Cisco – What Happened and What Is Next

I recently wrote an article on Seeking Alpha on Cisco, which can be found on this link.  The key points in the article are as follows:

Cisco really surprised Wall Street when it reported last week as its guided to a decline in revenues of 8%-10% year over year. Cisco has never reported such a decline when the US is not in a recession. With US GDP growth improving in the past three quarters, but Cisco’s orders decelerating, the guidance Cisco provided is disturbing.

The weak guidance is likely due to three main points:

1. Cisco is not focused on growing its set top box business, as the company de-emphasizes lower margin solutions/products for the home given the exit of its Consumer business a few years ago and the sale of its Linksys home networking business.

2. Cisco if facing major product transitions in high end switching and routing that are likely to impact year over year sales growth for 2-4 quarters.

3. Cisco is fighting an emerging but significant battle against cloud commoditization as Amazon and other cloud operators deploy lower cost “white box” networking equipment rather than traditional equipment from companies like Cisco.  Of the three issues Cisco is facing, this is the one that investors will focus on the most longer term in determining whether to invest in the stock or not.  Cisco’s recent launch of Insieme/ACI is how the company plans to attack the threat of “white box” networking.

Cisco’s weak guidance and commentary that business slowed at the end of the quarter combined with overall finished goods inventories being slightly up sequentially is likely to lead to Cisco managing down inventories in the next quarter. This may result in lower than expected orders to Cisco’s supply chain.  Suppliers and contract manufacturers that are exposed to Cisco could be impacted by these reduced orders.  Supply chain companies that recently have had high exposure to Cisco include Cavium, EZchip and Finisar, although it is fair to say these stocks have already been hit post Cisco’s results and may be discounting the bad news.

Is Cisco Investing in C-RAN?

While most Cisco investors will be primarily focused on the company’s official launch of the Insieme Nexus 9000 data center product on November 6th and the company’s earnings report on November 13th, I wanted to share my opinion on what Cisco may be working on to disrupt the traditional wireless infrastructure market.  CEO John Chambers recently made some bold statements in an interview with Barron’s stating that Cisco has invested in a start-up as part of the company’s disruptive plan to enter the traditional wireless infrastructure market currently served by Alcatel-Lucent, Ericsson (ERIC), Huawei and Nokia Solutions and Networks (NOK).  My guess as to what Cisco is considering for this disruption is Cloud-Radio Access Network (C-RAN) technology.  In theory, C-RAN technology aims to centralize (“in the cloud”) the baseband processing done at each cell site base station in wireless networks resulting in a more optimized utilization of baseband resources.  In addition, C-RAN facilitates joint processing and scheduling between various cell sites allowing for reduced interference, increased throughput and improved performance of the network. C-RAN also supports less energy consumption, which would support Cisco’s sustainability efforts and a more environmentally friendly deployment of wireless networks.  C-RAN also fits the Software Defined Networking (SDN) and Network Function Virtualization (NFV) framework, which Cisco aims to exploit for new revenue streams.  Commercial deployment of C-RAN technology is probably at least a couple of years away, but given the traditional wireless infrastructure market which Cisco does not current play in is $40+ billion in size, and the company has already made $2 billion of wireless acquisitions in the last year in other segments of the wireless market, it would seem the logical path for Cisco to try to enter the wireless market.  Time will tell what Cisco actually is planning for entry into the wireless infrastructure market.

For more information on the topic of Cisco potentially investing in C-RAN technology and my current thoughts on Cisco’s stock, please visit my recent article on seekingalpha.com.

 

 

 

What Does Cisco Have Up Its Sleeve With Insieme?

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I recently wrote an article on Seeking Alpha discussing my view on the potential strategic objectives of Cisco’s Insieme spin-in. Cisco plans to formally announce the Insieme product on November 6th in NY.  A quick summary of the article on Seeking Alpha is as follows:

The three main strategic objectives of Insieme in my view are:

–       Attack Nicira/VMware’s (VMW) pure software approach to Network Virtualization via a converged hardware/software approach to be delivered by Insieme’s Application Centric Infrastructure solution.

–       Attack lower cost and “White Box” data center Ethernet switches potentially enabled by VMware and/or Software Defined Networking (SDN) as Insieme is likely to have significant improvement in price/port metrics for Ethernet switching.  Its interesting that John Chambers, the CEO of Cisco, highlighted the “White Box” switch as a major threat to Cisco just a week or so ago in a Barron’s interview, knowing that the Insieme launch is just a few weeks away.

–       Expand into non-traditional markets or markets with limited market share in the data center via virtual implementations of traditional security and Layer 4-7 appliances (and perhaps even some elements of flash storage given Cisco’s recent acquisition of privately held WHIPTAIL)

Over the past 18 months, Cisco has been aggressive in filling its product weaknesses via acquisitions (e.g. Sourcefire in security) and addressing the market’s concerns around network virtualization and SDN.  The Insieme launch, in conjunction with prior announcements around Cisco ONE and OpenDaylight, will likely be the last Big Bang effort by Cisco in 2013 to take on the threat of VMware/Nicira and convince the market that Cisco has the right data center architecture for the future of networking as well as diminishing the threat of the “White Box” network.

 

 

 

AT&T Domain 2.0 – Who Will Flinch?

On September 23rd, AT&T issued a press release on Domain 2.0, which outlines at a high level its next generation network vision and supplier strategy.  As part of this strategy, AT&T plans to use Domain 2.0 to transform its network through utilization of Software Defined Networking (SDN) and Network Function Virtualization (NFV).   In doing so, AT&T plans to enhance time to market and flexibility of new services as well as beginning a downward trend in capital spending likely beginning in 2016.  The goal is to achieve a downward bias in capital spending through separating hardware from software and control plane from data plane in traditional network infrastructure products while also improving software management and control.  The goals of Domain 2.0 are more focused on a network transition, faster service creation and lower capital spending, as compared to the goals of the 2009 Domain 1.0, which were to reduce cost and time to market for new services by dramatically reducing AT&T’s supplier base to a much smaller set of strategic suppliers/integrators.

While AT&T is certainly sincere in its plans to evolve towards SDN and NFV, I also think the public announcement of the Domain 2.0 strategy serves as a message to its shareholders that through the implementation of Domain 2.0, AT&T expects capital spending to begin to decline starting in 2016.  This is an important message from AT&T as it is likely to have increasing pressure on its cash flow and cash needs beginning in 2014 given higher cash taxes and potentially a significant acquisition overseas.

Wall Street analysts that cover AT&T have often written that the company will likely have to pay higher cash taxes in 2014 unless the current bonus depreciation rules get extended.  The increase in cash taxes beginning in 2014 is likely to raise the dividend payout ratio at AT&T from around 65%-70% to close to 75% next year according to analyst reports.  At the same time, AT&T has a history of raising its dividend annually.  The likelihood of higher cash taxes and dividends next year, thus, will result in lower available cash for stock buybacks and acquisitions.   Clearly AT&T would like a way to reduce its capital spending if possible.

Regarding acquisitions, the press and Wall Street analysts have recently both written that AT&T is likely to make a significant international acquisition in 2014 and some are guessing that Vodafone (post its sale of its ownership of Verizon Wireless to Verizon) is a likely target.  A large acquisition on the scale of Vodafone is likely to require the addition of significant debt on AT&T’s balance sheet (e.g. some analysts suggesting over $70 billion), resulting in additional debt service and a more levered balance sheet.

In my view, the public messaging of Domain 2.0 was targeted to two distinct audiences, namely, AT&T shareholders and equipment suppliers. For its shareholders, AT&T was messaging that it plans to help offset the increasing dividend payout ratio and potential higher debt service due to any future acquisition through a lower capital spending trend after Domain 2.0 begins to be implemented.  For its equipment suppliers, AT&T was messaging that it plans to use SDN and NFV to extract a more agile and lower cost network and to be prepared for this change through lower pricing facilitated through separation of hardware/software and control/data planes (not that the equipment vendors really needed any public messaging from AT&T on lower prices as that is business as usual).   In a sense, AT&T is partly using this press release to remind its equipment suppliers know the “hammer” on pricing is coming and be prepared to help them migrate towards an SDN/NFV architecture or potentially be eliminated as suppliers in Domain 2.0.

Coincidently, Barron’s interviewed the CEO of Cisco Systems, John Chambers, the same week that AT&T issued its Domain 2.0 press release.  According to the Barron’s article, when asked what Cisco’s biggest competitive threat is, Chambers mentioned that at or near the top of the list are service providers who just buy cheap “white box” routers and switches.  While it may be just a coincidence that Chambers made this comment just a few days after AT&T made the public release of Domain 2.0, which implies a migration towards less software intensive routers and switches, its does raise the question on how serious AT&T will be in its migration plans to SDN/NFV and whether Cisco is willing to adjust to meet the needs of AT&T.

Most significant equipment suppliers to AT&T typically have a high dependency to AT&T with sales typically near or above 10% of total company sales (e.g. Ciena, Alcatel-Lucent, Juniper, Adtran etc.).  Given the broad nature of Cisco’s business, however, AT&T is not as material a customer to Cisco as it is to other equipment suppliers.  While not as significant a customer, AT&T is an important customer to Cisco, and Cisco wants to expand its presence at AT&T beyond routing and switching to also include optical equipment given its recent product launches that converge optical and packet technologies into new platforms.  The convergence of packet and optical technologies is also a likely part of Domain 2.0 given this convergence is an enabler of reducing network cost as IP packets and flows can be carried more cost effectively in a converged IP/Optical network.

So the question is, who will flinch in AT&T’s path towards Domain 2.0, Cisco or AT&T.  AT&T has a network vision and higher priorities for its cash in the form of cash taxes, dividends and acquisitions and will seek to reduce capital spending in the future.  While these higher priorities always existed, SDN and NFV now provide an architectural change that could facilitate lower capital spending in the future.  Cisco is the largest and strongest financial company that spans both packet and optical technologies among AT&T’s suppliers; is not heavily dependent on AT&T as a customer as compared to most other suppliers to AT&T; and has a large installed base at AT&T.  Cisco will not easily submit to separately selling its hardware from software and data plane from control plane in Layer 2/3 and converged optical/packet products.  It will be clearly be an interesting process to watch, one that will likely have ramifications for other service provider SDN network migrations in the future.

Disclosure: NT Advisors LLC may in the past, present or future solicited or generated consulting services from any company mentioned in this post.

The Tangled “Web” of Cisco, EMC and VMware

I recently wrote some articles on SeekingAlpha.com on the Cisco/EMC/VMware dichotomous relationship, Palo Alto Networks and Infoblox.  I have provided a quick summary and links to these articles below.

Cisco/EMC/VMware: I continue to be positive on Cisco stock and expect the company to formally launch its widely anticipated Insieme product at the Interop NY trade show in October.  CEO John Chambers will be keynoting at the Interop conference. I do not think John has done a keynote at an Interop trade show for many years, so it is likely Cisco wants to use this trade show as a platform to make a big announcement.  The launch of Insieme, the recent acquisition by Cisco of solid state drive storage vendor WHIPTAIL and the introduction of the NSX network virtualization platform by VMware at VMworld a few weeks ago continue to highlight the increasingly dichotomous relationship between Cisco and EMC/VMware.  I think Cisco and EMC/VMware will continue to promote their VCE partnership which has been successful to date, but at the same time seek to both be the leading player in the virtual and physical domains of the emerging next generation software defined data center.  At some point, one has to question when one of these companies makes a strategic move that could truly threaten the VCE relationship.

Palo Alto Networks:  While Palo Alto Networks remains a high growth company and leader in the security market, I am not positive on the stock given its high valuation, the low growth nature of the overall security firewall appliance market and the beginning shift in security spending towards cloud based security solutions.  Palo Alto does have a cloud based product called WildFire, and thus could capture a good part of the shift in security spend. To me, the success or lack of success of WildFire will be the main catalyst to watch for the stock in the longer term as well as the ultimate outcome of its ongoing litigation with Juniper Networks.  As a side note, I also was not a big fan of the company’s decision to exclude its legal expense related to its ongoing litigation with Juniper from its pro-forma guidance.  To me legal expenses related to lawsuits, inventory write-downs etc. are part of ongoing operations and should not be excluded from pro-forma results.  Obviously, there are many different opinions on this topic and I am sure Palo Alto had some valid reasons whey they chose to exclude the legal expense from their guidance.

Infoblox: I have been positive on Infoblox given it has a leadership position in a unique niche in the automated network control market and is seeing new product success via their DNS firewall security product.  DNS cyber attacks are becoming more prevalent, which could set the framework for increased awareness and demand for the Infoblox DNS firewall.  The stock, however, has had a significant appreciation this year and at this point the valuation probably does not support significant upside from these levels.

“Quien Es Mas Macho”: Software Or Optics?

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Last week I attended an Optical/SDN conference in NY while I also moderated an SDN user panel at another conference in Silicon Valley.  In attending such conferences, I always look forward to learning how traditional service providers (e.g. Verizon) and content providers (e.g. Google) utilize or plan to utilize SDN to address major operational pain and cost points in their networks.  For example, major content providers speaking at these conferences have already begun to utilize internally developed software-based load balancing and security applications within the SDN framework.  As an example, one major content/hosting provider told me at one of these conferences that they no longer add appliance based load balancers to one of their network services as they have developed and utilize their own internally developed virtual load balancer.  The virtualization of some basic functionality typically found within security and application delivery controller appliances, is now an initial use case within the SDN framework by content providers like Amazon, Azure, Facebook, and Google.

When it comes to service provider wide area connectivity, however, it is striking for me to hear how Google has achieved up to 90% utilization on their data center to data center WAN links in their current SDN deployment, while traditional telecom operators like Verizon, CenturyLink etc. continue to echo that their respective optical transport networks remain dramatically underutilized given these networks were designed for peak traffic load rates and up to 50% of the networks were constructed as spare, idle capacity to address various failure scenarios (e.g. fiber cuts, human error when servicing equipment etc.).  So, is the SDN software development expertise of content companies like Google so superior that it allows them to achieve such a high WAN utilization rate vs. traditional telecom operators?

Certainly software centric content companies like Google have significant resources that allow them to develop SDN based network optimization software to achieve such high WAN connectivity rates, but they also have the advantages over traditional telecom operators in the type of traffic they carry across their WAN and that they don’t typically deploy their own national fiber network.  For example, when one thinks of the main end user Google applications, Gmail, YouTube and Search come to mind.  While these are important services, users do not typically pay directly for such services given the advertising model and Service Level Agreements (SLAs) are not likely as comprehensive as what a carrier like Verizon has with its customers.  Also, when an end user experiences a slow/choppy video experience with YouTube, the user usually blames its broadband service provider, not Google.  Separately, Google probably does not utilize its SDN network optimization software down to the optical layer as it likely utilizes carriers like Verizon for national optical transport.   Finally, since carriers like Verizon in the US are not permitted to use Deep Packet Inspection (DPI) techniques to prioritize traffic to help improve transport utilization (which could be especially useful during failure scenarios), the solution for a carrier like Verizon to improving and maximizing transport utilization is not likely to be via a software-based SDN solution alone.

With this is a backdrop, it seems that there is an opportunity for equipment suppliers to traditional telecom operators to “marry” SDN software and optics while also using utilizing other tools like the GMPLS and network analytics to dramatically improve optical network utilization across the WAN and within the optical transport network while also maintaining a high level of service assurance.  Optical transport is a huge cost for network operators, and if the effective average optical transport utilization rates are in 15%-25% range, that seems like a pain point that is ripe for a solution.  The start-up company Plexxi is “marrying” optics, SDN control and mathematical algorithms to address scale and service agility to tackle pain points within the data center. If successful, Plexxi may end up being “Mas Macho” in the data center given this vision.   I would not be surprised if Cisco data center switching spin-in Insieme may also be looking at some level of SDN control and optics integration for the data center as part of their product solution.  We will likely formally hear about Insieme’s product this summer.

As for the WAN, however, VCs, are not typically enthusiastic about funding service provider equipment companies given long sales cycles with Tier1 carriers and customer concentration issues.  Throw in the word optics to business case and that makes for strike three.  Thus, traditional optics and/or router equipment companies may have an opportunity to differentiate themselves in solving the high cost, low WAN optical transport utilization rate problem.  While SDN is about separating the control plane and data plane and using software applications and network virtualization to achieve service creation and network agility, its initial focus was for Layer 2/3 switches with an “electrical” based fabric within the data center. Optimizing expensive WAN links for traffic flows that span both electrical fabrics within the data center and optical wavelengths across the WAN while dealing with vendor specific optical intricacies such as Forward Error Correction (FEC), amplifier settings, modulation techniques etc. is not likely to be solved by SDN software control alone.  To be “Mas Macho” in solving the optical WAN utilization challenge, the solution is likely to require multiple ingredients, including, SDN software control, multi-vendor element management system support and visualization, network analytics, a strong optical pedigree and the use of industry protocols (e.g. GMPLS, Openflow etc.).

It is no surprise that Cisco has acquired both SDN software and optical sub-system companies (e.g. CoreOptics and Lightwire) over the past couple of years.   While silicon photonics will play a critical role in achieving single chassis, highly dense routers with 400G interfaces, is Cisco also looking beyond next generation 400G port routers and the broader issue of low WAN utilization rates?   Alcatel-Lucent, another company with core competencies in routing and optics also recently announced its Nuage Networks SDN Virtualized Services Platform solution. While Nuage offers some innovative WAN features in service provider MPLS VPNs, it does not address utilization issues in the optical transport domain.  Will Alcatel-Lucent seek to leverage its initial Nuage SDN software solution with its traditional competency in routing and optics to address the optical transport utilization issue?  Time will tell whether Alcatel-Lucent, Cisco and/or other vendor(s) will be “Mas Macho” marrying software with optics in solving perhaps one of the most significant cost pain points today in service provider WAN transport.

Be Careful What You Wish For

Wall Street has generally focused its research and analysis on how SDN will impact the technology sector. I have also expressed my views on this topic in prior blog posts and have generally taken the view that Layer 4-7 appliance companies may be most at risk as such appliances will be replaced by software applications, merchant silicon semiconductor companies may be poised to benefit as replacement cycles compress for networking equipment once the control plane is detached from switches, and the jury was still out on traditional switching/routing companies depending on how these companies maintain some level of software differentiation over emerging “white box” networking suppliers.

Last week I attended the OFC/NFOEC optical conference and walked away with some additional elements of my evolving SDN investment thesis.  In particular, while traditional telecom operators should benefit from the potential benefits of deploying SDN in their network, they may be also be at risk as SDN will move the value away from the physical network to the application layer where differentiation will be determined by using software for service creation.  While traditional telecom operators are clamoring for SDN as a way to reduce vendor lock-in, lower network cost and enhance service creation, I am not yet sure how well they will compete against software-centric rooted large data center operators like Google in cloud computing services.  Thus, as the value moves away from the network to the software layer, SDN may actually be a threat to traditional telecom operators.  Companies that can help traditional telecom operators through this transition to allow them to better compete vs. software-centric data center operators, will ultimately derive significant value in the financial markets in my view. 

While OFC/NFOEC is supposed to be a conference specializing primarily on optical communications, SDN permeated several of the presentations and seminars.  What I found interesting in several of these presentations was the contrast of how large data center operators like Google and Facebook talked about their specific traffic patterns and resulting approach to building out their data centers and network and how they plan on using SDN in this regard vs. how traditional telecom operators discussed the same topic.    The following table shows some general initial takeaways I had from these presentations.

Attribute

Software Centric Data Center Operator

Traditional Telecom Operator

Traffic Mostly machine to machine Mostly end user driven
Hardware Disposable Asset Long Term Asset
Software Core competency Bundled By Vendor
Network Protection Algorithm Focused Network Focused
Benefits of SDN Service creation

Reduce complexity

Reduce cost

Lower cost

Remove vendor lock-in

Service creation

Let me reflect on a few points on the above table.  Large data center operators like Google and Facebook are fundamentally software companies while traditional telecom operators are generally not.  The ultimate virtualization of the network layer, which is a key objective of SDN, will make software more of a differentiator between data center operators than it is today and could further differentiate data center operators in business and cloud computing services vs. traditional telecom operators in the future.

For example, a large data center operator at the conference talked about how they replace their servers every 18 months in their data centers as it is more cost effective for them to purchase new servers than to run their data centers on older servers.   Now I am not sure what the replacement cycle for servers are in data centers are large telecom operators, but the mindset of hardware being disposable is not typically embedded within the culture of traditional telecom operators.

Another example that resonated with me at the conference was how several telecom operators (and data center operators) talked about how optical transport cost is now about 80% of the network core capital spending costs vs. 20% for routers whereas several years ago the percentages were exactly the opposite.  In addition, some of telecom operator presentations also talked about how network protection in the optical core sometimes equates up to 50% of the network cost.  So, if routing is becoming a much lower relative cost in the core than optics, why are telecom operators putting so much focus in SDN presentations on vendor lock-in within Layer 3 of their network? Clearly all types of cost reduction should be pursued and attacking 20% of the cost is still important, but if separation of the control/data plane in Layer 3 is only going to address 20% of your cost, perhaps there should be more focus on industry standards for optical layer control protocol (e.g. extension of Openflow to the optical layer) and API software development that attacks network utilization and restoration.

So in summary, my main conclusions from the OFC/NFOEC conference in relation to the evolving SDN market are:

  1. While traditional telecom operators will benefit from SDN, they may also be at risk given a more software centric culture and pedigree at certain large data center operators.  Companies that can help traditional telecom operators becoming more software savvy will likely become valuable companies.
  2. Optics is becoming a larger part of the network cost problem than routers for both data center and telecom operators.  Hardware and software companies that attack and solve this problem will likely become valuable companies. Although funding for such hardware initiatives is not in vogue, hardware companies could include merchant silicon companies for coherent optical DSPs or companies that innovate on integration of optical components (e.g. silicon photonics, indium phosphide).  Software companies could include companies that solve high costs associated with network utilization (given the very wide spread in network traffic between peak and average traffic loads) and network protection.
  3. While switching remains an important cost problem, it presents a much bigger problem within the data center in terms of network agility and an obstacle to service creation.   Data center operators want switching solutions that scale horizontally with the control plane disaggregated.

Oracle Goes Telecom II

Well it seems Oracle is serious about expanding its business with telecom operators as it announced today it will acquire diameter routing and SS7 signaling specialist Tekelec. This complements and adds to the announced acquisition of Acme Packet, which was announced just over a month ago on February 4th.   It looks to me that Oracle clearly wants to expand its business with telecom operators, but it is doing it in a very complementary and focused way through these two acquisitions.  So far, both acquisitions of Tekelec and Acme are providing Oracle relatively high margin revenues in the telecom market in the control, policy and management layers of the core of telecom networks.  This complements Oracle’s database revenues in telecom networks focused on business operations, end customer engagement and applications.

My two quick observations on Oracle’s recent telecom acquisitions are as follows:

Staying Focused, Watching SDN For New Entry Points: So far, Oracle has stayed away from entering network infrastructure products that actually carry network traffic and end user information (e.g. routers, switches, optical, etc.).   Oracle seems very focused on staying within the network management, policy and control supervisory layers of the network and not entering classic network infrastructure.  I suspect Oracle will stay true to this plan of action. In the future, however, as SDN and network virtualization develop as new markets, I would expect Oracle to look at taking advantage of this technology disruption as certain hardware based infrastructure functionality becomes software based running on the network core as potential future revenue opportunities.

Offensive and Defensive Acquisitions Given Cisco’s Software Aspirations: While Cisco and Oracle are not that competitive today, Cisco’s ambition to be more of a software company clearly suggests the two companies are more likely to compete for acquisitions and new markets in the future.  I believe Oracle has stepped up its acquisition efforts in the telecom vertical to gain a stronger foothold in telecom policy, control and management core as both an offensive move to expand its addressable market, but also as a defensive move against Cisco as it looks to expand its software business.  “Big IT” business models are converging and will continue to converge in the next several years.  As an example, five years ago neither Cisco nor Oracle sold servers, now they both do.  As network and storage virtualization open up new software markets for new entrants like Oracle and Big Data Analytics potentially open up new software markets for new entrants like Cisco, convergence among “Big IT” players Cisco, EMC, HP, IBM and Oracle is likely to continue to continue.

SDN And Silicon Photonics The Buzz at OFC

While the OFC exhibit floor opens today, I attended a few seminars and the OSA executive session the last couple of days.  The two topics that were more prevalent this year than last year in these sessions were SDN and Silicon Photonics.  My thesis on these two technologies is that the Telecom and IT capex cycle will trump both the longer-term impact of SDN and Silicon Photonics in 2013 in short term investing in 2013. Below are some the interesting takeaways I took from the past couple of days.

Optical Now A Bigger Cost Factor In The Core Than Routing: Major telecom operators like CenturyLink gave presentations that stated that today 80% of their core network cost is in optical equipment with 20% in routers, which is a complete flip of the relative cost structure several years ago.  This will certainly put more pressure on optical companies to seek further cost reduction in their equipment. The general consensus on how that will be achieved is further integration of optical modules (e.g. development of commercial merchant silicon DSPs for coherent optical functionality, silicon photonics or other methods).  It is interesting that the VC community continues to avoide funding optical companies to help solve this cost problem.  Perhaps companies like Broadcom or Intel will look into developing such commercial products in the future.

Fiber Leasing in Europe Should Help Optical Capex: European operator TeliaSonera presented and discussed while there is plenty of fiber capacity in Europe, operators now do not have all the fibers where they need them.  This is causing a increase in leasing dark fibers between carriers, leading to more dark fibers being lit.  This is generally a positive for optical equipment demand as it typically costs more in optical equipment capex to light a fiber than to just add wavelengths to existing fiber routes.  I think this will only help the optical spending cycle in 2013.

Cisco Shows Off The Fruits Of Its Lightwire Acquisition: Cisco showed its new optical module used in its routers and optical systems that was developed from its Lightwire acquisition.  Visually, the new module was impressive as it was about 1/3 of the current size of merchant modules in the market from optical component suppliers.  While there was a lot of debate at this presentation whether optical component suppliers would soon catch up to smaller footprint and lower power modules like Cisco was showing, Cisco has clearly raised the bar for the industry in the race for better optical integration.  I suspect Cisco will use this technology in its new core router, which is likely in my view to hit the market in 2H13.

SDN Is The Panacea: SDN commanded several of the seminars.  As an example, the CTO from Ciena called SDN as the single most important technology in the industry for the next 5-10 years.  Google and Facebook talked about how they have already implemented SDN within their networks.  Google, however, has some unique attributes vs. traditional telecom operators, which has allowed them to implement SDN well before the rest of the industry.  Namely, the vast majority of their traffic is machine to machine and Google is already a software company, which allows them to write their own “SDN-like” applications that can be used within an SDN framework in their network.  Traditional telecom operators all expressed a strong desire to move towards an SDN architecture for both speed and flexibility of new service creation and to better maximize capacity utilization in their networks.

Disclosure:  I currently own shares of JDSU in the optical industry. NT Advisors LLC may currently or in the future solicit any company mentioned in this report for consulting services.

Telco Capex, Big IT War Chests and Optical Component Stocks

I have been traveling quite a bit these past couple of weeks and working on some consulting projects, but wanted to provide a quick update on topics I have been writing about in the past few months.

Telco Capex:  As a continuation of prior blog posts since November of last year, I continue to believe telecom capital spending trends will be positive in 2013 and the momentum still remains positive.  Telco operators are often like Wall Street in that they follow the “herd mentality”, namely, they tend to follow each other in either being offensive or defensive in their respective spending plans.  The setup for a favorable capital spending cycle in 2013 seemed good given the challenging 2011 and 2012 spending environment led to a period of underinvestment going into the build-out cycles associated with LTE, Data Center connectivity and residential broadband upgrades.  While 2011 and 2012 were years of preservation of capital and a defensive posture, 2013 and perhaps 2014 will be years where telecom operators go on the offensive by investing in new technologies in an attempt to gain share and offer new services.  I have already written about how we have seen such offensive moves in the US (e.g. AT&T and Sprint) and Europe (KPN, Telecom Italia, and DT).  Last week, we got the important endorsement of this trend from China Mobile, the wireless operator with the largest wireless capital spending budget in the world.  China Mobile announced its 2013 capital spending budget will be up 49% over 2012, well above analyst expectations of a 23% increase.  I continue to be favorable on telecom equipment stocks given this ongoing positive momentum in capital spending in 2013 and view Ericsson as a reasonable way to play this cycle.   It is important to realize here, however, that most telecom equipment stocks are cyclical, not secular, stocks. Ericsson is up over 50% from the bottom and is already discounting the recovery in telecom capital spending. The “easy money” likely has been made in the stock, although I still think there might be another 10%-20% upside from here.

Big IT War Chests: This past week Salesforce.com raised about $1B through a convertible note while EMC/VMWare announced plans to IPO their Pivotal Big Data/Cloud initiative sometime in the future.  I view both of these events as ongoing evidence how Big IT companies (e.g. Cisco, IBM, Oracle, EMC/VMWare, etc…) are gearing up for an M&A cycle to better position each of them in the battle for Everything Cloud (e.g. Big Data, SDN, Data Center Virtualization etc…).  Salesforce.com already has about $1.8B in cash/investments and generates over $500m a year in free cash flow. The company also has a very high PE multiple of almost 90x 2013 earnings.  Acquisition targets, especially private companies, may find taking Saleforce.com stock as too risky given the high multiple and would prefer cash.  I believe Oracle’s recent acquisition of Eloqua (announced in December) perhaps accelerated Saleforce.com’s desire to have a greater cash balance to have a greater war chest for future acquisitions. In order for Saleforece.com to compete for such acquisitions against more cash rich companies like Oracle, Cisco etc…, they needed to increase the cash balance.  EMC/VMWare on the other hand have the other problem.  In the past, VMWare provided EMC a high multiple currency to make stock based acquisitions, while EMC and VMWare both have had ample cash to make cash based acquisitions. The recent selloff in VMWare stock post reporting 4Q12 results, however, lowered VMWare’s forward P/E multiple to about 20x vs. the historical average of about 35x-40x.  The announcement of the potential IPO of Pivotal in the future helped both stocks and ultimately will provide EMC/VMWare another high multiple stock to make stock based acquisitions.    With Cisco aiming to be more of a software company, Oracle trying to expand more in the telecom space (e.g. Acme Packet acquisition) and all the Big IT companies striving to be leaders in Big Data, SDN and Everything Cloud, we are likely to see an increasing M&A cycle in 2013 and 2014 and these companies are getting their respective war chests ready.

Optical Component Stocks: Silicon Photonics vs. The Cycle: In a prior blog post, I expressed some concern on optical component stocks (e.g. JDSU, FNSR etc…) given the technological threat posed by the emerging Silicon Photonics technology.  I am still concerned about how Silicon Photonics initiatives at Intel and others as well as vertical integration efforts by large buyers of optical components like Cisco (through the acquisitions of CoreOptics and Lightwire), will impact future valuations and stock performance of optical component stocks.  While I still have this concern, the near term cycle of optical spending is likely to trump the longer-term risk of Silicon Photonics in my view.  In a way, Silicon Photonics will be to optical component stocks in 2013 like SDN was to networking stocks in 2012.  As a reminder, Cisco’s stock suffered in 2012 as SDN became a hot topic and VMWare acquired network virtualization specialist Nicira.  While SDN is still a hot topic, Cisco’s stock has performed well in the past several months as the company has beaten estimates, preserved its gross margin and SDN is not viewed a near term threat.  I think the optical cycle is recovering and we should see good spending trends in optical systems and components in 2013, as 2013 will likely be a recovery year after a difficult 2012. In addition, telecom capital spending trends continue to show positive momentum in 2013 as I mentioned above.  Thus, while there will continue to be a lot of discussion and analysis on how Silicon Photonics will impact optical component suppliers in the future, 2013 should be a year where optical companies beat Wall Street estimates.  I think such a playbook will allow optical stocks to further appreciate for a few more months.  Like telecom equipment stocks, optical component stocks are cyclical and they all have already appreciated significantly off the bottom.  Thus, upside from current levels may be limited and the stocks remain very risky and volatile. We should get further information on the status of the optical cycle and the threat of Silicon Photonics this week at the annual fiber optic OFC trade show, which I plan on attending.

Disclosure: I currently own Ericsson and JDSU mentioned in this blog.  NT Advisors LLC may currently and in the future solicit any company mentioned in this blog for consulting services.