AT&T and Cisco: A Bandwidth Bonanza

The two telecoms have cemented a deal in which AT&T will buy core routers from Cisco to upgrade its communications network. It's great news for Cisco

When AT&T went shopping for high-tech gear to soup up its communications network with advanced video, broadband, and voice services, it turned to long-time supplier Cisco Systems (CSCO). On Dec. 10 the nation's largest telco announced a deal that could be worth up to $500 million to Cisco over the lifetime of the upgraded AT&T network, according to Jim Kelleher, an analyst at Argus Research.

What's noteworthy isn't simply the size of the deal but the vast amount of bandwidth it represents. When Cisco brought out its top-of-the-line router in 2004, many analysts felt it was so powerful that only a handful of companies would ever buy one. Now, AT&T (T) plans to link 25 cities with these mighty machines to help it handle the rising tide of Net traffic—particularly video. This bodes well for a Cisco unit that has traditionally brought in a steady 25% of networking giant's $34 billion sales.

Now other telcos and cable companies, located everywhere from Korea to Bulgaria, are flooding Cisco with orders—and helping realize its dream of conquering the telecom market, long a domain of Alcatel-Lucent (ALU), Ericsson (ERICY), and Nortel (NT). Cisco's service provider business finally had a major growth spurt this year, shooting up to nearly 30% of overall sales. To put this in perspective: Cisco's carrier revenues are nearly as large as all of Nortel's. And service provider sales "could grow another percentage point or two [as part of total sales] next year," says Eve Griliches, an analyst with consultancy IDC (IDC).

Why is Cisco on such a tear? It enjoys a far broader product line than most rivals, both for the basic routers that carriers need to run their networks and for related products, such as Scientific Atlanta cable TV set-top boxes and pricey videoconferencing systems, that can be resold by carriers to consumers and corporations.

Huge Implications

Thanks to all this activity, Cisco has been grabbing market share. Its piece of service provider sales has grown from 7.5% to 8.4% between the second quarter of 2007 and the same period last year, according to IDC. That growth has come at the expense Alcatel-Lucent, establishing Cisco as the world's fourth-largest equipment provider for carriers, a bump from No. 5 last year. As telcos jump into video services, they're replacing separate voice, data, and video networks with a single one based on Internet technology. "Cisco has become a lot more relevant," says Tony Bates, senior vice-president and general manager of service provider technology at Cisco.

The quick growth of its service provider business carries huge implications for Cisco. In a world in which more and more computing occurs out on the Internet as opposed to inside PCs and corporate networks, the companies that handle all the communications needs—carriers and cable companies—become increasingly crucial.

But Cisco also wants to sell to consumers that want to buy gear directly, rather than rely on carriers. It's a question of so-called channel conflict. Cisco is well-positioned to reach consumers in both ways, either by striking a deal with your local phone or cable company or by selling you gear at the local Best Buy (BBY). Many analysts think the latter will become more popular, as a generation of Web-savvy consumers seeks to create their own Internet experience rather than pay a big monthly bill for premium services from carriers. Cisco's challenge: how to go after this direct business without ostracizing its carriers, which are banking on selling those premium services to avoid having to subsist on selling basic connections at commodity prices.

Witness the company's recent behavior as evidence of this conundrum. For years, Cisco has been working to build a consumer brand of its own, as familiar to children and grandparents as Intel (INTC), producing chips for PCs (BusinessWeek.com, 5/10/07).

Cisco Should be Cautious

But several sources say the company has yet to decide on a product strategy to back it up. Earlier this year, Cisco seemed poised to move ahead with a slate of new products to be sold direct to consumers. Now that effort seems to have slowed down—in part over concerns from people at Cisco's Scientific Atlanta unit, which relies solely on sales to carriers.

To be sure, Cisco needs to tread carefully. Whenever a big phone or cable company wants to roll out a new service, the company gets a lucrative twofer: Not only do new services require the purchase of new kinds of gear but they also require an upgrade of the basic Internet infrastructure to handle all the additional traffic.

AT&T, for example, will buy the new CRS-1 routers that can each cost $1 million or more to build out next-generation broadband networks. Such routers can be thought of as traffic cops, directing packets of transmitted data where to go and when. And by putting such vast bandwidth in place, AT&T will have the room for new services its marketers dream up. Sales of routers and switches alone for such new networks based on Internet Protocol (IP) exceeded $7.6 billion in 2006 and will nearly double to $14 billion by 2011, according to IDC—making this sector one of the fastest-growing equipment markets around.

Cisco's Innovations

The carrier relationships could also lead to higher sales to corporate and government customers, Cisco's bread-and-butter market and 70% of sales. As business networks get more complex, their owners are outsourcing a greater part of their management to carriers like AT&T, explains Kelleher. If AT&T is happy with its own CRS-1 gear, "they'll act as a dealer of Cisco's equipment," he says.

To win carrier goodwill, Cisco is making it easier for carriers to tinker with software that comes with its equipment, so that the service providers can create nifty custom applications and video services. The company is also expected to unveil several new set-top boxes in 2008, allowing people to move video more easily from one room of the house to another and to take phone calls right on the TV (BusinessWeek.com, 12/13/07).

Cisco may also introduce a new, so-called edge router, moving smaller chunks of data along the telecommunications network. While the CRS-1 routers haul massive amounts of Net traffic between major cities, edge routers pull it off these interstates of the Net and deliver it to the company, home PC, or cell phone it's meant for. With so many regions of the world receiving a growing variety of services, this is where much of future innovation and growth is expected to occur. "Eventually, it will be a very good sales boost," Griliches says.

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