EXCLUSIVE: Here's What Happened When Cisco Lost A $US1 Billion Deal With Amazon

John Chambers frownBloomberg via Getty ImagesCisco CEO John Chambers

Next week, on Nov. 6,Cisco will finally show offwhat it hopes will be a game-changing product built from its super-secret startup Insieme Networks.

The product stems in part from a $US1 billion deal with Amazon that collapsed before it was finalised. Insieme is creating Cisco’s answer to a new technology called “software defined networking” (SDN).

SDN is a huge threat to Cisco because it changes the way companies build networks. It takes the high-end features built into expensive routers and switches and puts them into software that can run on cheaper hardware. Corporations still need to buy routers and switches, but they can buy fewer of them and cheaper ones. It also leads to all kinds of new startups based on networking software.

As we previously reported, Insieme is technically not part of Cisco, but a startup, wholly funded by Cisco with a $US100 million investment. If it does well, Cisco has an option to buy it for $US750 million.

But, make no mistake, Insieme is still Cisco. It’s new product is so important to the company that it will be introduced by Cisco CEO John Chambers, not Insieme’s CEO. Insieme is run by Cisco’s star engineers, Prem Jain, Mario Mazzola and Luca Cafiero, who have built other Cisco products via this “spin-in” (as opposed to spin-off) method including Cisco’s storage product and Cisco’s server.

But doing SDN as a spin-in was a controversial choice for Cisco. SDN isn’t a new area for Cisco. It is the evolution of the switching/routing market that Cisco currently owns with about 70% market share, according to Synergy Group. Doing this product as a spin-in ruffled feathers inside Cisco because it implied that top brass didn’t think its engineers were capable, sources told Business Insider.

As Gigaom’s Om Malik wrote at the time Insieme was announced:

Cisco which has made a fortune from selling routers and switches should be thinking about developing next generation platforms. The fact it can’t shows that as a company it has become addicted to the old way of doing things.

Now a source close to the company tells Business Insider why Chambers chose to do this as a spin-in. Two things happened.

The first was a deal with Amazon. Cisco thought it was going to sign $US1 billion deal for network gear for Amazon, one of the largest network deals ever, the source said.

Instead, Amazon shocked Cisco by buying only about $US11 million, using cheaper hardware and SDN for the rest of its needs, the source said.

The second was that Chambers asked his top executives to do an analysis on what would happen if Cisco plunged into the SDN market. They concluded it would turn Cisco’s “$43 billion business into a $US22 billion business,” our source said.

In other words, it would gut the switching/routing biz. Chambers was concerned that Wall Street would throw a fit if Cisco’s cash-cow hardware business was cannibalised by SDN.

In fact, Wall Street analysts are worried about that now. Last month, Credit Suisse First Boston released a whopping 121-page report called “Cisco Systems and the Software Defined Disruption.

The report says that SDN “threatens the most profitable part” of the hardware business, network gear. Analysts wrote:

“While the impact will take time, the threat will be very real, shrinking gross profit dollars for the industry. Irrespective of whether Cisco executes well in SDN environments, the company is in a vulnerable position amidst this transition.”

Cisco wouldn’t comment on the Amazon deal, but did deny that SDN will hurt its core switchin/routing business. It’s official position is that networking software will become an “incremental” business for Cisco that generates $US670 million for the company. So said Cisco CTO Padmasree Warrior in an April, 2012, blog post.

In comparison, Cisco’s brought in $US14.7 billion in annual revenue from network switch hardware in fiscal 2013. Plus it sold another $US8.2 billion in routers. Together these two hardware units make up over 60% of the company’s revenues, according to forms filed with the SEC.

The company also said that “investments in early stage companies aren’t unusual for Cisco. We currently have investments in companies totaling $US2 billion. Sometimes those companies are acquired by Cisco. Sometimes not.”

But Chambers doesn’t launch the products for all of those early stage companies.

Next week, the industry is expecting the Insieme product to be something that works with, and likely requires, Cisco’s expensive hardware. The idea would be to convince people to keep buying it, rather than replace it.

This might not fly with some of the nation’s biggest corporations. They are so excited about the new SDN technology, that a year ago, they started something called the Open Networking Group. This group is telling vendors how they want SDN products built. It’s run by companies with clout: IT professionals from Bank of America, Fidelity Investments, CitiGroup, The Gap.

If vendors don’t listen, other big users of networking technology are stepping in and building SDN hardware on their own. Google already famously builds its own network hardware.

Over the summer Facebook’s Open Compute Project agreed to build a SDN switch and share the design for that for free with everyone.

Disclosure: Jeff Bezos is an investor in Business Insider through his personal investment company Bezos Expeditions.

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