It’s common knowledge in the close circles of the optical module business that Cisco (CSCO) has built an extremely profitable business on the backs of optical module companies. What is not appreciated is its magnitude and the corrosive impact it has on the profitability of the optical module business.
The over investment of the optical boom created a large glut in optical module manufacturing capacity. This glut remains and is fueled by too many second tier suppliers that remain sufficiently capitalized to continue operations despite the fact their core business is unprofitable. Industry consolidation has yet to take place and until it does module suppliers will face a hazardous pricing environment. The problem is compounded by the fact that though there are too many suppliers, only one customer accounts for the majority of unit demand. That customer is Cisco.
Cisco dominates the market for Ethernet Switching equipment with a 60% market share. As a result, they dominate the supply chain for components used in those applications. We estimate that Ethernet optical modules account for 90% of module unit volume, and that Cisco purchased 6.1 Million of the 8.7 Million optical modules (70%) used in Gigabit Ethernet applications in 2005. As a result, Cisco is in a strong position to control supplier pricing, guide R&D investment, dictate contract terms, and control the destiny of small supplier firms.
A monopsony is a market situation in which the product or service of several sellers is sought by only one buyer. Cisco has established a monopsony in the market for certain optical modules that represent the vast majority of unit volume in the module market.
Pricing pressure on optical module supplier margins has been extraordinary. No other component industry has been squeezed as hard by Cisco’s much respected Global Supply Chain Management (GSM) organization.
Finisar and Avago sell short reach modules in large volumes to Cisco for $25, netting out around $5 in gross profit on each module sold. Cisco then resells this module (which has been pre-packaged and labeled for Cisco by Finisar/Avago) for $150 to $300, depending on the customer. Cisco has added no value to the product yet extracts a gross profit 25-50x greater.
Cisco has shrewdly built a high margin business reselling these optical modules to customers. The resale of standard form factor GBIC, SFP, and XENPAK modules was responsible for $0.26 (25%) of Cisco’s FY06 earnings, and accounts for the majority of Cisco’s operating income growth since FY04.
Virtually all of the value created by optical module manufacturers is monetized by Cisco. A reversal of this trend would be incredibly positive for module makers and quite debilitating to Cisco’s earnings growth.
Suppliers of lower-end commodity modules (the market Cisco controls) will find it difficult to realize higher margins on incremental revenue until the Cisco monopsony is broken. We believe this monopsony can only be broken through further consolidation and vertical integration of high volume module suppliers.
While the resale of optical modules does create real profit and cash flow today, it is not representative of Cisco’s generally perceived core competencies and its ability to generate long term returns on invested R&D. Significant unseen risks exist that could negatively impact Cisco’s ability to sustain 90% profit margins in this business unit. The next Michael Dell may sell optical modules.
Investors and the market are currently unaware of the earnings risks posed by a potential unraveling of the Cisco optical monopsony.
We examine these risks and their financial impact in this report. Detailed pricing, volume, and margin estimates for Cisco’s optical modules are included. This data is coupled with Cisco’s historic operating results to illustrate how this resale business impacts Cisco financials. The report also examines future technical and market risks to the profitability of this business and the resulting financial impact.
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