Cisco Systems Inc. (CSCO), the largest maker of computer-networking gear, faces fresh threats to its profit margins from a new breed of software that's helping customers handle data traffic with fewer switches and routers.
Technology from startups such as Arista Networks Inc., Big Switch Networks Inc. and Cyan Inc. is designed to help businesses run their computer networks more efficiently, lessening the need for the kinds of devices that make up most of Cisco's revenue.
Demand for cheaper ways to manage a rising flood of information over networks will propel software-related networking revenue to $17 billion worldwide by 2016, from $6 billion last year, according to Pacific Crest Securities. Oracle (ORCL) Corp. and VMware Inc. have used acquisitions to make forays into the market, fueling concern that Cisco's profit margin -- which slipped to 61 percent in fiscal 2011 from a peak of 70 percent about a decade ago -- will come under further pressure.
"It's a healthy shift," said Erez Yarkoni, chief information officer at wireless carrier T-Mobile USA Inc., in an interview. "I don't think Cisco keeps those 60 percent margins unless they start selling more software themselves."
Cisco, which is scheduled to report fiscal fourth-quarter results tomorrow, will have a gross margin of 62 percent for the year, according to the average of analysts' estimates compiled by Bloomberg. VMware (VMW) is projected to generate a margin of 88 percent this year, while analysts estimate Oracle will have an 80 percent margin for its 2013 fiscal year, which ends in May. Among peer companies on the Russell 1000 Index, Cisco has had the smallest average profit-margin growth over five years, data compiled by Bloomberg show.
Chief among Cisco's challenges is a nascent technology called software-defined networking, which lets customers program networks from one central console and do more jobs with fewer switches and routers. VMware made a foray into the market last month when it bought Nicira Inc. for $1.26 billion. Oracle announced plans a week later to buy Xsigo Systems Inc.
Wireless carriers that once deployed technicians to adjust cables on machines as traffic shifted can use SDN to reconfigure networks with a few clicks of a mouse, T-Mobile's Yarkoni said.
"Increasingly, it's less about chips and hardware, and more about software," said Arista Chief Executive Officer Jayshree Ullal, a former Cisco executive. "We saw that happen in servers and in storage, but it's taken decades for networking software to evolve. Now, you're seeing the next wave."
Arista, based in Santa Clara, California, makes most of its money from high-speed switches used by AT&T Inc. (T) and EBay Inc. to rapidly handle Internet traffic and by many Wall Street firms to trim microseconds from their high-frequency trading programs. The company uses open-source technologies that other developers can use to write applications for its hardware, a feature recently adopted by Cisco.
Ullal said the company has been profitable for the past six quarters and is searching for a new chief financial officer, often a precursor to an initial public offering. Arista is on track to bring in sales of $100 million to $200 million this year, according to two people familiar with the matter who asked not to be named because the information isn't public.
Cisco, recognizing the value of software, said in March that it will acquire NDS Group Ltd. for about $5 billion, adding programs that run cable set-top boxes, power digital video recorders and enforce copyright restrictions that prevent piracy. Chief Executive Officer John Chambers said at the time that Cisco is "moving to a more software-based model."
The company announced plans in June to publish instructions for developers to write programs running on its equipment. Cisco also said it will introduce an open-source central console capable of running hardware from other companies.
"We not only want to participate in this market, we want to lead," said David Yen, manager of Cisco's data-center group, in an interview.
Cisco also was in talks to acquire Nicira, and was outbid, two people with knowledge of the matter said.
Even as Cisco expands in software, Padmasree Warrior, chief technology officer, has downplayed the potential for networking startups to curb demand for switches and routers.
Software innovations "are not going to commoditize the underlying networking infrastructure," Warrior said in an Aug. 2 blog post. "These architectures actually place more demands on the core infrastructure."
The technology can also provide alternatives to Cisco's hardware. Cyan focuses on phone carriers that need to keep pace with soaring Internet traffic. Cyan's machines combine routing features in optical gear that transports data within cities, so traffic such as e-mail between neighbors doesn't need to go through a router to reach its destination. The Petaluma, California-based company also makes stand-alone software that customers can run on other suppliers' routers.
Cyan's revenue will approach $100 million this year, according to two people familiar with the matter. Mike Hatfield, founder and president, declined to provide sales figures, though he said revenue has doubled in each of the past three years.
"We're at the scale that we can be a public company," Hatfield said in an interview. "We're going to monitor when the right time is."
TDS Telecommunications Corp., a phone provider in rural U.S. communities, has been using Cyan's gear for more than two years, said Ken Paker, vice president of engineering and architecture.
"We're not putting routers into places we otherwise would have," Paker said. "People talk about replacing routers. We talk about avoiding putting more in."
Omar Baldonado, another former Cisco executive, heads product management at Big Switch, a Palo Alto, California-based provider of open-source tools for making networks faster and more affordable to operate. Its programs act as a central console, so data center operators can easily control hundreds or thousands of separate pieces of networking hardware.
Nicira makes technology to help networks run more efficiently, helping companies cut hardware costs. Xsigo gives Oracle technology to simplify cloud-based computing over the Internet and let customers connect any server to any network, reducing hardware needs. Oracle paid about $200 million for the company, a person familiar with the transaction said.
Big Switch, the closest competitor to Nicira, is likely to be acquired soon, said Brent Bracelin, an analyst at Pacific Crest Securities. Potential suitors include International Business Machines Corp., Oracle and Dell Inc., he said.
Arista could be bought for more than $1 billion, drawing interest from the same companies that might consider Big Switch, Bracelin said.
Cisco, for its part, might snap up storage companies such as NetApp Inc., he said. Cisco could also deal with competition by pushing into the same kind of networking software offered by startups, said Simona Jankowski, an analyst at Goldman Sachs Group Inc., in a research report.
Networking software could spark the development of thousands of powerful new ways for companies to get more out of their networks. Since software is much more profitable than hardware, "this could be phenomenal news for Cisco," said T- Mobile's Yarkoni.
"Now they have to pick up the ball and run with it."