Capex Continues Its Slow Drift Upwards

Following up on my most recent post on July 8th, I continue to see a slow but steady drifting upward of both telecom and networking capital spending.  An increasing competitive environment in the US wireless industry, the likely ramp of LTE spending in China in 2014 and the beginning signs of telecom spending bottoming in Europe should support service provider centric communications equipment stocks. In addition, while enterprise centric IT spending has not shown as vibrant of a recovery, recent results from distributors and other supply chain companies are starting to point to a recovery in enterprise networking spending.

Stocks that I have liked and continue to like in this current environment are Cisco, Alcatel-Lucent and JDSU.  While I continue to like all three of these names, I think the potential returns from current levels are not as significant as the respective returns over the past year. Specifically, I am looking for returns of 10%-20% over the next several months to year for both Cisco and JDSU, while ALU may have a bit more upside, yet with more risk as well.

Both Cisco and JDSU report earnings this week.  Wall Street is generally looking for Cisco to report results that are slightly better than consensus estimates, while there is a mixed view on JDSU going into its earnings.  The overwhelming consensus that Cisco will report a slightly better than expected quarter is a bit concerning as there seems to be little controversy going into results as compared to prior quarters. Thus, expectations are generally positive for Cisco, which leaves little room for any disappointment in their results. Even so, however, most signs seem to be positive for Cisco going into its results, including positive data points from its supply chain in 2Q results (e.g. distributors, contract manufacturers etc.), the continued strength in telecom capital spending in the routing area (as witnessed from both ALU and Juniper results) and a generally improving IT spending environment.  In addition, Cisco will be reporting its fourth fiscal report when it reports this week, which is generally a strong bookings quarter for Cisco.   This should support a solid year end backlog when results are reported.

With regard to JDSU, there is a mixed view going into their results, as most of its peers in the test and measurement business (e.g. Ixia, Spirent etc.) reported disappointing results.  On the other hand, optical component suppliers (e.g. Finisar, Alliance Fiber etc.) have generally reported (or pre-announced) positive earnings results.  Thus, there is more uncertainty around JDSU’s upcoming results and guidance.  My sense is if JDSU does offer either disappointing results and/or guidance, Wall Street will look at it as a buying opportunity as both these business segments are likely poised to improve in 2H13.

For my recent views on the security market post Cisco’s acquisition of Sourcefire, check out the following link.

Disclosures: I am currently long Alcatel-Lucent, Cisco and JDSU.  NT Advisors LLC may in the past, present or future solicit consulting business or have generated consulting business from any company mentioned in this post.

“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.

Switch Wars (At An Interop Near You)

This week the networking industry will attend the annual Interop trade show in Las Vegas.   While Software Defined Networking (SDN) and its potential disruption or new growth driver to the networking industry continues to be the main hot topic in the industry, the Data Center Ethernet Switch market remains a vibrant, good growth market in the near/intermediate future.  SDN will clearly be a major force in the networking industry over the next several years, but winning Ethernet Switching Data Center customers and footprint today will only enhance a networking company’s chance of being relevant and driving the transition to SDN.

In the past week, Data Center switch vendors Arista, Brocade and HP all announced new Data Center Ethernet Switch products.  In addition, Juniper announced its new Data Center switch about a month ago.  These and other competitors such as Extreme, Dell, and Huawei are all aiming to be of significant size and the number two Data Center Switch vendor after Cisco, which clearly dominates this market with over 65% market share.  In looking at all the recent Data Center switching product announcements, it seems to me that Arista with its new 7500E continues to stay ahead of the Cisco challengers when looking at a variety of key metrics such as latency, scalability (i.e. supports up to 100,000 servers in a two-tier design) and interface port flexibility (i.e. single line card for 10/40/100GbE).  While these hardware metrics suggest Arista continues to stay ahead of its peers, Arista also was early in developing an open based operating system based on Linux, which positioned the company’s Data Center switch products on the SDN path well before SDN was a hot topic in the networking industry.   In simplest terms, Arista seems to be given the networking industry what it wants, namely, a strong technical product line that offers both best in class hardware metrics and an open and easy to use operating system.

While the battle for number two after Cisco in the Data Center switch market is far from over, especially given the larger resources some of Arista’s competitors possess in terms of R&D, distribution and product breadth beyond switching, Arista seems to me as the one to beat.  I also think Arista’s technology product momentum is making them the likely company to beat in the high profile NYSE Data Center Switching “jump ball” that has been ongoing on for several months.   From a stock perspective, if Arista (currently a private company) can continue to leverage its technical advantages in the Data Center Switch Market through increasing market share, its success will likely take away a key potential stock catalyst for its publicly traded competitors.   While Cisco will always be the number one in Data Center Switching, a strong, rapidly growing number two could make for a good investment opportunity.  Right now, Arista is making that challenging for its publicly traded peers.

Disclosure: I do not currently own shares of any company mentioned in this blog post.  NT Advisors LLC may solicit any company mentioned in this blog post for consulting services.

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.

Did Lloyd Carney Really Know About Q-Fabric When He Was At Juniper?

When a company has been struggling or experiencing an underperforming stock price for many years, an agent of change through new a new CEO is typically needed to attempt a turnaround.  When I was a Wall Street analyst, I would always listen very carefully to what a new CEO of a public company would say in their first public interactions with Wall Street.   In particular, I would listen to see if the new CEO was likely to be an agent of change or not and whether the initial comments seemed rational and well thought out.  A case in point many years ago that raised a yellow flag for me in a company in the TMT sector was when a new CEO of a company talked about bringing integrity/ethics back to the company was a priority.  Shortly after this first conference call, however, the new CEO was sued by his former employer for violating an anti-compete clause.  Maybe it was a coincidence, but the turnaround never happened in this company

One recent example of a positive change of CEO has been Marissa Mayer of Yahoo.  In watching her speak during a January 2013 Bloomberg TV interview, I was very impressed with how she acknowledged Yahoo’s current lack of presence in mobile, but how she planned to address this by leveraging mobile partnerships (e.g. with Facebook) and the daily habits people have using Yahoo for content around sports, stock quotes, weather, etc. as a path to a stronger presence in mobile.  There was no facade or setting ridiculous expectations, but rather a realistic assessment of the current situation and a reasonable path to improve the company’s position in mobile.  The interview of Ms. Mayer can be found here:

http://www.bloomberg.com/video/yahoo-ceo-says-personalization-is-future-of-search-XDvwyS~OTCOMXwWq~j8m2w.html

Ms. Mayer is also getting a lot of press lately about her decision to have Yahoo telecommuters return back to the office.  The reality is telecommuting does not foster a strong culture for technology companies in my view.  More importantly here, is Ms. Mayer is trying to change the culture at Yahoo.  She is trying to be the change agent the company needs.  For Yahoo to turn around and be a more important company in mobile and social networking, the company will need to work more together.  Since Ms. Mayer took only a two-week maternity leave, she is clearly practicing what she is preaching.

Now, let me reflect on another recent CEO change and my initial concern on some of the comments made by the new CEO.  Specifically, I am talking about Lloyd Carney, the new CEO of Brocade.  In looking at Lloyd’s background, he seems like a good choice for Brocade.  Lloyd was formerly CEO of Xsigo (which was acquired by Oracle) and Micromuse (which was acquired by IBM), the COO of Juniper and President of Nortel.  With such a strong background, Lloyd certainly has the qualifications and potential to be successful in being a change agent for Brocade and generating strong returns for its shareholders.

While Lloyd Carney’s background seems solid, I was confused with some comments he made in two recent public appearances as CEO of Brocade.  Specifically, Lloyd made some comparative and reflective comments on the Q-Fabric Data Center Switch, which was developed at Juniper Networks, a competitor to Brocade.  The two comments are shown below:

…. And I’m a technologist at heart, an engineer at heart. And the thing that attracted me most, primarily, to Brocade was technology. I mean, I saw the fabric. I was at Juniper as COO, so I knew how QFabric was created.

Source: seekingalpha.com

Brocade Communications Systems Management Discusses Q1 2013 Results – Earnings Call Transcript, February 14th, 2013

… The fabrics that compete with us today are the Juniper Fabric, which uses the QFabric, which uses the ASIC chipset that I developed 10 years ago when I was there. Very complicated, not very scalable solution,…

Source: Seekingalph.com

Brocade Communications Systems’ CEO Presents at Morgan Stanley Technology, Media & Telecom Conference (Transcript), February 25, 2013

Lloyd Carney was COO of Juniper in the 2002-2003 timeframe. At that time, Juniper was not even in the Ethernet Switch business (Juniper formally entered this market in 2008), let alone the more elaborate Q-Fabric data center switch that was generally released to the market in the second half of 2011.  Juniper publicly disclosed the R&D efforts around Q-Fabric in 2009, when the product was code named Project Stratus.  I find it hard to believe that Lloyd new anything about Q-Fabric when he was at Juniper, as the product concept most likely did not even exist in 2002-2003 and I also doubt the ASICs used in Q-Fabric were being conceived in 2002-2003.

Now while this all might be obvious given how long ago Lloyd was at Juniper, the question is why did he make such comments?  I do not know and I hope next time he speaks in the public domain, someone asks for a clarification. But until then, these comments raise a yellow flag to me.  In the meantime, I wish Lloyd all the best in his new role as CEO of Brocade.

Disclosure: I own shares of Yahoo. NT Advisors LLC may currently or in the future solicit any company mentioned in this blog post for consulting services.

 

SDN: Open, Fragmented Chaos

I wanted to follow up on a prior blog post after attending a recent SDN conference where I also moderated an investment panel.  In summary, I walked away from this conference and reading other recent SDN news thinking that 2013 will be a year of increased entropy for the SDN market.  VCs will continue to fund new start-ups, incumbent large IT companies will announce SDN plans/roadmaps, users will demand open standards to avoid vendor lock-in and the press release and marketing onslaught will be intense.  From an investment perspective, I still think it is too early to make any definitive conclusions given all this disorder and timing of SDN revenues being significant still being a couple of years away, but I believe that existing merchant silicon suppliers like Broadcom can only benefit from the deployment SDN with little threats from start-ups, while Layer 4-7 based appliance companies like F5 are most at risk given the ultimate SDN architecture and significant VC start-up funding in this area. 

Users Want Open Standards: Not surprising, both enterprise and service provider end users are weary of being locked-in to single vendor or vendor coalitions. After all, one of the main goals of SDN is to unlock monolithic data center hardware and appliances to allow for more innovative and faster feature development.  What I think will be challenging here is any standards efforts typically involves multiple constituents with different agendas.  This tends to slow down the standards process and results in compromises in the ultimate standards that limit functionality and flexibility.  A very relevant example in the recent past was the standardization process for IP Multi-media Subsystem (IMS) in the telecommunications industry.   When I asked a senior technical executive from the telecom industry at the SDN conference on whether there were any lessons learned or best practices from the IMS standardization process that could be applied to SDN, the answer was not encouraging. Specifically, the executive mentioned how the standards process around IMS was tedious, took longer than expected, and resulted in compromises that ultimately left the standard somewhat inflexible for some future unforeseen requirements (e.g. certain aspects of machine to machine communications over 3G/4G wireless networks).   Although not yet formally announced, the new open-source Daylight controller consortium from traditional networking and IT vendors Cisco, Citrix, HP, IBM and NEC will be interesting to watch.  Is this is a true open-source initiative, or a coalition effort from those that benefit from the current processes in data center design, implementation and hardware sales that just want to keep the status quo as we transition to SDN over the next few years.

Fragmentation and Chaos: To me, the SDN market right now is both fragmented in terms of company functionality and chaotic in terms of vendor positioning and marketing.  I say fragmented as most start-ups (and public companies for that matter) I see are offering one or a few pieces of the overall SDN solution, but not one is all that encompassing. That make sense given how broad SDN is both in terms of architecture and functionality.  It is likely we will see continued funding of start-ups to fill in functions within the SDN functional grid as well as acquisitions as existing public companies and mature SDN start-ups seek to fill out their SDN offerings.  The F5 acquisition of LineRate was a recent example of this as an existing appliance based Application Delivery Controller company F5, acquired an SDN start-up focused on Application Delivery Control.  Thus, the fragmentation of the SDN market is likely to remain and supportive of continued VC funding, which will continue to fuel consolidation as mature start-ups, traditional networking, hardware and software companies seek to fill in the gaps of their SDN solution.  I continue to believe such a cycle and the ultimate timing of significant SDN revenues being 3 years away will make it highly unlikely any true SDN start-up goes public in the next two years.

I also characterize the SDN market as chaotic right now given the marketing onslaught of large technology companies in 2013.  In the past several days alone, we have seen initial indications of the open-source Daylight controller (e.g. expected to be supported by Cisco, Citrix, HP, IBM and NEC), SDN announcements from traditional vendors Ericsson and Huawei and ONUG releasing its top five recommendations to enable Open Networking.   While 2012 was the year start-ups garnered virtually all the attention in the SDN market, 2013 seems to be the year that technology incumbents are scrambling for mind share through coalitions, product launches/roadmaps and acquisitions.  On top of these developments, venture capitalists on the panel I moderated at the SDN conference indicated they expect further investments in 2013 for new SDN start-ups.   Seems like the SDN crescendo will only intensify throughout the year.

Investment Thoughts:  My investment thesis around SDN continues to evolve as I continue to digest new information.  I provide some takeaways from the investment panel I moderated at the SDN conference below, which are of-course subject to change in the future as new information becomes available.   

  1. Little Competition for Merchant Silicon Companies: Everyone agrees that there will be strong demand for merchant silicon for new hardware platforms as the SDN market develops.  On the other hand, it appears VCs do not want to fund merchant silicon start-ups given the high R&D and other costs associated with semiconductor companies vs. software companies.  Thus, my conclusion is that Broadcom and maybe Marvel (if they can get some traction with their merchant silicon products) could be companies to benefit from the growth of SDN, although it will take a few years for SDN to truly drive merchant silicon sales. Intel would be another beneficiary, but merchant silicon would likely be too small of a business for such a large semiconductor company.
  2. Layer 4-7 Companies More At Risk Than Cisco: While all incumbent data center equipment suppliers are potentially at risk from the future of SDN, I think special purpose appliance based Layer 4-7 companies like F5 are more vulnerable than Cisco.   I say this because the ultimate SDN architecture will still require physical switching fabrics in the data center. Perhaps these fabrics will be merchant silicon based and Cisco will suffer share loss or margin pressure, but perhaps not.  On the other hand, the stand alone Layer 4-7 appliance is not present in the future SDN based data center, but rather replaced by a pure software solution in the application layer.  While its possible companies like F5 can pivot and transition their business models to be the suppliers of such software, the VC community seems intent on funding talented start-ups to attack this technology discontinuity while at the same time they are not funding merchant silicon companies at all and seem to be rarely funding data center fabric companies. 

Disclosure: I currently own shares of Cisco, HP, Marvel and Ericsson mentioned in this report. I may currently or in the future solicit any company mentioned in this report for consulting services for NT Advisors LLC.

Oracle and Cisco On A Collision Course

Today Oracle announced it was acquiring session border controller equipment supplier Acme Packet for about $1.7 billion.   Acme Packet has roughly 50% market share of the $500 million session border controller market.  What I find interesting in this strategic move by Oracle is that they are entering a market (albeit a relatively small market) that is served by traditional communications equipment suppliers like Cisco, Alcatel-Lucent and Ericsson.  One has to ask, why is Oracle entering such a market?  My view on this is Oracle sees that the combination of high speed public roaming wireless technologies like LTE, the maturation of IP Multi-Media System (IMS) for IP service manageability (which SBC is a part of), more sophisticated mobile devices (e.g. tablets and smartphones) and cloud hosting as allowing for the first time communications service providers (e.g. Verizon and AT&T) to truly offer a full suite of managed fixed and mobile services to the enterprise customers.    Oracle wants to be a solution provider to service providers and large enterprises in the areas of business/services operations, IMS core manageability and application creation elements.  Oracle already does a significant amount of business with service providers in business/services operations and is likely looking to expand its offering in IMS core and application creation.  Acme fits into the IMS core.  I would not be surprised to see Oracle acquire Layer 4-7 application companies within the Software Defined Networking (SDN) architecture as well to enhance their offerings in application creation.  These companies, however, may not necessarily be public companies, but rather private start-ups developing pure software applications rather than special purpose network appliances.

What is also clear to me in this move by Oracle is how Cisco and Oracle will become more competitive over time. This is not surprising, as both companies are somewhat mature and seeking new growth vehicles.  What probably also accelerates this increasing competition between the two companies is Cisco’s recent strategy shift to being more of a software company.  Acme was a main competitor to Cisco, albeit in a small market of only about $500 million.  Even so, this deal likely portends of more competitive clashes between the two companies in the future.  So while the street has been focused on the increasing competitive dynamics between EMC and Cisco after VMware acquired Nicira back in July of 2012, now we can add another competitive battle with Cisco in the form of Oracle.

Large cap technology companies like IBM, Oracle, Cisco, EMC and HP all are mature when one looks at single digit organic revenue growth or even less for IBM and HP.  We are likely to see more of these technology titans continue to compete with each other as we have already seen in the past several years.   Even though this is obvious, predicting the actual M&A decisions by each company has not always been so obvious.  While VMware acquiring Nicira was not too shocking, I don’t think many were predicting Oracle would buy Acme Packet.  More such surprises are likely in 2013 and beyond to the point one has to question how the networking equipment industry landscape will look like in a few years.

Disclosure:  I currently own shares of Cisco and Ericsson mentioned in this blog post.  NT Advisors LLC may currently or in the future solicit any company mentioned in this blog post for consulting/advisory services.

What (if Any) Part of the Networking Value Chain Will Be Disrupted by SDN?

I have been following the topic of Software Defined Networking (SDN) for the past three years.  Three year ago the technology was not well known by Wall Street but now is enjoying an intense level of discussion by investors. When the technology was first presented to me three years ago, my initial reaction was SDN would be a risk for technology companies in the Ethernet Switching and Routing markets (e.g. Cisco and Juniper), while creating new opportunities for semiconductor companies selling merchant silicon (e.g. Broadcom and Intel) and newly created SDN software companies.   After visiting a few SDN private companies in the past couple weeks, talking to industry participants and reviewing recent SDN acquisitions by Cisco, Juniper and others, it is actually less clear to me now how SDN will dislocate the current networking value chain.  I am not questioning the value proposition of deploying SDN or the likelihood that it will be a significant investment cycle in the next five years, as I view that as a given.  Rather, the question whose answer has become less obvious to me is which publicly traded companies (if any) are most vulnerable to the upcoming SDN technology cycle and when will this dislocation most likely begin being reflected in these company stock prices.

– Will the ultimate acceptance and deployment of SDN match my simple initial reaction that it will be negative for Cisco and Juniper as switching and routing face competition from more open oriented hardware platforms (Arista and Pica8 are examples of privately held open hardware platforms)?

– Will SDN actually require more complex and high performance hardware platforms in the data center as the real value around SDN will be operational simplicity and cost reduction rather than a focus on hardware costs (data center privately held platform companies include Arista and Plexxi)?

– Will SDN be more of a risk for Layer 4-7 companies that are selling special purpose appliances that may be made obsolete by more multi-functional and integrated software applications in the SDN orchestration layer?

– Will both Layer 2/3 and Layer 4-7 companies be at risk?

– Will SDN create the opportunity for a Network As A Services (NaaS) model and disrupt the entire networking value chain?

– Perhaps, SDN will be some combination or elements of all the above scenarios?

I will be moderating an investment panel at an SDN user conference in a couple weeks with some very smart and experienced investment professionals and hope to get more insight into these topics, which I plan to share on this blog.  In the meantime, lets take a look at how sentiment on SDN’s impact to current publicly traded companies has changed over the past several months and why it is likely SDN developments will not be that relevant to public company stock prices in 2013 as they were in 2012.

The first major wake-up call on SDN to the public markets was July 23rd, 2012, when VMware announced it was acquiring Nicira for $1.26 billion.  Since this announcement occurred after the market close, I was curious to see how Cisco and VMware would trade the following day.  As it turned out, Cisco’s stock lost 6% of its value (about $5 billion in market value) the next day while VMware fell about 0.3% (note VMware announced earnings the same evening it announced the Nicira acquisition which likely muted the impact of the Nicira acquisition to VMware’s stock price movement the next day).  What was interesting about the market reaction was that Cisco lost $5 billion in value while VMware barely budged after spending $1.26 billion for a company that at the time was likely to generate less than $50 million in revenue in calendar 2013.   Clearly, the market at that point viewed SDN as a massive technology risk to Cisco.

Over the course of the next several months, however, Cisco formulated its SDN strategy, made a couple of SDN acquisitions of its own (vCider, Cariden and funded Insieme) and communicated its SDN strategy at its analyst day on December 7th, 2012.  Juniper acquired SDN start-up Contrail and communicated its SDN strategy on January 15th, 2013.  In addition, Nicira/VMware seemed quiet in terms of market penetration and customer deployments post the announcement of the acquisition in July.  So, in the span of 6 months, SDN went from a perceived significant risk factor to Cisco and Juniper to being more of an unknown entity both in terms of potential impact and timing of that impact.  Investors slowly began to realize that SDN would have little impact to 2013 and maybe even 2014 financial results.  Also, Cisco and Juniper are fighting back and will aggressively try to leverage their installed base of equipment to take advantage of SDN as a new revenue opportunity.

Now lets look at Layer 4-7 (e.g. security, load balancing, application delivery control).  What I find interesting here is several of the new SDN private company fund raising in the past several months were for companies attacking this segment of the networking value chain.  Companies that might fall into this category include Embrane, LineRate, PLUMgrid and Pluribis.  Several industry people I speak to suggest that Layer 4-7 will actually be the first area of SDN deployment in data centers given the need to provision and manage policies/applications/security at scale in the data center, which proves to be difficult when managing multiple single purpose appliances and that managing this in the orchestration layer within the SDN model potentially provides an elegant and scalable solution.   It might be coincidental, but in listening to the F5 earnings call this week, I found the following dialogue in the Q&A portion of the call on why F5’s Technology Vertical has not been performing well in the past couple of quarters very interesting as it relates to this topic. Below is how F5 management responded to this question:

“So, on the Tech Vertical issue, you’re right. I mean, the Tech Vertical has trended down over the past several quarters for us, and we believe it’s driven really by a couple of our larger customers that are taking alternative architectural approaches in terms of how they’re building things. So, generally they’re building some basic functionality into that app. And, so we’ve been seeing that going on, and obviously we’re doing something about it.

We’ve got projects going on internally that we believe will provide this type of customer with ways that will make it easier for them to integrate our functionality into the applications [inaudible] that they’ve got.”

Source: Seekingalpha.com

What is interesting here is that the Technology Vertical within F5 results typically includes major data center and cloud providers in the category of Facebook, Apple, Google, Yahoo, etc.  While I do not know which specific customers F5 was referring to in this comment, it is valuable to see how such large-scale operators are already implementing certain parts of the Layer 4-7 stack on their own.  One can easily infer why Layer 4-7 SDN start-ups are getting funded at a nice clip given the potential for disruption here. Obviously, publically traded Layer 4-7 companies are not standing still as this is happening and are already offering virtual instances of their appliances, which I would imagine will ultimately be offered as applications in the SDN orchestration layer.

Finally, start-up Pertino appears to be focused on using SDN as a framework for Network As A Service (NaaS).  While they are not likely to be the only company pursuing such a business plan (perhaps some of the companies mentioned above), it does the raise the option that NaaS could be disruptive to the entire networking value chain especially if we see large players like Amazon, Google and others pursue such an offering or if a new disruptive start-up emerges to be the Saleforce.com of NaaS.

So in summary, SDN it is going to be a very disruptive technology. What was initially viewed as a technology shift that will be a negative for Cisco and Juniper is now potentially more complex to predict in terms of public market investing.  What is likely, however, is that SDN will have little impact to publicly traded stocks in 2013 as other macro and company specific fundamentals will be more relevant to stock prices in my view.  I doubt we will see another VMware/Nicira type of deal in 2013 both in size and in its impact to publically traded stocks like the $5 billion in lost value Cisco experienced the day after this deal was announced.  However, over the course of the next year or two, the potential impact of SDN to publically traded companies and how these companies either capitalize or fall victim to the adoption of SDN will be more evident.  It will certainly be fascinating to watch!

Disclosure:  I currently own shares of Cisco mentioned in this blog post.  NT Advisors LLC may currently or in the future solicit or have as clients any company mentioned in this report.