Tuesday, August 10, 2010

Cisco Earnings Preview

by David Gross

I normally don't like to write these "previews". Neither Lisa nor I think it matters whether a company's EPS comes in a penny short or higher, or if revenue comes in 1.2% higher than expected. Part of the objective of this site is to raise the debate away from the MBA conventional wisdom that leads investors to buy and sell with the herd, and does little to advance understanding of the industry in general. But with Cisco (CSCO) reporting Wednesday after the close, there is one very important metric everyone should be paying attention to - the percent of product revenue coming from switches and routers.

One of the things that's always amazed me about Cisco is how few hedge fund portfolio managers, Wall Street analysts, and other financial types can't tell me what the company's proprietary technologies are. Cisco's monopoly is built on developing proprietary routing and switching protocols that force the customer to buy more Cisco routers and switches to connect them to. The key technologies that accomplish this are EIGRP in routing, and ISL and VTP in Ethernet switching. These protocols, along with a few others, are to Cisco what Windows is to Microsoft. Moreover, just because I buy a Windows PC doesn't mean my neighbor has to. But if I buy a Cisco Ethernet switch and I run ISL and VTP on my VLAN, the neighboring switches can't have a Brocade logo and still work. But instead of touting these technologies, Cisco IR presentations are filled with all kind of gibberish about e-learning, e-health, and borderless networks. Yet these issues just divert investors' attention away from the key technologies that make Cisco so dominant in routing and switching.

Cisco has dominated switching since it bought the company that pioneered the concept of switched Ethernet, Kalpana, in 1994, in addition to buying Crescendo Communications in 1993. It's dominated routing since it surpassed Bay Networks around the same time. For all the other acquisitions the company has made, and all the new products its launched, it still gets 64% of its product revenue from switches and routers. Moreover, those have been its fastest growing products recently. Last quarter, switch revenue was up 40% year-over-year, routing revenue 31%, while advanced technologies was up just 18%. Switches and routers were down to 62% of total after the quarter ended April 25, 2009, but have been gaining again with their faster growth.

Cisco now sells over $20 billion of switches and routers a year - and growing. There is no one it can acquire to water down this massive market where it has massive market share. It could very well end up dominating the fast growing telepresence industry, but even if its telepresence revenue reached $1 billion in 2012, routers and switches could surpass $25 billion by then.

In the data center, Cisco is about to repeat history with its proprietary FabricPath, which is an "enhanced" version of the IETF's TRILL routing protocol, just like ISL was an enhanced version of the IEEE's 802.1q, and IGRP was an enhanced version of the IETF's RIP. John Chambers and Cisco executives will not be talking about EIGRP, ISL, or VTP, on the call, but proprietary routing and switching technologies are far more important to Cisco's future than any of the futuristic applications they will be discussing. For investors and observers, understanding the significance of these technologies is as important as understanding the significance of Windows if you're investing in Microsoft.

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