The TSC Streetside Chat: Carl Russo of Cisco

With Nortel's (NT Quote - Cramer on NT - Stock Picks) emerging dominance in optical networking, the telecommunications designed to enable massive growth in voice and data traffic, networking king Cisco (CSCO Quote - Cramer on CSCO - Stock Picks) finds itself in the unusual position of picking its spots, rather than taking the competition head-on.

This has caused Cisco, a ferocious competitor that is often seen by rivals as arrogant, to take an uncharacteristically humble approach to this new yet highly valued sector of the telecommunications-gear market. In a recent discussion with TheStreet.com's Scott Moritz, Carl Russo, Cisco's chief of optical networking, described that approach while tempering investor expectations about recent acquisitions.

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TSC: When Cisco acquired Cerent in November, you came with the package and effectively took over the helm of Cisco's optical networking operations. I realize you came into the picture less than a year ago, but from what you know, why did Cisco respond only recently to the optical networking opportunity?

Russo: I think the challenge with any company that addresses a new space is that it takes you a while to look at it and figure it out. Is this real or isn't it? Can we address it? How do we address it? Do we acquire or do we build internally? All those questions you grapple with. And, at the end of the day, the Cisco leadership team and the board came to the conclusion that this was a strategic imperative for the company and that it was going to go be in this space, and be in it to be effective.

And I think Cisco generally, when it chooses to play in a space, chooses to be No. 1 or No. 2 in any market. But this market is so huge, you just don't go and become No. 1 or No. 2 overnight. So, as long as you take a growth approach and recognize that it's a large market and you're willing to make the investments and play for the long term, it's a great market to be in.

TSC: I'm not sure if this is a fair question, but in light of Nortel's two-year head start in optical networking, why do you think Cisco saw the same opportunity and moved to get to a place that's clearly very important right now?

Russo: Well, I think it's an entirely fair question, but we have to be careful that we're not too revisionist, right? If you go back 10 years, optical networking was a nascent market all its own, and it was only going on in the telecom space, not in the data communications space. That's two separate customer sets, and two utterly separate equipment-provider sets. What's changed that, fundamentally, is the Internet. The telecom business has been growing at a relatively pedestrian rate, based upon voice traffic growth of 5%, 10%, 15% per year, for a number of years.

The Internet comes along and it's growing at a phenomenal rate. I think the figures that are currently being used are a doubling of traffic every four months.

Now all of a sudden the telecom folks have to take on -- in essence -- attributes of data networking. And for the data-networking folks who already had those attributes, it would be foolish if they didn't look at the telecom market and say, "Wait a minute, we know all about data networking. Let's go address this telecom market."

To bring this all the way back to your question, the next space, which is the optical networking space, is simply the next step as you come in from the edge of the network. Which if you think about where Cisco has traditionally been strong, in the corporate data-systems business, the first place that they would go to sell to service providers would be at the edge. "Cisco, generally, when it chooses to play in a space, chooses to be No. 1 or No. 2 in any market."

TSC: Clearly, demand for bandwidth and the sheer economic advantage of running traffic over light waves rather than electronic pulses are driving the emergence of optical networking, right?

Russo: Well, yes. The challenge is that the pages you're pulling down are content-rich, and they're gluttonous consumers of bandwidth. What the optics do is make small pipes big pipes.

TSC: Let's assume the ultimate goal here is to provide optical products for every part of the network, so that all this Internet traffic can travel in the most economical manner. Does Cisco have an all-optical portfolio yet, and, if not, where do you think you'll need to fill in?

Russo: Well, let's back up. The network will never be -- certainly not in my lifetime -- all optical, because you will have to examine the packets to understand where they need to go.

You really have two segments of the network: One is the core, which hooks up all of the big switching centers into a big mesh, and the other is the metropolitan network, which backhauls all the traffic to those switching centers.

The backhaul network will be optical, the core network will be optical, but, in between, you'll have a very big electrical interconnect, which is basically a switching [connection]. You'll come to the interconnect optically, and you'll leave the interconnect optically, but in between it will be handled electrically.

So with that in mind, the answer is yes, we intend to have a full portfolio of optical products throughout that network. What we don't intend to do is build me-too optical products to go into existing markets that are not going to undergo any change.

TSC: Give me an example of that.

Russo: Sure. In the core of the network, the backbone of the network, they're building OC192 -- 10-gigabit-per-second transport equipment. That market is probably 90% or more held by Nortel. They built the OC192 systems many years ago when nobody was looking at OC192 as even being viable. They went ahead and built them, and they own the market today because of that decision.

What's happening at the core, however, is that we're moving from rings to meshes, and as we move to meshes, that equipment that we just talked about, it doesn't play.

TSC: The SONET [synchronous optical network, the current network standard that is seen in some cases as a bandwidth hog] equipment?

Russo: The SONET ring-based equipment will only function on a ring. But as you move toward a more mesh-oriented architecture, you need new equipment.

TSC: Essentially you're talking about WDM [wave-division multiplexing, which saves bandwidth by breaking light into component colors], then?

Russo: It's not just WDM, it's also the notion of the topology of the network. And specifically, rather than have anything shaped in rings, you have things that are shaped in a mesh. And so what you're actually doing is building an entirely different topology.

As those topologies change from rings to meshes, it enables a customer to buy a new piece of equipment, from, potentially, a new vendor. And that's our market entry point to that network. If we intend to be a sustained, long-term player, the best thing that we can do is to pick our entry points, make sure we have the best product to go into that point. "The next 10 years are going to be about utterly radical economics."

TSC: What is this product you're talking about and where does it sit in the network?

Russo: We're going into the core optical networks with a product called the ONS15900; that product came through the acquisition of Monterey. Specifically, it's referred to as the wavelength router.

I don't know that we've done a very good job of helping the outside world understand this: We're not trying to take on all comers at all times with all products. There are specific places where we think we can enter and be competitive and be successful, and move to next-generation networks. Selling a product that's a me-too is not a good entry point. Because, obviously, a customer will say, "I'm already buying this from a vendor, why do I want to switch?"

TSC: So at this stage in the optical game, Cisco can't go head-to-head with the competition but instead has to pick its points of entry?

Russo: Oh, this game is just starting. All of this change is being driven by the Internet, and this change is just starting. So it gives us a huge opportunity to go attack it.

The last 10 years of development in optical technology have really been about incremental economics and incrementally improving your equipment. The next 10 years are going to be about utterly radical economics.

Because, if you can envision something that used to be growing at 10% a year that's now growing at 10 times a year, an incremental approach no longer works. And so this is why I say a new game is just starting.

TSC: One of the challenges I guess you've faced is that you sell to a crowd that really prefers incremental change vs. tossing out their legacy systems and starting fresh. How have you handled that?

Russo: Two ways. By making sure that, first and foremost, we sell to the next-generation network start-ups.

The second part of your question is how do you go and approach the incumbents? And the way you approach the incumbents is by truly building products that enable them to migrate to these networks at whatever pace they choose.

For example, our Cerent product is sold to both groups. The incumbents like it because it can be used inside their existing networks today, and yet it gives them an ability to migrate those networks to a more data-intensive future. But you are clearly not going to go and build an end-to-end network for a large incumbent carrier. I mean, Cisco's not going to walk in and sit down with Bernie Ebbers, CEO of WorldCom, and say, "Now look, we're going to build end-to-end networks. Please rip out all your stuff and let's put in some new stuff." "All of our optical equipment is built to standards that no one else builds their equipment to."

TSC: That's a good segue to my next question. John Roth, president and chief executive of Nortel, has said that Nortel can learn to spell [Internet protocol] faster than Cisco can learn to spell reliability. How do you respond to the critics in the phone camp who say the data camp can't deliver high-quality, "carrier-class" voice service?

Russo: That's a great question. But here's the answer: It's the wrong question and let me explain why.

First off, we are striving for high reliability. All of our optical equipment is built to standards that no one else builds their equipment to. And so he may be right, that Cisco, per se, may or may not be able to understand how to build that equipment. But Cisco does a very good job of acquiring and integrating companies that do.

Here's the real issue. How reliable is cellular service? Has cellular growth suffered as a result?

We are willing to sacrifice reliability because we get something back. In wireless, it's mobility: pervasive mobility.

When you look at the Internet, what you get back is incredible content, and the growth rate has been utterly unimpeded by any reliability issues. Reliability continues to improve, but I suspect the question is not as germane as everybody thinks.

TSC: Great. Let me shift gears a little bit.

Acquisitions. Cerent, as you fully demonstrated, has been quite successful, and I know you're on a billion-dollar run rate for the year. Pirelli and Monterey seem to be a question. Will we see products from Monterey sold this year? And what about Pirelli, what's the status of any products coming from there?

Russo: The Pirelli systems are doing quite well, and growing quite fast. But I think when we did the acquisition, it was assumed we were going to go after the large, existing networks. But we never actually intended to do that. So shame on us for not communicating that.

TSC: So do you see a product coming out of Pirelli in the near future?

Russo: There's a future product road map that we believe to be quite healthy.

TSC: Do you have any kind of run rate on Pirelli products?

Russo: Not that I would be willing to share. Suffice it to say in our optical products, the second-largest sales would be Pirelli.

To swing over to the Monterey system, here's another example of where I think we did not correctly set expectations in the marketplace. It's a long sales cycle, it's a long testing cycle, and so, from a revenue standpoint, we don't anticipate recording revenue before the end of the year. "It's a wonderful time to be in this industry."

TSC: Have you run into any problems retaining some of the talent, the folks who would help you integrate the Pirelli and Monterey products into your own?

Russo: The retention issue has been, I think, better across the optical space than Cisco's average on acquisitions, and the Cisco average on acquisitions is phenomenal.

Let me give you one example: Cerent. We're approaching 500 employees and we've lost only five.

I'm actually tremendously encouraged by the overall rate. It's almost the esprit de corps that exists inside the optical group inside of Cisco. There is this sense that we can go out and change the world. I know that sounds a little too cliched, but, to know you can render the Internet and all the advantages and benefits that it has, that's pervasive. It's a wonderful time to be in this industry.