Did We Mention How Great Our Servers Are?

During an otherwise dour earnings call with Wall Street analysts on Feb. 10, Cisco Systems (CSCO) executives uttered the phrase "data center" 29 times. It was, in part, an effort to keep attention on server sales, which are growing fast as corporations and phone carriers build massive data centers to handle increased Internet traffic. Sales of Cisco's Unified Computing System servers, introduced in early 2009, were up 700 percent last quarter and are on pace to hit $650 million this year. "The data center evolution is playing out as we anticipated," said Chief Executive John T. Chambers.

The trouble is that $650 million is just 1.5 percent of Cisco's expected revenues of $43.7 billion this year, and it is facing unfamiliar pressures in the other 98.5 percent. Once known for its spookily consistent ability to deliver a penny more in earnings per share than Wall Street forecast, Cisco has missed expectations three quarters in a row. After twice coming up short on revenues, profit margins fell to 62 percent last quarter, below the company's guidance of around 64 percent. It also has been losing share in some key markets, including cable set-top boxes and its mainstay router business. Spooked by un-Cisco-like uncertainties, investors drove the stock down 14 percent after the earnings call, and it has yet to recover.

Cisco sees the $50 billion server market as one of its most promising growth opportunities. Its UCS servers are part of Cisco's so-called network-centric approach to building data centers. Cisco says pairing the UCS with the company's line of Nexus switches will let data center operators get by with one-third less gear. (With this setup, the network becomes like an omniscient traffic cop, assigning tasks far more efficiently.) That saves on data center space, power bills, and operating costs.

But servers won't bring relief to Cisco shareholders any time soon. Cisco had less than one percent of the server market in the fourth quarter, according to researcher Gartner. And the company is paying a surprisingly high price for admission into the market. Analysts say Cisco has given away many servers to win traction with customers used to buying them from Hewlett-Packard (HPQ), IBM (IBM), and Dell (DELL). That's one reason for the decline in profit margins in the recent quarter. It's also the reason for some competitors' taunts: "We don't typically give away many servers—because we don't have to," says Forrest Norrod, general manager of Dell's Data Center Solutions unit. Cisco spokesman Lee Davis says Cisco loans UCS servers, but not permanently.

Cisco's move into servers has turned HP and Dell—and to some extent, IBM—from partners into competitors. The trio used to sell billions of dollars of Cisco's networking gear each year as part of their big corporate contracts. Now that Cisco is a rival, all three are pushing alternatives. (IBM's consulting arm continues to sell Cisco gear to customers who request it.) And HP has moved aggressively into Cisco's home turf by acquiring 3Com, the networking gear maker. "It's the first time in a decade [Cisco] is seeing the level of competition they're seeing now," says HP Senior Vice-President Marius Haas.

Padmasree Warrior, who runs Cisco's massive corporate technology business, says the company gained 1,000 new UCS customers in the fourth quarter, nearly tripling the number from the previous quarter. While most have been small or mid-sized companies, she says accounts with large corporations—where most profits lie—are now picking up. Cisco is known for having one of the most aggressive, effective sales and marketing teams. It has 740 salespeople and a growing number of resellers devoted to servers. "There are a lot of doubters out there, but they've done a good job," says Jere Brown, CEO of Data Dimension Americas, a large technology distributor.

Gaining share in servers, which have margins roughly half what Cisco is used to, is not an end in itself. Chambers's intent is to use servers as an entry point to persuade customers to also buy its networking and storage products, as well as consulting services. Stephanie Carullo, senior vice-president of data center sales, urges patience. "We've been in this for 18 months, not 45 years" like some of Cisco's competitors. "I think it's not a bad achievement."

The bottom line: Networking king Cisco is trying to dominate data centers by aggressively marketing servers and offering loaners to customers.

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