Cisco Systems, Inc. (CSCO) Earnings Call Transcript & Summary

Hi folks, thank you very much for joining us. We're coming to you live today from the Optical Fiber Conference, OFC. This is Simon Leopold, Raymond James, Data Infrastructure analyst, and I'm pleased today to be hosting Bill Gartner of Cisco, who runs the optical business unit over there. We've got some prepared questions. We're going to go through in sort of a fireside chat format today. Bill, I think we'll have a lot of interesting thoughts on what's going on in the industry. He has been around for a bit. So Bill, why don't we start off, just set a little bit of context for our audience so folks understand your scope of responsibility and you're fit within Cisco.

Yes. Thanks, Simon. First of all, thank you for having me. And let me just start with a forward-looking statement that I'm encouraged to make by our Investor Relations team, and that's that I will be making forward-looking statements, and our actual results may differ materially from those forward-looking statements and are subject to the risks and uncertainties found in our most recent 10-K and 10-Q. With that, I have responsibility for really, you can think of as 3 separate businesses within Cisco. One is the Optical Systems business, that's the traditional DWDM business that's used to carry signals over long distances across the city, across the country or subsea, are typically using chassis-based solutions that include ROADMs and amplifiers. The second business is our Optics business, which are the transceivers that are used by switches and routers inside a data center or inside a central office or in a campus environment, typically less than 10 kilometers for those applications. And then I have responsibility for Acacia, which was an acquisition we completed just about 4 years ago. And Acacia provides the underlying technology for our optical systems as well as pluggable coherent technology that we use in many applications, and we'll be talking more about that.

So great. So Bill. The trade show is just about to kick off. We attended the Executive Forum yesterday. So what do you think will be the hot topics at the show? And don't simply say AI. We want to get a little bit deeper than that. But what do you see as the hot topics? And what will Cisco be highlighting?

Yes. So certainly, AI is sort of the overarching theme behind a lot of the things that are driving capacity in customer networks, whether it's hyperscalers or service provider and ultimately, enterprise networks as well. I think one of the hot topics is co-packaging. People seem to be very -- that has sort of renewed interest around co-packaging, and we can talk a bit about our views on that. Cisco has been very deliberate in advancing the idea that pluggable coherent optics can replace transponders in many network applications including data center interconnect, metro and now long haul. And we're showcasing a 400-gig ultra-long haul optic that can be used in applications up to 3,000 kilometers as well as 800-gig and 800-gig ZR+ optics that really advance the state of the current 400-gig optic used in inter data center and metro applications. We're also showcasing a new optical line system that's really optimized around metro applications, optimized around point-to-point metro applications, leveraging our NCS 1014 chassis that has historically been used to host transponders. We've now expanded that to include line system components like amplifiers and mux/demux. And we'll also be showcasing client optics that are optimized for AI applications. So 400-gig and 800-gig client optics really are targeting AI applications.

So I definitely want to get into some of the more technical discussions. But let's start off with a little bit about what's going on maybe near term in the marketplace. There's been a lot of noise about the AI builds by the large hyperscalers being lumpy, some projects being deferred. What's being slowed down, accelerated? What is your take from somebody in the trenches as to the level of activity?

Well, let me say for the first half of our fiscal year, which began August 1, the demand has been exceptionally strong and mostly driven by hyperscalers. And I would say that I would characterize that demand as very lumpy. It comes and goes, and we've seen huge upswings and huge downswings in that demand over time. This most recent period was almost all upswing. We do see some of the hyperscalers take a breath at this point. But overall, in aggregate, I'd say the demand is still very high. They are building out data centers and crossing data centers for AI applications, which has an impact on things like our ZR optics at a rate that we've just never seen before. So we are pretty bullish on the near-term prospects for continued growth. But I would say we're also cautious. We've been caught up in cycles before where things just slowed down without any particular explanation. So the real challenge for a company like Cisco is how much inventory do you build and carry in anticipation of that demand continuing to grow and being ready when that demand is there versus scaling back and trying to take a more conservative position.

And maybe this is a little bit out of scope for you. But just wondering if you've got thoughts on what's creating lumpiness. Is it a product transition where we know NVIDIA is going from Hopper to Blackwell? Or is it more sort of macroeconomic questions? Or is it simply managing large projects takes time?

I think it's all of the above. In some cases, it's a given customer may be waiting for fiber build-out, for instance, or they can't get components that are required to build out the data center. And there's a number of things required. Obviously, you have to have servers, you have to have GPUs, you have to have networking, you have to have optics. If all those things don't line up, they're going to tap the brakes a bit. When all those things are lining up, they're hitting the gas. And so it can be a number of things. I don't think it's a macro issue, though. They've all signaled very strong CapEx plans for the year. So I don't think there's a macro issue that we would see here, but I do think that there can be things like fiber build-out or specific supply chain issues that might be slowing down in some cases.

So interesting disclosure Cisco made on the last earnings call that about half of the $350 million of AI-related business were optics. I sort of feel like that's not been well appreciated. So maybe help folks understand how optics fit into that? And what's the AI business and what's the optics in that?

And I'd say there's 3 categories of optics that I would consider in that. One is the obvious client optics that are used in switching, networking. And then there's, for some applications, when a hyperscaler has indicated to us that it is an AI build-out. And in some cases, they call it their AI WAN as an example. It might be an optical system capability that we're delivering to that customer or a ZR class optic. Most of the -- all of the hyperscalers, I would say, at this point, are deploying ZR class optics, either ZR or ZR+ 400-gig for the most part. And that -- when they have signaled to us that it's part of an AI build-out, we would include that as part of our AI business that we are -- we've signaled to the Street, we'll do $1 billion this fiscal year. So it includes really any of those 3, the transceiver optics or optical systems or ZR, but it has to be part of an AI build-out. We wouldn't consider that part of just a normal WAN development for any of the customers.

Now Cisco did a product press release last week that caught my attention. So I want a little bit of help kind of putting this in context and significance. It was a new 3-nanometer, 1.6-terabit PAM4 DSP, 200-gig per lane. So I don't know that people typically associate Cisco with those kinds of products. Maybe give us a little bit of background on what's the strategy here?

Yes. So Cisco, I think one of the things that's underappreciated about Cisco and especially the optics area is that we do have one of the biggest optics businesses on earth, and that's largely due to the fact that we serve all of our customers, whether it's an enterprise customer or commercial, public sector, service provider or hyperscaler with optics that are sold as part of our routing and switch sales. We also sell optics to customers that may have chosen a third-party vendor, whether it's white box or a competitor. And in that case, we're happy to offer optics to that customer. And we should talk a little bit more about that buying behavior as well. We developed some of those optics in-house, and we source some of those optics from the industry. And what we announced last week was really the -- a 1.6T DSP that we're developing, that's actually being developed as part of the Acacia team who has very significant experience in developing DSPs, obviously. And we'll be offering that DSP to module manufacturers who may want to incorporate that into their module and sell it on the street and we'll also be including that in our own optic that we'll be offering to customers.

And just to clarify, I believe this is 200-gig per lane inside the data center, not wide area network.

This is not a ZR optic. This is a more conventional short-reach optic that would be used inside the data center.

So let's pivot the discussion to the proverbial elephant in the room, co-package optics. I don't think you could swing a dead cat and not run into that conversation. Let's start off at a very high level. Just what's your take on the technology?

So I would say I want to offer somewhat of a balanced view here. I think that's going to be -- we're in a froth cycle in the last, I would say, month or so around co-packaging. Cisco demonstrated a co-package solution at OFC actually 2 years ago, OFC 2023, and it was a 25.6 terabit switch that included co-packaged optics. I think Broadcom demonstrated one at the same time. And I would say the industry response and by the industry, I mean primarily customers, the customer response was fairly muted, muted to negative. And the reason -- there were a lot of reasons why customers looked at that and said that may not be something I really want to consider deploying. And so let me just outline a few of those reasons that became apparent to us at that time. One was that the -- if you think about today, there's a number of silicon providers, Broadcom, Cisco, NVIDIA, a couple of others out there. But there's many optic suppliers for the industry. And our customers benefit from the fact that there's a multi-vendor optics community that they can leverage and make sure they have supply chain integrity and diversity and choice and the ability to negotiate. When you build a co-packaged solution, you're effectively consolidating the value of both the silicon and the optic into one monolithic structure that then really deprives the customer of that choice on the optic. And I think many customers looked at the co-package solution and said, there are power benefits. That was a primary argument for co-packaging. There's a power benefit that's delivered. But that power benefit is probably not worth trading off the multi-vendor supply base that I have in optics. I think that was one issue. The other is that optics today in many applications are pay as you grow, meaning they buy a switch with 32 or 64 ports on it, and they populate that over time. And they take advantage of the fact that they can defer the cost of that over time. That goes away with co-packaging because all of the optic has basically delivered day one. And then I would say there are applications where customers mix and match optics on a given switch or router, it's not one monolithic optic like a 2-kilometer or 500-meter optic. There's mixing and matching depending on the infrastructure and depending on the needs. You might have ZR optics and short-reach optics, for instance, in one router. That goes away as well. And so at that time, I think the feedback we got from the industry was we should pursue other ways to reduce power while preserving a multi-vendor optics environment. And other ways included things like looking at LPO and LRO ways that we can focus on the optic and take power out of that solution, but still preserve the multi-vendor optic space. So that was kind of the state of the world in 2023. NVIDIA, just last week announced that they're going to be deploying co-packaging as part of their InfiniBand switch and ultimately, as part of their Ethernet switch. And I think that's kind of juiced up the industry in terms of, hey, what's happening here? I'm not sure that the fundamentals that I outlined as some of the objections for the industry have really changed. So I think it's going to be interesting to see what the customer take is for this and whether the power savings that are delivered are really worth trading off some of those -- the things that they would get otherwise. And one other thing I would say is when we look at power savings, I think you really have to look at the whole solution like the whole AI solution, whether it's within a rack and a scale up or whether it's across racks and a scale out. My somewhat cynical analogy is, if you reach into your refrigerator and you -- you replace the incandescent light bulb with an LED light bulb, you can claim 70% power savings on the light source for your refrigerator, but you're not going to change your electric bill. And I think there's some of that, that we have to look at in this context as well as to say, yes, we can get, say, 30% power savings if you look at the switch plus the optic, but what does that really represent as a part of the total power that's being consumed in a GPU structure. There's an argument that says, look, every little bit counts, and we should get every little bit we can. So that's a fair argument. But I think you have to look at what the trade-offs are. And so I think I would say that we're in a bit of a state of let's see how this plays out. I think we'll see some trials. We'll see some customers dabble with this. There may be a compelling event at some point in the future where co-packaging becomes the only option for us. I don't think we're at that compelling event yet.

Maybe step back a little bit for an audience as financial analysts, not technologists. What's going away when we do CPO and how does that compare with the acronym soup LPO, LRO? Walk us through some of the basics here.

So in co-packaging , first of all, in today's world, you have a switch or a router that fundamentally has a piece of silicon in it. And that silicon has to deliver traces to the faceplate where there's pluggable optics that would be plugged in as the customer needs the given capacity. And a typical switch or router has 32 or 64 ports on it. Each one of those ports accepts a pluggable optic. That pluggable optic is delivered by suppliers in the optics industry. And the switch or router is delivered by guys like Arista, Cisco, Juniper, Nokia, others. And we, of course, also deliver optics, but customers have a choice of using our optics or some third-party optics. That's always a choice that they have. One analogy to think about is it's a little bit like if you have, for instance, an HP Inkjet printer at home, if you buy your ink from HP because you're worried about -- you've read the warranty and the warranty says if you buy your ink from somebody else, your warranty is void. If you buy your ink from HP, then you look like a sort of a very conservative customer that we would have that would say, I'm going to buy my optics from Cisco, and I'm going to buy my switch from Cisco because Cisco is going to take care of me. And if there is any problem, I know it's going to be taken care of. If you buy your ink from a third party because maybe you use a lot of ink and you really want to save a few pennies, then you look like the customers that are saying, you know what, I'm going to buy optics from a third party because I'm pretty sure it's going to work. And -- and I'm not too worried that things are going to break. And I would also say, if you buy ink by the barrel and fill your own cartridges, you look like some of our hyperscaler customers. And so that's kind of the analogy I would use for the optics world. We have customers that buy directly from us. We have customers that buy from third parties and customers that try to build their own as well. That goes away effectively. That choice goes away with co-packaging because co-packaging suggests that you take the guts of the optic and you physically package it with the silicon. And so it now becomes one monolithic structure that's mounted on the switch or router line card. And the only thing coming out of the faceplate are fiber connectors, but there's no more pluggable that's part of that solution.

And the LPO, LRO option?

So the LPO, LRO options are basically playing a bit with some of the innards of the optic to say if we remove some of those pieces and ask the switch silicon to work a little harder, could we reduce power? And that's really what LRO and LPO is all about. Is it -- it's basically shifting some of the problem that is dealt within the pluggable optic today into the silicon -- into the switch silicon and delivering an end-to-end solution through better switch silicon performance and a little bit better optic performance, but removing things like a DSP that might sit in the optic today. And in doing that, you can achieve some pretty significant power savings, maybe not as quite as much as co-packaging, but pretty significant.

Great. And I guess one of the things that intrigued me out of NVIDIA's announcement a couple of weeks ago was that initially, their CPO would run on an InfiniBand switch. So in my circles and your circles, there's been this debate about AI clusters migrating from the InfiniBand protocol to the Ethernet protocol. So now that we consider the fact that CPO will initially run on an InfiniBand switch, what does that tell us about this evolution, transition, competitiveness?

Yes. So I think, first of all, not surprising, NVIDIA has got a large embedded base of InfiniBand switches. So it's not surprising that they're going to leverage that first. The other thing I would remind people is we announced a couple of weeks ago a partnership with NVIDIA, where NVIDIA is actually qualifying and including Cisco Silicon as part of its reference architecture. Cisco Silicon and optics as part of its reference architecture. We're the only silicon provider other than NVIDIA that will be standardized as part of that reference architecture. So over time, I would expect that customers are going to migrate to Ethernet. Ethernet is much more widely deployed than InfiniBand. We believe Ethernet has a much longer life in AI applications. And -- so over time, I would expect the industry is going to see a much bigger shift to Ethernet, and that would include Cisco Silicon as well as the NVIDIA silicon.

So maybe the partnership is intriguing what is sort of the rest of Cisco's play and whether it's LPO, LRO, co-packaging? What else are you doing in this context?

So we are -- and in fact, we're demonstrating capabilities here at OFC for delivering optics into the AI stack, whether it's a scale up or scale out solution, that includes for instance, 400-gig optics that would go into the NIC and includes 800-gig optics that would go into a switch. That will be used as part of a scale up or scale out. It would also be used in an enterprise AI application. And I think that's the big thing to come still in AI and it's part of the reason why Cisco has partnered with NVIDIA is NVIDIA brings a lot of the technology in the form of GPUs. Cisco brings the access to the enterprise customer base. And with that partnership, we expect to be delivering AI solutions for enterprises that want to have an on-prem solution. Obviously, that would be a much smaller solution than what training model looks like, but it will be a highly optimized AI solution for customers. We've called that the AI hyperfabric, and that will be used for enterprise customers that want to run an inference model on-prem. And that would include our networking, our optics, our software managing that and then NVIDIA GPUs and NICs.

So one of the topics I feel like has been glossed over in these announcements is, how does one manufacture CPO. So maybe you can help folks understand what are the hurdles to bringing this kind of technology to market?

Yes. I think that is a bit underappreciated in the -- a lot of the enthusiasm around CPO. The -- my view is that, that is going to be the major barrier in terms of CPO really penetrating the market in a significant way. If you think about the -- today, the industry around silicon is very mature. This industry knows how to package silicon, how to cut up a wafer and then package that, whether it's for an Intel CPU or whether it's switch silicon, that industry is very mature. There is an industry that is also mature around optics, making transceivers and dealing with some very specific optics issues like fiber attach, like how do you attach a fiber to a piece of silicon. That's a process that requires a lot of skill, a lot of development and have certain yield associated with it. When you bring those two together, we have to find sort of the -- who is the -- where is the ecosystem that does both of those together because now we're talking about packaging silicon and optics together. And dealing with all of the issues that you have to deal with packaging silicon and all the issues that you have to deal with in packaging an optic. And we know when we talk about large-scale CPO, we're talking about something that would include between 2,000 and 4,000 fibers. So the manufacturing challenges, whether it's a fiber attach problem, the process development has to be very, very, very high quality, much higher probably than what we have in the industry today. We'll have new connectors that have to be created to allow for sort of modular approach to manufacturing because you don't want to build one of these things and then go test it and find out that it doesn't work. You need to kind of build it in a modular way. Connectors that have to be attached to the optics chips -- chiplet and then MPO connectors to actually deliver the optics to the faceplate. It has to be fiber routing, how do you route all that fiber on this switch line card. So many, many manufacturing processes that really have to be refined here. And I would say the industry is at an early stage of that. And history says this is going to be a multiyear challenge for the industry. This is not something that's going to be solved in a couple of months. This is going to be a multiyear challenge to get the industry to a mature state where manufacturing can be done in a highly reliable way with very high yields. And people look at sort of the PowerPoint slide and say, well, the cost should be better with this, reliability should be better. You can kind of wave your hands and convince yourself if that's the case, but that all presumes that we've overcome all these manufacturing challenges. Reliability can be better, but it would be much, much worse if we have problems with fiber attach or problems with how the connectors are mounted. So all of these issues really are still ahead of us, I think, as an industry.

How do you square that with NVIDIA's time line of suggesting their InfiniBand switch will be out before the end of this calendar year?

I think you should probably ask NVIDIA that. But I would say, generally speaking, like we've built co-package solutions. They can be built. The question is can they really be built in volume at scale and with the appropriate reliability. And building tens or hundreds of something is very different than building thousands or millions of something. So I think that's really the -- where the challenge in the industry will be.

And maybe take this to sort of the implications of what does this mean for the laser. So there's sort of this argument of laser is the most likely thing to fail. So you want to have your laser separate, how are they getting around that?

So the basic architecture of co-packaging will have an external laser source. It will be a pluggable laser or a set of lasers that plug into the faceplate that deliver the laser to the co-package solution. And that does remove the most likely failure element. The laser is of the various piece parts, assuming it's silicon photonics that's on the co-packaged optics and silicon as part of the switch, the laser is probably the most likely failure element. But again, that presumes that we've got connectors and we can mount these things in an appropriate way that's robust. So I think the architecture of this is -- we'll rely on these external laser sources. NVIDIA, for instance, I think, had 18 of those in the switch they demonstrated. So that will help convince people that the reliability can be good, but again, we have to overcome all these yield and manufacturing issues to make that really true.

And what's your take on the implications for your transceiver business then? So if we start doing co-packaging, we have fewer transceivers. Do transceivers go away? Do some transceivers go away?

I think the transceiver business is going to be a robust and growing business even in -- even with co-packaging. And if you look at some of the industry analysts views, the pluggable market continues to grow. Co-packaging sort of sits on top of that as part of the growth. If co-packaging is wildly successful, it will eat somewhat into the pluggable market, but like 20% is the highest I've seen in terms of a forecast for that. And I think we have to think -- remember that co-packaging will find its home in those most dense applications that require like a homogeneous set of optics, fully populated day 1 that tends to be in the hyperscaler large-scale applications. It doesn't occur on the WAN side. It doesn't occur in service provider markets, it doesn't occur in enterprise market. So I think pluggables will still have a very long life.

And I guess, maybe time undetermined, but what are the implications for your switches that would go into these AI fabrics?

Yes. So presuming co-packaging becomes a -- we start to see customer pull for it as opposed to vendor push. That would mean that we would start to build switches probably 2 flavors. One that has co-packaged option and one that has pluggable optics. And then the question is, do we hit a wall where you -- the only way you can get to a certain scale is with co-packaging. I think that wall -- there is a potential for that wall to hit us. And if you asked me 2 years ago, I would have said, when we get to 200-gig SerDes, we don't really know if we can support pluggables, today that's commonplace. If you ask me a few months ago, I would say, maybe it's 400-gig SerDes. But you and I were at an Executive Forum yesterday and saw many suppliers out there saying, look, we're going to solve the 400-gig SerDes problem. So I don't know if that wall is really right in front of us or not. If I had a draw line today, I'd say 400-gig SerDes is probably the first point you'd see CPO really deployed in any volume. And then the question is, is it really hard wall? Or is it just -- are there other reasons why CPO is being deployed for customers? I also don't think like a campus customer, an enterprise customer is not going to typically require the same scale that a hyperscaler would.

So it sounds to me that you've given, I think, a good argument for why LPO and LRO are good compromise for the industry. Where is the market? Because sitting at OFC, you wouldn't think that's the case, but it seems like a logical argument. What -- how would you make that argument? Where do you think the reality is?

I think the reality is that we will see LPO and LRO solutions at 100-gig SerDes and we will likely see them at 200-gig SerDes. I think beyond that, LRO and LPO start to have some really significant challenges with things like signal integrity. But I also think -- I'm a complete believer in the innovators in the industry. And when people see what appears to be a hard wall ahead of us, I have faith that this industry innovates. Power is a huge, huge issue for our hyperscaler customers in a given application. It is probably the most significant issue. It's not the most important issue for many other applications in the networking world. So we have to solve power problems. We have to find ways to incrementally improve on power. I think the industry has got a lot of thoughts on that. And things like liquid cooling will play a role there as well. So there will be other -- other things that come into the market that help to reduce the power problems that we're facing today.

So I want to pivot to a different technology that I don't feel like gets much attention, but it's this concept of an optical switch. So I think Google has been public about building its own. We've seen a number of companies enter the space. So maybe just sort of -- first sort of set the foundation, what is an optical switch and how are they being used?

Yes. So I think the easiest way to think about optical switching is if you had -- if you were looking at a patch panel where you would manually pick up a fiber and connect it into the patch panel so that you can connect it to another fiber, these manual patch panels exist in customer data centers today and in labs for customers today. And that's how we move traffic around. Somebody walks up to it and picks up the fiber connector and moves it to another port. It's a physical connection that's moved. An optical switch or an optical cross-connect effectively automates that. So it uses technology like MEMS technology or in some cases silicon photonics technology, in some cases actually robotics technology to actually affect that switch. It's a slow moving dynamic typically, but it's effectively automating what was done with a manual patch panel. I will say, I have 2 patents in optical cross-connects, both of which are expired, which tells you how long this technology has been around, looking for a real problem to solve. Historically, it's been around for quite some time. It hasn't proven in economically for a given application. And so I think today, we are now seeing some applications where optical circuit switching may have a role to play. I think it's early stage. Google has been probably the most vocal, but I'm certainly aware of others that are now either contemplating deploying this or are in early stages of deploying it.

I guess one of the things I've been struggling with is, I feel like it's maybe a misnomer to call it an optical switch rather than to call it a cross-connect or an automated patch panel. And I guess there's some nuance to that. My understanding is they're not switching every packet.

Yes. That's very important to understand. It's called an optical circuit switch really to, I think, harken back to like literally circuit switch days where things were basically nailed up and you stayed up for a phone call. And that's switch was just put in place for the duration of that call. That's really where the name came from. In optical cross-connect same sort of thing where the idea is that connection is made between 2 ports, and that connection stays. But there's -- you can think of it as literally a passive connection between port X and port Y. There's absolutely no packet processing taking place there. In fact, there's very little insight about what's going on there. You're effectively connecting one port to another port physically. The light passes through. There might be some level of monitoring on that, like what's the signal level of the light, but there's no idea what's going on inside that wavelength. Nobody is looking at the packets to try to examine what's happening. So it's a slow switch typically. It's not a fast-moving switch -- a switch of packets speed, for instance. And it's got very little insight about what's really being carried on that wavelength.

So are there use cases that either can flatten the network or could reduce the number of actual electronic switches, either based on Silicon One or Broadcom's Tomahawk? Can we reduce the number that somebody needs with the use of optical switches?

I think so -- I think there is potentially some use cases, and I would say it's very early stage. I don't think there's a lot of use cases. I will be surprised to see this become a huge portion of the switching market. Google's case, I think, is probably most well documented and advertised at this point, and that is really to improve the reliability of their infrastructure. They've got a unique AI infrastructure where -- and this is somewhat of a surprising point for a lot of people, but there are -- when you have thousands of GPUs interconnected with optics, something is going to fail and something is going to fail at least once a day. And in AI, unfortunately, the challenge is that when something fails, everything stops. And so you basically have all these GPUs idle until you can fix that problem. That's a very expensive problem. And Google's approach really is to say we're going to have effectively a spare bay of equipment. And if something fails in one bay of equipment that includes GPUs and optics and networking, we're going to just switch over all of that traffic to another bay and restart everything, and we're doing that with an optical cross connect. And you can think about that that's literally like the alternative could have been they send somebody into the lab and start moving all the fiber connections from one bay to another bay. That's effectively what they're doing with this optical switch. And they effectively increase their -- improve their utilization by doing that switching. So that's one application. We've seen other customers begin to think about like in a spine-leaf architecture similarly saying if a leaf fails, you could effectively switch to a spare leaf and just have a -- bring on a new leaf with an optical switch, effectively creating the same infrastructure, but with a spare leaf now that's passing through this optical switch. Again, it's kind of a reliability argument. There's some thought that says, well, for AI workloads, you kind of set up the workloads between GPUs and say, for this workload that might run for hours or days, we're going to pass traffic from port X to port Y and that's all the switch at this level and the network is going to do. It's going to pass traffic from port X to port Y to get from this set of GPUs to that set of GPUs. And then I think people are looking at that and saying, do I really need a switch, an Ethernet switch to do that? Or can I just have something that blindly passes everything coming from port X into port Y, and that could be the role of an optical circuit switch. Again, it's not doing packet processing. It's basically -- I don't want to call it a dumb switch, but it's a dumb switch in the sense that it's not really examining any of the packets. And I think there's -- that's an application where could we place an Ethernet switch. Again, I don't see that as like putting a big dent in the Ethernet switching market. But this is early stage for this technology. So there's a number of startups playing in this game. There's some established players who are playing in this game. And I think there's a fair amount of investment going into this. So this -- we could be at an inflection point where this technology actually starts to find a home in various applications.

Another topic that's sort of been bandied about is the idea that coherent optics, sort of the classic Acacia wide area network technology is making a move to find applications inside data centers. A little bit of more talk about that. I've struggled with it on just the basic economics. The price points of coherent are much higher. For a good reason, they do more, send signals further. Can you help us understand, I guess, from the demand side, what makes us more interesting? And then from a technological side, how do you take a relatively expensive technology and make it cheaper?

Yes. So let me geek out for one minute here and just explain why people make that claim. When you -- first of all dispersion is an impairment that occurs in the fiber that limits how far we can send a signal. It's just -- it's a characteristic of the fiber and it limits the distance that we can send a given signal. When you double the bit rate, say, go from 100-gig to 200-gig, the penalty for dispersion actually is more than double. It's actually 4x. So theoretically, when you're going from 100-gig, let's say, at 100-gig, you could go 10 kilometers as just an argument. If you double that to 200-gig, your penalty for dispersion is actually 4x as bad. So that means at 200-gig, you might only be able to go 2.5 kilometers. So every time you double the bit rate, you're going to have a factor of 4 impairment in terms of the distance. And so the argument for coherent says, well, our approach inside the data center has been to double the bit rate, double the bit rate, and then we got to add a few tricks like PAM4. But at some point, we're going to get to the point where we want to increase the bit rate, say, from 800-gig to 1.6T or 1.6T to 3.2T and that dispersion penalty becomes so bad that I can't send the signal over a conventional distance. A conventional distance in the data center is 2 kilometers or maybe 10 kilometers for some applications. And so what was -- what worked for 10 kilometers, for instance at 800-gig is probably not going to work at 1.6T. Maybe the best we could do is 2 kilometers. And what do you do now for the customer who says, I really need 10 kilometers in my data center or what works at 2 kilometers might not work for 2 kilometers anymore. Now we're talking like 500 meters. So what do you do? And the answer is you got to add more tricks in order to solve that problem. And we're now sort of out of the bag of tricks that are the easy -- relatively easy solutions, PAM4 was one of them. And now we have to start relying on some of the tricks that we played in the coherent world in order to send signals over very long distances. In coherent, we -- if you remember 10, 15 years ago, people were kind of stuck at 40-gig and said, I don't know if I can send 40-gig over a reasonable distance in the network. Now we send terabits, and we're relying on this coherent technology, which does very sophisticated signal processing on the optical signal. And so the argument is that as the bit rate increases, the penalties are going to continue to increase, and we may not be able to send the signal over the distance required in the data center without applying some of the tricks that exist in the coherent world. And so you have to bring some of those tricks into the short-reach optics. Now your question is, well, the economics aren't going to make sense for that. And that's exactly -- that's true. So the question is, well, do you want that -- do you want to go to 3.2 terabits or not because at some point, the physics is going to work against you. And the only way you're going to get there is by increasing the sort of the sophistication of that solution. Now that doesn't mean you have to bring in -- in a coherent solution today, we can send the signal thousands of kilometers. We don't have that need inside the data center. So people talk about coherent light, as an example of saying, let's bring some of the coherent technologies into this solution and apply it inside the data center so that we can go 2 kilometers or 10 kilometers. And I think that's where we're going to see some industry investment as to say, what's the -- what are the elements of that coherent solution that you could bring in minimally in order to not have the cost go too far out of line, but solve some of these problems that you're going to have with the impairments.

Is there a way you could help us understand the relative price points. So 800-gig inside a data center PAM4 device compared to an 800-gig in a ZR pluggable. What's the relative price difference today?

It's factors of difference -- I would say anywhere from 4 to 10x it could be. So it's a big, big price difference. It's not like a 10% price. It's factors of pricing difference. So -- and that scares people. It's like how do you get that -- how do you get that savings while you're still trying to achieve the -- solving the problems inside the data center.

And I guess one of the sort of classic arguments I hear, it's about volume. And so I'm struggling whether or not this will apply. I think of the analogy of the comparison to high-definition televisions. First high-definition television, $10,000 a piece, 10 people bought them. Now they're $200, everybody has it. We wouldn't buy it. So are we at this situation where coherent technology is expensive because it's a low volume relatively device. Is it a question of, well, if you ramp your volume, then it's price competitive and how do you cross that chasm?

I think certainly volume is a huge factor in the cost. And yes, when you're talking about selling tens of thousands or something or 100,000 something versus millions, the volume, the cost curve changes pretty significantly. I think there'll still be a premium for a coherent solution. But to the extent that it's adopted widely, and we do get those volume benefits, the cost will come down. So that factor difference that I mentioned today will certainly get compressed over time. But there's going to have to be early adopters for that. Somebody is going to have to start deploying -- the early adopters will have to start deploying and paying that premium and then I think we will see a compression of the cost curve.

And what's your sort of best prediction of how or when that happens? What's the time line?

So I think we'll see 1.6T at 2 kilometers. Well, as an example, 800-gig, I think we saw OIF defined a coherent solution and an IMDD sort of traditional solution for 10-kilometer application. At 1.6T, I think 2 kilometers will be that breakpoint. If you need to go beyond 2 kilometers, you're going to have to bring in some additional technology like a coherent technology. So we will see a coherent light, I think, for 10-kilometer applications at 1.6T. And then at 3.2T, it could be a 2 kilometer.

And do you see that as like 2 years away, 3 years away?

2 years away, I would say, yes.

So I want to pivot the discussion to the wide area network. So we spent most of the time on the data center because that's what people care most about. But I think there's been this debate about, well, okay, we get the AI thing. We get the clusters. What are the implications for wide area network?

Yes. So certainly for the hyperscalers that are defining their -- what was a conventional wide area network is now the AI WAN. And it's mostly those that are using inter-data center communication to effectively create a larger scale AI network. We've seen dramatic, dramatic take there, as you alluded to earlier in even our first half results, we've seen a lot of optics being used in that application. But I think more widely as we start to see AI applications in enterprise take hold, I think our service provider customers are going to begin to see much more traffic, whether it's because they're hosting the AI application for those customers, or even in the case where the AI application is on-prem and there has to be some reach back to a data source, for instance, we're going to see different traffic patterns. And so we do expect that our service provider customers are going to see growth in their networks as well as AI starts to take hold in enterprise applications.

So you've been a proponent of an alternative architecture or technology known as ZR. This is the idea of pluggables used in the wide area network. Maybe help us understand a little bit of the argument of the economics. I know we've been down this path before, but a little bit of a refresher and where does the industry stand today on the transition from platforms to pluggables?

Yes. So I would say, first of all, the -- we acquired Acacia 4 years ago, this month. It's been a terrific acquisition for us. And Acacia at that time was delivering technology to its customers, including Cisco for optical system solutions, traditional transponders. But Acacia had also innovated in the area of taking that technology and putting into pluggable form factors. And we saw a trajectory where that pluggable would effectively be the same form factor that's used inside the data center. So there was no -- there was no custom form factor required to support coherent. And we felt that would be a tipping point for customers adopting a coherent pluggable solution that would go directly into a router and replace a transponder. The way you can think about this is if, let's say, you have to send an optical signal 500 kilometers. One way to do that is to buy an optical chassis that has a transponder that can send that signal 500 kilometers. But now you can actually take a pluggable optic, put it in the router and directly send that signal 500 kilometers, eliminating the chassis, eliminating the transponder. And when we did -- started to do some economic analysis on that, we saw that a transponder would typically would be 200, 250 watts and a pluggable was typically 20 to 25 watts. So customers will get a 90% power savings by eliminating the transponder, eliminating the chassis and all the associated hardware that goes with it, like controllers and fans and replacing that with a simple pluggable that goes directly in the router. And on top of that, we felt that largely due to the volume curve that you alluded to earlier, as customers began to adopt this pluggable technology that we would start to see that become a much, much more cost-effective solution than a transponder. So apples and apples, pluggable is going to be cheaper than a transponder today. And so customers get day 1 CapEx savings and day 1 OpEx savings, power savings and cost savings. And our prediction was that, that would -- that would be the dominant deployment model for inter data center communications, which is often 100 kilometers, maybe a few hundred kilometers and we penetrate into metro applications, which service providers would start to adopt that as well and even into long-haul applications. And I have to say we've been very, very pleased that, that has really -- that's what we've seen now. The top 5 hyperscalers are all deploying this technology in their inter-data center applications. That's where the volume really is. But we've got 300 service provider customers now deploying this technology as well in metro applications, and we just introduced 400-gig for a long-haul application as well. So my prediction is that this technology is going to continue to attract a lot of the industry investment. It's open. It's compliant with standards, which is new for the optical industry because historically, it's been a closed proprietary solution. So it gives customers choice where before they did not have choice. The economics are super compelling. And so I see customers over time, we will see this become the dominant deployment model for metro networks and even many of the long-haul networks.

And I have the impression that this market had a pause during 2024 and it sounds like it's sort of restarted and it is getting moving. Was that supply chain-related event? Was that just customer concentration? What changed?

I think the service provider market, in general, has been slower to sort of recover from what was a supply chain issue. But also many of our customers invested in 5G infrastructure, did not really see a return on that investment. I think are looking for what is the next thing that would stimulate them to build a new network. And in many cases, it's a refresh like just a technology refresh. So I think we're probably into a normal technology refresh cycle here. I don't think we're going to see -- there's no 5G out there. AI could be a stimulant for service provider customers that either begin to host AI applications for enterprise customers or as the enterprise market starts to build out on-prem solutions, we can start to see service providers having to build out more capacity as well.

So I got a couple of questions on e-mail that I just want to hit before we run out of time. One of which is how do you sort of -- how do you see that your position in optics helping to pull through sales of either switches or routers or your Silicon One? What's the sort of attach rate and the relationship between the businesses?

I would say optics probably doesn't pull -- it's more of the opposite. I think Silicon One helps us pull through optics sales. But I would also say that Cisco has without question, the most significant standard qualification process for optics in the industry. I would put our qualification process as the gold standard for the industry and that we test optics against every single optic spec, every single electrical spec under all operating conditions, under all environmental conditions. And we subject them to really brutal, brutal corner cases like we'll put the optic into an environment that looks like a host, and we start to vary the voltage on all the signals coming from the host. We start to vary the SKU or the timing on all those signals. We do that at various temperatures. So that when we put a Cisco label on an optic, it is absolutely going to be a robust, very highly reliable solution for our customers. And I would say the one area that we are now seeing more take is that customers are buying our -- in some cases, buying our optics for third-party applications where they'll say, I'm going to buy Cisco optics and put it into a white box solution or a competitor product. And so that, I think, is a new dynamic for us. And I think our qualification is helping us to give customers confidence that when they put the optic in, it's going to be highly reliable.

And when we think about the evolution towards these enterprise opportunities. So I think it's really intriguing, you've got this partnership with NVIDIA, run NVIDIA on Silicon One. Do you see optics getting pulled in? Will enterprises be employing your optics in AI solutions?

Yes, completely. So for AI Hyperfabric, which is Cisco's enterprise AI solution, that will include Cisco switching as well as Cisco optics as part of that infrastructure.

So you made a comment very early that I sort of glossed over that somebody who's coming back to me. You used the phrase, hyperscalers might be taking a breather. You know the world I live in. Was that intended to be sort of something that you're seeing right now? Can you elaborate on sort of what you meant by that?

I should be very clear about that. I think net-net, our business is up and to the right here with hyperscalers. But when you sort of look at each one individually, you'll see different dynamics, some are in high demand and high -- stepping on the gas and others might be waiting for something like a fiber build-out or certain parts that they're trying to get. On average, we're seeing uptake in demand here.

And when we think about sort of the business, I think we've seen the power of the purse for the hyperscalers. How do you sort of think about the idea that they're crowding out telcos as customers?

I don't really see that. I mean I see -- actually, I think the telcos benefit from what the hyperscalers are doing because if the telcos look to the hyperscalers and say, I want to be on that cost curve and they adopt the technology that hyperscalers are adopting usually earlier, the telcos can get effectively sort of a significant cost advantage day one as they start deploying technology. They're typically following the technology curve for the hyperscalers. Hyperscalers might be earlier in deploying 800-gig or 1.6T. So to the extent that the telcos adopt that technology in pretty much the form that hyperscalers are, they can get a very significant cost advantage. That would be hard for them to get in historically.

So we're just about out of time. I always like to close with a question like the following. What do you think is the least appreciated aspect of Cisco's Optical business?

So I would say first of all, I think the Acacia business has been a terrific win for Cisco. And I think we've been right on target in terms of predicting how that technology would evolve over time and penetrating various segments, whether it's inter-data center or metro. And the other is, I think our optics business is a -- is really sort of a crown jewel within Cisco in terms of -- it is a huge business for us across our enterprise customers, public sector, service provider and hyperscalers. And I think it has the potential to be a much bigger business going forward as we look at AI build-outs for enterprises as well.

Great. Bill, thank you very much.

Thank you, Simon.

Lot of fun as usual. Folks, thanks for joining us. This is Simon Leopold and Bill Gartner, signing off from OFC.

Thanks, everybody.