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Cisco's Secret Franchise

Craig Matsumoto
9/6/2006
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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.


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Scott Clavenna
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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.

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