With revenues declining amid product transitions and the threat of software-defined networking (SDN) looming large, Cisco (NASDAQ:CSCO) is simplifying its enterprise marketing model for customers. Instead of selling a number of individual products, the networking giant plans to bundle them into four different tiers of suites and market them as Cisco ONE Essentials, Cisco ONE Foundational Elements, Cisco ONE Advanced Application Services and Cisco ONE Advanced Security Services. Although aligned under the same Cisco Open Networking Environment (ONE) developer platform for SDN, each of the packages serves distinct use cases and can be licensed out on a suite-by-suite basis. Cisco said that it will still continue to sell products on an individual basis to customers who prefer it, but the products themselves will assume less importance over time as it promotes bundled licenses instead. The new strategy will be initially targeted at the three enterprise domains of data center, enterprise WAN and access networks, but Cisco plans to eventually transition to a similar licensing model for service providers as well.
Included in each of these bundles, and central to the revamped branding strategy, is the Application Policy Infrastructure Controller (NASDAQ:APIC), Cisco’s new software-based controller which was unveiled last year as a key component of its Application Centric Infrastructure (ACI) SDN offering acquired from Insieme Networks. Apart from simplifying pricing and branding, the new marketing approach should help Cisco better promote its SDN platform as it takes on rivals such as VMware (NYSE:VMW) and Juniper (NYSE:JNPR), who are hoping to disrupt the enterprise market by using software to reduce dependence on proprietary Cisco hardware. With SDN threatening to pressure hardware margins, Cisco’s new licensing model should also help drive a shift in revenue mix towards higher-margin service/software solutions and protect overall margins.
Cisco looks to tackle SDN threat with ACI
Although Cisco has been steadily losing enterprise market share to rivals, it still accounts for almost three-fourths of the $3.5 billion enterprise router market. In the much bigger market for enterprise switches, more than five times the size of the router market, we estimate that Cisco has a dominant share of about 70%. Having entered the market earlier than most rivals, the networking giant has built its market position on the back of long-standing customer relationships and a sticky enterprise base that is mostly reluctant to replace existing Cisco hardware with rivals’ due to the huge scale of transition that they would have to undertake. Additionally, the plethora of hardware products such as blade servers, IP phones, Wi-Fi access points and video conferencing systems that Cisco has either built or acquired, have helped it defend its turf by providing enterprises with end-to-end connectivity solutions.
The advent of SDN, however, threatens to significantly eat into Cisco’s market share as well as margins. Competitors such as VMware and Big Switch Networks have launched SDN products that create software-based network overlays on top of existing hardware, thereby decoupling networking-related intelligence from the hardware and commoditizing them. This makes networks programmable and scalable, and gives enterprises the flexibility to implement technology changes through mere software upgrades. What makes SDN even more appealing to enterprises is that it allows them to put third-party software on cheap white-label networking hardware, making it a lot cheaper to implement than installing Cisco’s higher-margin hardware products that come with embedded software.
However, the overlay approach, which most rivals are advocating currently, has its limitations. Since the network virtual overlay is not well coordinated with the underlying data plane, IT departments will have limited visibility into any problems that might arise in the network. Troubleshooting network issues could take a lot of time, decreasing the reliability of such SDN implementations and making it a deal-breaker for many large enterprises. Cisco’s SDN approach attempts to rectify this by making applications the center of all network-related decisions, allowing the data center to dynamically match resources with the needs of applications rather than the other way around. A key component of this ACI SDN offering is the APIC controller, which is the central network automation software and will now be marketed as part of its bundled licensing offerings.
Software and services assume more significance
By bundling products with SDN as the central theme, Cisco is not only looking to simplify the buying process for customers, but also pushing its ONE software-defined networking platform to the fore. This way, it is looking to drive talks with enterprises in a direction where its hardware products would not lose relevance in a new, SDN-dominated world. With its programmable software controller (APIC), Cisco has a strong SDN offering around which to consolidate its product portfolio and protect its hardware margins. In order to incentivize customers to try out its bundled offerings, the company has said that using its custom hardware with APIC could drive long-term cost savings of as much as 75%, as compared to other software-only networking solutions.
The licensing model also helps Cisco increase its focus on software and services, which have higher margins than the company average. Cisco’s service revenue as a percentage of product revenues has been growing steadily over the last few years, increasing from about 24% at the end of 2010 to about 29% in 2013. We expect this to continue going forward, as the company promotes its SDN offerings and leverages its recent acquisitions of NDS, Meraki, Intucell, Ubiquisys and Collaborate to improve its mobility and cloud service offerings. The increasing business mix of software should not only help Cisco prepare for uncertain conditions by bringing in steady and recurring revenues, but also contribute to its bottom-line growth. Cisco’s non-product gross margins are about 6% higher than its traditional product solutions, by our estimates, and an increased revenue contribution from software and services should help the company better defend its overall margins.