Cisco's jump into servers: It's just business

When times get tough, the companies that weather the storm the best are those who 1) have a treasure chest of cash on-hand and 2) are smart enough to invest in technologies that will leave them well-positioned for the recovery. Sometimes, it means rocking the boat and recognizing that there could be pitfalls along the way.

When times get tough, the companies that weather the storm the best are those who 1) have a treasure chest of cash on-hand and 2) are smart enough to invest in technologies that will leave them well-positioned for the recovery. Sometimes, it means rocking the boat and recognizing that there could be pitfalls along the way.

Case-in-point: networking giant Cisco Systems. The product that Cisco is getting ready to launch later this year - a computer server that combines networking and storage to allow business customers to better manage data centers through virtualization software - is sure to turn partners into competitors and disrupt the cycle that has long existed in the computer hardware business. Some are calling it a technology war, a showdown between Cisco and its big name partners, including IBM, Dell and HP. But it's just the evolution of business.

Technologies - like virtualization software from VMWare - have already been changing the way companies manage applications in their networks. The fact that Cisco is looking to jump into a new arena - servers - and disrupt the partner chain is a result of other dominoes falling first. In a e-mailed statement to Bloomberg, the company said:

Right now, we have virtualized local area networks, virtualized storage and virtualized servers. The challenge is integrating the management of those systems so they all work seamlessly. We think the network is the logical place to solve that challenge.

And apparently, so do Cisco's partners, according to a New York Times report:

When Carleton S. Fiorina was chief executive of H.P., she sat on Cisco’s board, and her executive team encouraged H.P.’s sales force to promote Cisco products ahead of H.P.’s own ProCurve networking gear. Under H.P.’s chief executive, Mark Hurd, that strategy ended. H.P. has made ProCurve a crucial piece of its growth strategy, priding itself on undercutting Cisco’s prices... I.B.M., meanwhile, has long had a strong relationship with Brocade around storage networking products, and I.B.M.’s labs are working on their own networking hardware projects.

Still, Cisco's jump into this business, while disruptive, won't obliterate the partners-turned-competitors. It will just send them into action to respond. In the meantime, investors might start thinking differently about Cisco, especially if the profit margins are severely impacted - a likely scenario. The Times piece notes that the business of selling switches and routers has been good to Cisco's investors, with profit margins of close to 65 percent - compared to the margins of 25 percent or so for companies selling basic servers. Sure, an enhanced server product will generate greater profits than basic servers but can the company bring the new products to the margin levels that are enjoyed now?

Regardless, Cisco - like so many other companies impacted by a global economic downturn - has little choice. It needs a boost. In November, Cisco beat Wall Street's estimates for its fourth quarter, topping the $10 billion mark in revenue, a 10 percent jump over the same quarter a year earlier. Yet, the rate of growth was also the slowest in three years.

Flush with cash, a company like Cisco could invest in innovation or jump directly ahead by acquiring companies that have already done the hard work - virtualization software company VMWare, for example.

VMWare most recently saw a 28 percent jump in profits and a 32 percent increase in revenue for its third quarter. But the Seeking Alpha blog notes that license revenue for that quarter was only up 15 percent from the previous year while maintenance revenues (support and updates) were up 70 percent. The blog notes:

Software companies charge their customers a maintenance fee to receive updates and support and are typically priced as a percent of the undiscounted license fee. It appears that VMW is discounting product licenses, but is not discounting maintenance fees, which are 18% of the license fee and is charged annually. Discounting license fees is typical when competition increases (BEA Systems did that too). This is a sign of weakness and implies that maintenance revenue growth will slow significantly.

VMWare reports its fourth quarter earnings next week.

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