IBM Cedes Network Hardware Game to Cisco

The deal gives IBM a way out of the network hardware business, which has been a loss leader for Big Blue for some time.
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SAN FRANCISCO -- Firming their friendship,

IBM

(IBM) - Get Report

is handing

Cisco

(CSCO) - Get Report

the keys to its network-hardware business.

Big Blue said Tuesday morning it will stop making the routers and switches that run computer networks. Instead, Cisco will buy IBM's patents and move its estimated 30,000 customers to Cisco gear.

Steve Milunovich, an analyst with

Merrill Lynch

, estimates that Cisco is buying the rights to IBM products that brought in annual sales of $375 million to $450 million. Cisco's revenue totaled $12.2 billion in its fiscal year ended in July. But the deal potentially will boost Cisco sales by as much as $5 billion over five years, according to Cisco senior vice president Selby Wellman.

The deal is the latest effort by Cisco to strike partnerships that can furnish its customers with service and support. Early this month it invested more than $1 billion in the consulting firm

KPMG

.

For its part, IBM has won increased service contracts with Cisco customers. Also, Cisco has committed $2 billion to IBM, including the purchase of IBM components. While IBM will keep building other network systems, it's largely focused on components and services, not network products.

"The deal is a major coup for Cisco, and gives IBM some cash in return for killing off a significant portion of its struggling networking division," wrote

Ryan Hankin Kent

analysts Matt Walker and Joe Skorupa in a report.

And Cisco's customers -- corporations and service providers alike -- need IBM's consulting services. "This stuff has gotten incredibly complicated," says Jeremy Duke, president of the consulting firm

Synergy Research Group

. "It requires a lot of handholding and guidance." Cisco is a client of Synergy.

Cisco and IBM have long sold products and services jointly. By making peace in network hardware, Wellman says, "you're removing a major inhibitor and constraint from the two companies doing everything together." He says IBM suggested the truce to Cisco in March.

The network hardware division, or NHD, as it is called by those inside Big Blue, has been a loss leader for the company for some time, says Joe Ferlazzo, vice president at research firm

Technology Business Research Group

. "It was decided at IBM that hardware products were no longer going to be a strategic imperative," says Ferlazzo. "IBM missed the key switch to Ethernet two years ago and hasn't been able to compete with Cisco ever since."

According to research firm

Dell'Oro Group

, Cisco claimed a 74% share of the router market and 44% of the corporate switch market in the second quarter, compared with 2% and 1% for IBM, respectively.

Ferlazzo says IBM is quickly realizing that the network semiconductor market is growing faster than the PC chip market. He speculates that IBM might partner with

3Com

(COMS)

.

IBM Technology Group's Chris Sciales wouldn't comment on additional moves, but did promote a significant product announcement the company would have later this week. As it fills its services division, IBM likely will move some staff from its Raleigh, N.C.-based network hardware division, according to Sciales. IBM plans to extend its reach beyond hardware, providing its prolific patented technology to others. In the past, IBM would watch more nimble players take advantage of its breakthroughs, while it received no compensation in return. This latest deal ensures them that they can gain new revenue streams from not just the hardware industry, but the networkers as well.

But unlike its previous deals in the computer industry, IBM will rely on Cisco to build its network hardware revenue stream. Fortunately for IBM, that's not a bad bet to let ride into the new millennium.