Nyquist Capital

The Landscape

The overinvestment 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.

The Catalyst

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 (Wikipedia Link) 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.

The Result

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.

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.

The Future

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 Report

Investors and the market are currently unaware of the earnings risks posed by a potential unraveling of the Cisco optical monopsony. We will 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 profitabilty of this business and the resulting financial impact.

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• Length: 22 Pages. All Signal. No Noise.
• Cost: $2500. Includes telephone Q&A.
• Table of figures
  1. Optical Module Consumption – Ethernet Applications
  2. Internal view of SFP Module
  3. Insertion of Pluggable Module
  4. Cisco GBIC Module
  5. Cisco SFP Module
  6. X2 Module
  7. XFP Module
  8. Cisco Catalyst 4500 User Guide (LINK)
  9. Cisco Gross Profit from Optical Module Resale
  10. Cisco Revenue Breakout w/module profit overlayed
  11. Percentage of Reported Cisco Operating Income attributable to Optical Module Resale
  12. Summary: Operating Impact of Module Resale Business
  13. Cisco FY07 EPS Impact of Module Revenue Erosion
  14. Cisco’s Annualized Financial Performance w/ and w/o modules
  15. Gross Profit by Module Type
  16. Cisco Optical Module pricing vs. Clones
  17. Non-GAAP Cisco P&L with Module Business Breakout
  18. Total Cisco Optical Port Shipments
  19. Optical Module COGS and ASP assumptions
  20. Synthesis of P&L Values for Optical Module Activity
  21. Cisco Gross Profit from Optical Module Resale
  22. Cisco Revenue Breakout w/module profit overlayed
  23. Percentage of Reported Cisco Operating Income attributable to Optical Module Resale
  24. Summary: Operating Impact of Module Resale Business
  25. Cisco FY07 EPS Impact of Module Revenue Erosion
  26. Cisco’s Annualized Financial Performance w/ and w/o modules
  27. Gross Profit by Module Type
  28. Cisco Optical Module pricing vs. Clones
  29. Non-GAAP Cisco P&L with Module Business Breakout
  30. Total Cisco Optical Port Shipments
  31. Optical Module COGS and ASP assumptions
  32. Synthesis of P&L Values for Optical Module Activity