Cisco Systems Inc. (Nasdaq: CSCO) customers are just about forced to buy optics from Cisco, and at hefty markups. The practice is an annoyance to some customers -- and now a report suggests investors should start worrying about it, too.

Cisco's practice of reselling optical modules represented 25 percent of the company's operating income in fiscal 2006, according to Andrew Schmitt, principal of Nyquist Capital, in a report being issued today.

To put it another way: Cisco's pro forma earnings per share for fiscal 2006 totaled $1.12. The figure drops to 86 cents when you take out profits from modules, Schmitt claims.

The modules in question connect a linecard to an optical fiber, and they come in standard formats such as GBIC and SFP. Cisco buys these modules from vendors like Finisar Corp. (Nasdaq: FNSR), then resells them to Cisco customers, charging a massive markup. Along the way, Cisco does almost nothing to the module beyond adding some identifying information (which is important -- more on that later).

Cisco doesn't consider optical module reselling to be a separate business unit. But Schmitt claims the practice generates some eye-popping revenues -- $2.5 billion in fiscal 2006, or 9 percent of Cisco's total, he believes.

Cisco officials wouldn't comment, noting they don't publicly disclose this level of detail for their operating results.

Schmitt isn't accusing Cisco of any chicanery here. "In a sense, there's nothing wrong," he says. "They have done an excellent job of taking their strong position in Ethernet and extracting value out of what is a commodity device."

But the margins on optics are so high -- up to 90 percent gross profit, Schmitt figures -- that they're padding the company's profit growth, he says. Investors looking at the raw numbers would think Cisco's profits are increasing because of technology when, in fact, a good chunk of the increase comes from the optics markup.

It's analogous to the situation at Lucent Technologies Inc. (NYSE: LU), where profits are sometimes propped up by gains from the company's pension fund. (See Notter Nixes Lucent.) In both cases, something outside the company's normal business is boosting income -- and the X factor isn't necessarily sustainable.

"This has really been an engine for their earnings growth -- and how long is that growth going to continue?" Schmitt says of Cisco's optics business. "If you measure return on invested R&D for Cisco, do you include this business or not?"

It could be an important question. When Cisco's module markups are factored out, its profit growth during the last three years doesn't look so steep, by Schmitt's calculations. And that would imply the stock is overvalued.

Now, why does Cisco get away with reselling optics at these prices in the first place?

The answer dates back to 2003, when the company tweaked its Internetwork Operating System (IOS) to reject optical modules that didn't come from Cisco. So, even though the standards-based modules are supposed to be interchangeable, Cisco customers have had to buy their modules from Cisco. (See Use Our Optics, or Else!)

The practice began with the GBIC and SFP module types for Gigabit Ethernet, and it's expanded to the Xenpak and X2 modules for 10-Gbit/s Ethernet, Schmitt says. Cisco's trick is to put identifying information onto the memory chip that's inside each module -- Schmitt refers to this as "copy protection," but a 2003 Cisco document used the much more entertaining term, "Cisco Quality ID."

So, Cisco can charge a premium for its optics. But it gets better: Since Cisco represents the majority of optical module sales -- particularly when it comes to Ethernet -- it's able to buy at a low price from the module manufacturers. The result is a nice fat margin for very little effort.

(Your word-of-the-day moment: The term Schmitt bandies about is "Monopsony," a situation in which multiple suppliers are trying to sell to one customer. It's like the mirror image of a monopoly. Schmitt figures components suppliers will have to consolidate in order to reduce Cisco's monopsony power.)

Market forces might already be in motion that could keep Cisco's module margins in check. As one might expect, Asian entrepreneurs have begun cloning Cisco-approved optics, Schmitt says. Cisco hasn't filed any lawsuits yet -- and the law might not come to Cisco's aid, anyway. Schmitt sees parallels with the companies that sell knockoff ink and toner cartridges for printers, a business that's stood despite legal challenges.

We'd like to know what our readers think about Cisco's resale practices. Please take a minute to complete our very brief poll: The Cisco Markup.

— Craig Matsumoto, Senior Editor, Light Reading


Interested in learning more on this topic? Then come to our upcoming conference, Optical Expo 2006. This conference and exhibition will be staged in Dallas on September 19 & 20, 2006. Admission is free for attendees meeting our prequalification criteria. For more information, click here.


(68)  | 
Comment  | 
Print  | 
Newest First  |  Oldest First  |  Threaded View        ADD A COMMENT
Page 1 / 7   >   >>
Scott Clavenna
50%
50%
Scott Clavenna,
User Rank: Light Beer
12/5/2012 | 3:42:04 AM
re: Cisco's Secret Franchise
Great article in a recent Harper's Magazine on monopsony, in their case referring to WalMart's power over its suppliers. The article makes a compelling claim that WalMart's status as a monopsonist is the result of an evisceration of the anti-trust laws that govern the U.S. marketplace (remember, this is Harper's).

The author finds this trend worrisome not because monopolists or oligopolists in the U.S. will charge consumers higher prices, but that they will dictate pricing from their suppliers, and that "it deprives the firms that actually manufacture products from obtaining adequate return on their investment. In other words, the ultimate danger of monopsony is that, over time, it tends to destroy the machines and skills on which we all rely."

That seems to apply more to Bookham and Avanex than to Fininsar and Agilient, but Andrew points out a very specific example here of monopsony at work: the customer (Cisco's enterprise and service provider customers) do not suffer so much from high prices from Cisco's near monopoly on Ethernet switching as do Cisco's suppliers. This has opened the door for Chinese competitors to come in, and therefore has a negative consequence on domestic suppliers and our economy in some slight way.

This pratice, writ large across the whole U.S. economy, definitely warrants some critical thinking. The author lays the blame at the feet of Reagan-era legislators, who pushed free markets so hard that the market in many cases now is anything but free (Wal-Mart being the best example for suppliers of consumer goods). When I read this article a few weeks ago, I couldn't help but think of telecom, and this report seems to confirm my suspicions with some real detail.

Thanks, Andrew

Scott Clavenna
Peter Heywood
50%
50%
Peter Heywood,
User Rank: Light Beer
12/5/2012 | 3:42:01 AM
re: Cisco's Secret Franchise
In case you missed it, we're running a poll on this topic:

http://www.lightreading.com/su...

So far, the consensus is that Cisco is overdoing it and the jury's out on whether investors should be worried or not.
Pete Baldwin
50%
50%
Pete Baldwin,
User Rank: Light Beer
12/5/2012 | 3:42:01 AM
re: Cisco's Secret Franchise
I've asked occasionally, during the past three years, whether Cisco has started allowing the use of optics purchased elsewhere, and the answer (obviously) continues to be No ...

Users seem to have stopped the practice from spreading (Extreme backed out of doing things this way, IIRC) but don't seem to have swayed Cisco. Has this just become a plain fact of life, an extra expense for Ethernet networks?

More to the point, *can* users do anything here? I don't see a lot of reasons for Cisco to stop doing things this way, even if the cloners are on the rise.
brahmos
50%
50%
brahmos,
User Rank: Light Beer
12/5/2012 | 3:42:00 AM
re: Cisco's Secret Franchise
cloning of the entire vendor specific memory is hard to stop because router can only enforce serial# or any id field uniqueness within a chassis( and shut down all but the 1st port in the set).

next step: a config dialog that forces users to "register" to a central machine (like MSft) and there the global SFP serial# list be maintained

or maybe the MPLS fanatics always in search of a problem for their soln can come up with a fresh optical id distribution & sync protocol for routers to detect counterfeits in a distributed manner! attach list of sfp id#s to BGP updates :P
maybe "punish" the counterfeiter by sending back wrong / high cost routes....
c_headed
50%
50%
c_headed,
User Rank: Light Beer
12/5/2012 | 3:42:00 AM
re: Cisco's Secret Franchise
I think this article explains one of my main questions regarding optical component vendors (Finisar, Avanex, Bookham, JDSU etc.): Why are they all still losing so much money?

I kept thinking maybe there was still too much overcapacity from the tech bubble, but it turns out, if this article is true, that CSCO has simply been able to capture most of the profits that would otherwise go to the component vendors. What hogs! Investors, for example, that keep dumping new money into Bookham to keep it afloat should know that Bookham will never see a market return on their sales to CSCO and that they are really subsidizing CSCO's huge profits and margins.

Am I reading this correctly? Should we dump all of our optical sector investments and simply by shares of CSCO?

pnni-1
50%
50%
pnni-1,
User Rank: Moderator
12/5/2012 | 3:42:00 AM
re: Cisco's Secret Franchise
There is a secret command that will allow another vendors optics to work on some Cisco gear.

mum is the word :)
dustintodd
50%
50%
dustintodd,
User Rank: Light Beer
12/5/2012 | 3:42:00 AM
re: Cisco's Secret Franchise
Did the reporter attempt to interview Cisco about this?
Pete Baldwin
50%
50%
Pete Baldwin,
User Rank: Light Beer
12/5/2012 | 3:41:59 AM
re: Cisco's Secret Franchise
There is a secret command that will allow another vendors optics to work on some Cisco gear.

mum is the word :)


I wonder how many operators just now dove into their CLIs to try typing "mum". :)
Pete Baldwin
50%
50%
Pete Baldwin,
User Rank: Light Beer
12/5/2012 | 3:41:59 AM
re: Cisco's Secret Franchise
I did contact Cisco, but they wouldn't comment because the story touches on a level of detail Cisco doesn't publicly disclose -- namely, the fine-grained components of operating income.

Cisco also doesn't disclose optics pricing, so they wouldn't comment there.

So, we don't have Cisco's take on the numbers, although I suspect they'd say the numbers are a bit high (as any company would, in Cisco's position.) I'll keep hunting around to see if I can find another way to get their take on things.

What else would you want to ask Cisco?
ron202
50%
50%
ron202,
User Rank: Light Beer
12/5/2012 | 3:41:58 AM
re: Cisco's Secret Franchise
Craig,
Say that you are working to customer support @ cisco and recevive a phone call from a customer screaming that the damm expensive CRS router doesn't work - shows errors. Between the other things you ask the customer to replace the optics - he does and doesn't work either. After a few replacement cards shipped to a large cost , with user traffic disrupted you realize that the customer purchased a lot of cheap made in the middle of nowhere optics. And yet you take the blame (the router should work with all the garbage exsisting outhere).
By the way as far as I know EMC has the same policy for their 24/7 service.
Plus if you can obtain density (power related ) and EMC compliance with only some qualified vendors the things are moving in a technology area anyway.

True they may charge too much for the optics but again they may charge too much for everything.

Page 1 / 7   >   >>
Flash Poll
From The Founder
Last week I dropped in on "Hotlanta," Georgia to moderate Light Reading's inaugural DroneComm conference – a unique colloquium investigating the potential for drone communications to disrupt the world's telecom ecosystem. As you will see, it was a day of exploration and epiphany...
LRTV Documentaries
Verizon's Emmons: SDN Key to Cost-Effective Scaling

5|22|15   |   03:53   |   (0) comments


For Verizon and other network operators to ramp up available bandwidth cost effectively, they need to move to SDN and agree on how to do that.
LRTV Documentaries
Lack of Universal SDN a Challenge

5|21|15   |   04:51   |   (3) comments


Heavy Reading Analyst Sterling Perrin talks about how uncertainty about SDN standards and approaches may be slowing deployment.
LRTV Custom TV
Steve Vogelsang Interview: Carrier SDN

5|20|15   |   05:02   |   (0) comments


Sterling Perrin speaks to Steve Vogelsang, Alcatel-Lucent CTO for IP Routing & Transport business, about the new Carrier SDN-enabling Network Services Platform and the operator challenges it solves.
LRTV Custom TV
Carrier SDN: On-Demand Networks for an On-Demand World

5|20|15   |   20:52   |   (0) comments


Steve Vogelsang, Alcatel-Lucent CTO for IP Routing & Transport business, talks about requirements and benefits of Carrier SDN during the keynote address at the Light Reading Carrier SDN event May 2015.
LRTV Documentaries
The Security Challenge of SDN

5|19|15   |   02:52   |   (0) comments


CenturyLink VP James Feger discusses concerns that virtualization could create new vulnerabilities unless network operators build in safeguards.
LRTV Custom TV
NFV Elasticity – Highly Available VNF Scale-Out Architectures for the Mobile Edge

5|18|15   |   5:50   |   (0) comments


Peter Marek and Paul Stevens from Advantech Networks and Communications Group talk about their NFV Elasticity initiative and the company's latest platforms for deploying virtual network functions at the edge of the network. Packetarium XL and the new Versatile Server Module: 'designed to reach parts of the network that other servers cannot reach.'
LRTV Huawei Video Resource Center
Bay Area Spark Meetup 2015

5|14|15   |   3:54   |   (0) comments


Developed in 2009, Apache Spark is a powerful open source processing engine built around speed, ease of use and sophisticated analytics. This spring, Huawei hosted a meetup for Spark developers and data scientists in Santa Clara, California. Light Reading spoke with organizers and attendees about Huawei's code contributions and long-term commitment to Spark.
LRTV Custom TV
The Transport SDN Buzz

5|12|15   |   06:01   |   (1) comment


Sterling Perrin, senior analyst at Heavy Reading, speaks with Peter Ashwood-Smith of Huawei and Guru Parulkar of ON.Lab about the evolution of transport SDN and the integration of technologies.
LRTV Custom TV
Next-Generation CCAP: Cisco cBR-8 Evolved CCAP

5|5|15   |   04:49   |   (0) comments


John Chapman, Cisco's CTO of Cable Access Business Unit and Cisco Fellow, explained the innovation design of Cisco's cBR-8, the industry's first Evolved CCAP, including DOCSIS 3.1 design from ground-up, distributed CCAP with Remote PHY and path to virtualization. Cisco's cBR-8 Evolved CCAP is the platform that will last through the transitions.
LRTV Custom TV
Meeting the Demands of Bandwidth & Service Group Growth

5|1|15   |   5:35   |   (0) comments


Jorge Salinger, Comcast's Vice President of Access Architecture, explains how DOCSIS 3.1 and multi-service CCAP can meet the demands of the bandwidth and service group growth.
LRTV Custom TV
DOCSIS 3.1: Transforming Cable From Hardware-Defined Network to Software-Defined Network

4|29|15   |   03:48   |   (0) comments


John Chapman, Cisco's CTO of Cable Access Business Unit and Cisco Fellow, explains how DOCSIS 3.1 can transform cable HFC network to a more agile software-defined network.
LRTV Huawei Video Resource Center
Predicting Traffic Patterns for Quality Mobile Broadband

4|29|15   |   6:45   |   (0) comments


Accessing information ubiquitously creates complexity and creates heavy traffic onto the network, especially at large-scale events like sporting events or festivals. In this video, Huawei's Mohammad Hussain speaks to experts about how to predict traffic and improve user experience during periods of heavy traffic.
Upcoming Live Events
June 8, 2015, Chicago, IL
June 9, 2015, Chicago, IL
June 9-10, 2015, Chicago, IL
June 10, 2015, Chicago, IL
September 29-30, 2015, The Westin Grand Müchen, Munich, Germany
October 6, 2015, The Westin Peachtree Plaza, Atlanta, GA
October 6, 2015, Westin Peachtree Plaza, Atlanta, GA
All Upcoming Live Events
Infographics
Network functions virtualization (NFV) is not the easiest of topics to take on board, so here's a Light Reading infographic, developed following conversations with the folks at HP, that helps make sense of where NFV is taking the industry.
Hot Topics
Verizon Saves 60% Swapping Copper for Fiber
Sarah Thomas, Editorial Operations Director, 5/19/2015
Choosing a Technology Supplier? Consider Changing Your Selection Criteria
Steve Saunders, CEO and founder, Light Reading, 5/18/2015
Chattanooga Charts Killer Gigabit Apps
Mari Silbey, Senior Editor, Cable/Video, 5/20/2015
10 Alternate Uses for Tablets
Eryn Leavens, Copy Desk Editor, 5/22/2015
Smarter 'Dumb' TVs Will Drive OTT Adoption
Mari Silbey, Senior Editor, Cable/Video, 5/18/2015
Like Us on Facebook
Twitter Feed
Webinar Archive
BETWEEN THE CEOs - Executive Interviews
With 200 customers in 60 countries, Stockholm-based Net Insight has carved out a solid leadership position in one of the hottest vertical markets going in comms right now: helping service providers and broadcasters deliver video and other multimedia traffic over IP networks. How has Net Insight managed to achieve this success in the face of immense competition from the industry giants?
My ongoing interview tour of the leading minds of the telecom industry recently took me to Richardson, Texas, where I met with Rod Naphan, CTO and SVP, Solutions, ...
I recently popped down to Texas to chat with CEO Eric L. Pratt about his company, Taqua.
Cats with Phones