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By | Timothy Prickett Morgan 23rd May 2011 05:00

Why Cisco should merge with Dell

Disco – A real data center powerhouse

Comment Cisco Systems has unleashed a world of hurt on its shareholders, masquerading as a consumer company that sells Flip phones, Umi telepresence, and Linksys routers. There's nothing wrong with selling gadgets to consumers. Apple does it brilliantly, and profitably. But Cisco isn't Apple.

In a sense, Apple might be a place where Cisco can find comfort in its time of trouble. People forget how screwed up Apple was in the 90s. The fact that Apple turned itself around can provide a ray of hope to Cisco shareholders and the company's beleaguered CEO, John Chambers. If Chambers can keep his job.

Server and PC marker Dell has also had its share of problems in recent years – accounting scandals, poor sales execution, exploding products – but of late, it has been on the upswing. It has had some success building custom servers for hyperscale data centers. It bought its way into the storage racket proper instead of just reselling other companies' kit (LSI and EMC, mainly). And it moved into services with its Perot Systems acquisition.

The rub is that Dell's networking business is no more real than its storage business used to be. It is merely rebranding kit from Brocade and others. Until Dell fixes that, it will not be a credible infrastructure stack player.

Meanwhile, Cisco has done a remarkable job building a server business out of nothing with its "California" Unified Computing System blade and rack servers – and with a fair amount of actual engineering – but it is not a profitable volume manufacturer any more than IBM was. Big Blue couldn't cut it in printers, memory, disk drives, and PCs, and Cisco is having trouble with anything other than core switches and routers.

One could argue that Cisco should not have entered the server market at all, but that is an over-simplified view. No doubt, the move into servers has not only annoyed Cisco's former partners in the server business, but compelled them to start selling their own networking products, either rebadged (from Brocade, Juniper, or Blade Network Technologies) or built with the help of ODMs (Sun and now Oracle does this, and so does Dell).

Switch hitch

Hewlett-Packard has had a switching business for decades, and the company, like Cisco, predicted that over time, server and storage networking would converge and virtualize. This is the consensus view now among all server and network equipment makers these days, but it was probably a radical view years ago when Cisco hatched its plans for Project California. Once Cisco figured networks would converge and flatten, it had no choice but to enter the server space.

That flattening has been more of a problem than server-storage convergence. Cisco bought its way into switching, and convinced customers that the best way to build networks was with three tiers: an access layer, a distribution layer, and a core layer. But as companies go to build clouds of all types and styles, they want to get rid of that middle distribution layer and use leaf-spine architectures that are cheaper and, quite frankly, scale further and with less latency on fewer hops from server to server or server to storage.

This, more than anything else, is what is hurting Cisco's switching business. Mellanox, Juniper, Brocade, Extreme Networks, Arista Networks, and IBM can make faster and lower-cost top-of-rack switches, and there are cheaper alternatives to Cisco's end-of-row plain-vanilla Catalyst 6000 and converged Nexus 7000 switches.

Chambers may believe that the price/performance of the Nexus 7000 compared to earlier Catalyst products is what is driving Cisco's switching biz down. But it is probably more accurate to say that Cisco's prices are too high relative to the competition, which is like a swarm of piranhas around the juicy Cisco carcass that has fallen into the Amazon.

Maybe Cisco should have not bragged about its router and switching hardware margins quite so loudly? You sow the seeds of your own destruction. Or, perhaps, resurrection.

Cisco's entry into the server market in March 2009 caused the server makers to get their networking acts together, or at least make an attempt at it. And this will presumably be good for customers, although I would say that tightly integrated stacks usually tempt vendors to milk their customers.

Think IBM's AS/400 midrange customers, who paid for every point of market share that Big Blue gained in the Unix racket in the past fifteen years with exorbitant hardware and software pricing, or IBM's mainframe customers, who pay felonious prices for their hardware and software because they really don't have another choice.

Cisco's two choices

Assuming that integrated stacks are good for vendors, and knowing that Cisco is in the middle of reorganizing itself and has said it will only stay in markets where it can be the number 1 or 2 player, then Cisco has two choices. It can sell off the UCS business and get out of the server racket, rebuilding bridges that it burned with the California machines and offering to provide integrated networking for IBM, HP, Dell, Fujitsu, and Oracle machines. Or, it can merge with Dell and actually become the number two server maker.

Cisco might be able to buy Dell, since it has $6.6bn in cash and $36.7bn in marketable securities. Even after a nice run-up in its stock last week after reporting much-improved profits on slim revenue growth, Dell has a market capitalization of only $30.5bn. Dell has $7.71bn in debts and $14.5bn in cash and equivalents, so that works out to $6.77bn of cash net of debt.

To my way of thinking, that means the underlying stock in Dell is worth only $23.7bn, but I am sure there are plenty of people on Wall Street who would argue that Dell has an enterprise value of closer to $40bn, and therefore an acquisition price of something more like $50bn.

Good luck trying to get that, even for a company that should bring in maybe $66bn in sales in its fiscal 2012 ending next January. Cisco might pull in something on the order of $44bn over the same term, so the combination would generate a $110bn IT powerhouse that would rival HP and IBM.

To do such a combination, Cisco and Dell would be wise to conserve their cash. They could pay out a big cash dividend to get shareholders on both sides of the deal excited about a merger. Chambers can be chairman of the combined company, and Michael Dell can be the CEO, and someone – make Steve Schuckenbrock of Dell and Gary Moore of Cisco wrestle for it – can be COO. Whoever loses runs the combined Dell+Cisco services business.

Dell would take over Cisco's nascent server operations and Cisco would take over Dell's equally juvenile networking business. There are plenty of executive VPs laying around the two companies to run the various units. They could think about whether or not they want to be in the PC business at all.

Let's call it Disco

What might Disco look like? It would have about $2.3bn a quarter in server sales, and probably something on the order of $500m in storage revenues per quarter that would very likely grow to around $1bn a quarter in fairly short order. Switching, once rationalized, would probably stabilize at around $3.5bn a quarter, and routing, where Cisco is not facing such staunch competition, would rake in about $2bn a quarter. If the combined company decided to sell PCs – rather than sell off the PC biz to a very eager Acer – then it could probably count on $4.5bn to $5bn a quarter in laptops and notebooks and about $3bn to $3.5bn per quarter on desktop PCs.

Dell's side of the server biz accounts for around $2bn in revenues per quarter, and Cisco is in the same range. There's another $1bn or so in Dell's software and random peripherals, and Cisco collaboration products and services would make up the balance of the Disco's $21bn in product revenues. Let's say the combined company can eliminate some back office overlap and data center costs (assuming Perot Systems can run data centers leanly), then the company could squeeze out some incremental profits.

The combination of Dell and Cisco would be able to peddle stacks of routers, switches, and custom servers to hyperscale data centers and service providers in one fell swoop. Similarly, Dell could converge the technologies in the UCS and PowerEdge server lines, and present enterprises with a single, integrated stack.

And in keeping with Dell's open tendencies, there is no reason to boot VMware's hypervisor or cloud extensions off the converged machines or standalone boxes, but it would probably be smart to back the KVM hypervisor and the OpenStack controller as the preferred cloudy software layer for the DEll+Cisco machines. Once OpenStack gets a virtual switch – the Open vSwitch is the obvious one to choose – neither company would need VMware, but could, of course, continue to sell whatever customers wanted.

You'll notice that I didn't mention the "Project Acadia" Virtual Computing Environment alliance between Cisco, EMC, and VMware and how the Disco merger might affect this alliance. It would kill it, dead. Such a three-way sales and marketing unit is tough to fly and runs counter to how IT vendors like to operate. They like to have control of one area, and they don't share well. That doesn't mean VCE is doomed or bad, but rather that it is just unnatural and requires coordinating the efforts of three companies with monstrous egos.

If there is a problem with the Disco combo, it is that the merged companies would have the same problem as HP: too much lean commodity hardware and not fatty software. Maybe the smart thing for Disco to do, then, would be to buy Red Hat with that big pile of cash. Red Hat has a market capitalization of $8.8bn and $860.6m in cash. Such an acquisition would be thinkable and doable for Disco.

If you give a mouse a cookie, he'll want a glass of milk. ®

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