Is U.S. Telecom Capital Spending Going Up in “Spectrum”?

Over the past couple of months several technology companies with meaningful exposure to telecom capital spending in the United States including Adtran, Ciena, Juniper and Procera have provided cautionary outlooks in their respective businesses. Most of the companies, analyst and press commentary on these earnings warnings primarily point to the impact of the AT&T Domain 2.0 vendor qualification process (including the associated architectural shift and additional pricing pressure it has brought to the industry), the pending consolidation of the some of the larger US telecom/PayTV operators (e.g. the AT&T/DirecTV and Comcast/Time Warner Cable deals) and a more front end loaded capital spending environment in the US than normal in 2014. While all of these factors are likely key contributing factors to the recent disappointing earnings of the technology companies exposed to US telecom capital spending, I also believe that pending wireless spectrum auctions in 2014 and 2015 are factors that have not received as much attention in the press and should be considered.

Wall Street analyst reports have suggested that the wireless spectrum being auctioned by the FCC in the AWS-3 auction in November 2014 is likely to cost the winners in the auction from $10-$15 billion with AT&T and Verizon likely being the major winners in this auction. To put this potential spectrum spending in perspective, AT&T and Verizon combined have an annual capital spending budget (both wireline and wireless capex) of about $36-$37 billion in 2014. Thus, if AT&T and Verizon spend a combined $9 billion in the November spectrum auction, it would represent about 24% of their combined capital spending plans for 2014, which is fairly significant percentage.

Another spectrum factor that potentially may impact capital spending in the short to intermediate term is the planned FCC Broadcast Television Incentive Auction, which the FCC estimates will take place in mid-2015. This spectrum auction is unique as the FCC plans on using free market forces to motivate existing broadcasters that own the spectrum to sell it in an auction format on a voluntary basis. Since the spectrum auction will be on a voluntary basis, its difficult to predict the potential timing, outcome and spending for the spectrum. Wall Street analysts, however, have written that wireless operators could pay as much as $34-$48 billion in the 2015 incentive auction for spectrum with AT&T and Verizon potentially spending a combined $21-$24 billion. Thus, if AT&T and Verizon combined spend about $9 billion and $22.5 billion in 2014 and 2015 respectively for wireless spectrum, this would represent about 43% of their combined overall capital spending budgets for the two years 2014 and 2015.  The following table shows how the potential spectrum costs in 2014 and 2015 compare to the overall US wireless industry capital spending budgets.

Estimates 2014 2015
AWS-3 Auction $10-$15 Billion
US Wireless Capex $34.1 Billion
AWS-3 Auction as a % of Capex 29%-44%
Broadcast Incentive Auction $33.6-$48 Billion
US Wireless Capex $34.5 Billion
Incentive Auction as a % of Capex 97%-140%

Source: Company reports and UBS Investment Research

Wireless operators have many cash pressures on their operating cash flow including network related capital spending, dividends, share buybacks, acquisitions and spectrum purchases.   Given the potential significant amount of spectrum purchases expected in 2014 and 2015 in the US, allocation of funds to spectrum spending by wireless operators may be another key factor that has led to weaker than expected network related capital spending, thus, resulting in weaker than expected earnings outlooks for certain technology companies. If one thinks about competing for cash outlays, deferring capital spending on equipment and allowing the network to run “hot” on a short-term basis, if possible, seems rational and plausible when such a large cash outlay is likely going to be needed for upcoming spectrum auctions. Network planning could also be potentially impacted as wireless operators have some uncertainty as to their spectrum assets pending the outcome of the auctions, which also could be impacting some spending in the network.

 

China: The Elusive Market For US Technology Companies

China ranks as the world’s largest country by population, second in annual GDP and is likely to rank second in terms of total Information Technology (IT) spending in 2013 at about 10% of global IT spending.  It is estimated by industry analysts that China will grow its IT spending by close to 10% per year over the next decade as IT spending only represents about 2% of its GDP which is less than half the level of more developed countries like the US.  While China represents a large and rapidly growing market for US technology companies, the path to success in this market has proven difficult and sometimes impossible due to indigenous suppliers, intellectual property protection and software piracy issues, pricing challenges and other unique market conditions.  China has also grown its own global technology powerhouses in certain industries like communications equipment and personal computers, materially impacting the competitive dynamics for traditional US and European players in not just the China market, but also the entire global technology market.  Finally, China has also developed its own Internet powerhouse companies that have made it difficult for leading US Internet and social media companies to succeed in China.   Is China “friend or foe” for US technology companies, and has history provided technology companies any lessons on sustainable business practices that can be applied to the Chinese market?

 

Over the past three decades there have been many failures and lackluster successes by US technology companies seeking to enter and profitably grow in the China market.  A high profile example was Google, who decided to exit the China market in 2010 after only about five years of formally entering the market with its own development center in China (and an earlier failed attempt to acquire local competitor Baidu).  Baidu’s market share only increased from the mid 40s to the mid 60s in the five years following Google’s entry, which was significantly higher than the 30%-35% share that Google was able to achieve during that period.   While Google pointed to censorship issues as the main driver to leaving the China market, it was also clearly the case that Baidu did a better job of understating the local market (e.g. Mandarin language searches, music downloads that “crossed” the line on piracy issues etc.) which contributed to Google not being a success in the search engine market in China as it was in other markets around the world. 

 

Google was not the only US Internet giant that failed to achieve its goals in China, as Yahoo and EBay entered and exited as well.  Both used acquisitions of Chinese-based companies as part of their respective entry strategies, but Yahoo could not effectively compete with Baidu in the search market while eBay lost out to Taobao.com (owned by Alibaba) in the online auction market.  In both cases, both eBay and Yahoo did not do a good job in understanding the local China market nuances for search and on-line auctions. Yahoo at least made a financially smart decision to exit the market and invest in competitor Alibaba, which took over its Internet operations.  It is estimated by some analysts that Yahoo’s investment in Alibaba is worth 50% or much more of Yahoo’s current market capitalization. 

 

In all the cases above, US Internet companies stopped their efforts in China within about a five-year period.  While the Internet may move a rapid pace of innovation, business success in China, especially in the technology sector, takes a much longer-term commitment.  Google’s former CEO, Eric Schmidt, initially stated that China had 5,000 years of history and Google would have 5,000 years of patience in China.  As it turned out, Google, eBay and Yahoo only had about 5 years of loss-making patience.  Unfortunately for US Internet companies, China continues to grow much faster than the US in on-line sales and is likely to surpass the US within the next couple of years as evident by China “crushing” the on-lines sales record on November 11th, 2013 as part of China’s annual “Single’s Day” national promotion.

 

The concern over protecting IP and pirating software has been an obstacle for US technology companies seeking to expand their sales business operations in China.  Taking legal action by US technology companies has often backfired.  For example, Cisco Systems’ first-ever corporate lawsuit on IP was against Chinese based Huawei in 2003, which allegedly copied Cisco manuals and software code.  Cisco dropped the lawsuit in 2004 after remedy actions by Huawei, but in my view the lawsuit cost Cisco more in reputational risk than any benefit from the lawsuit.  To this day, China represents less than 5% of Cisco’s total sales in China and the company often highlights China as being “unique” for Cisco when discussing its sub-par performance in the country.  Microsoft has faced software piracy issues around Windows for PCs in China since the company entered the market in 1992.   The issue of piracy in China is still an issue today for Microsoft as evidenced from its recent earnings call where it disclosed for the first time the performance of its Windows business with and without China (i.e. Windows is declining more rapidly in China than the rest of the world).  Microsoft is hoping to reduce piracy of software by selling cloud-based versions of its consumer software, thus, hopefully eliminating over time the availability of pirated software disks sold on the streets.

 

Cisco’s problems in China have intensified recently as the company’s orders from China fell 18% in its recent October 2013 quarter. Cisco is likely feeling the backlash of Huawei’s years of struggle and ultimate failure in building a US business, which was exacerbated by recent press reports on spying by the US National Security Agency. Other large US technology companies like IBM and HP also reported recent weakness in China and Qualcomm has made public comments that U.S. restrictions on Chinese companies and revelations about surveillance by the NSA are impacting its business in China.  As a result of these and other recent data points, there is now a growing view on Wall Street that US tech firms are seeing slowing sales in China due to the NSA spying claims. It is interesting, however, that Franco-American company Alcatel-Lucent announced the day after Cisco report its poor China results that it had won the largest market share in China Mobile’s network for Enhanced Packet Core (EPC) technology among all vendors (including Chinese based vendors). Alcatel-Lucent sells in China through a joint venture established in 1984. Perhaps Alcatel-Lucent is not feeling the same issues as other large US technology firms because it is technically a French company, but it’s long standing JV and the relationships established by this JV in China also has likely played a role in its ability to so far overcome the political backlash that other large US technology companies have experienced.

 

While China based Internet companies like Baidu (search engine), Alibaba (e-commerce) and Tencent (social media and gaming), have generally become dominant in their home market, China based IT centric companies Huawei and Lenovo have established global businesses which have led to weakening fundamentals for Western suppliers of communications equipment and personal computers.  Huawei generated sales of $35.4 billion in 2012 and is now comparable in size to Western leaders Ericsson and Cisco.  The dramatic success of Huawei over the past fifteen years contributed to the bankruptcy of Nortel, the failed mergers of Alcatel with Lucent and Nokia with Siemens, and the lackluster stock performance of Ericsson and Cisco.  Lenovo became the world’s largest supplier of personal computers in 2Q13 with both IDC and Gartner estimating their market share at 16.7% surpassing both HP and Dell for the first time.  In 2009, Lenovo ranked fourth in the world in PC shipments with about 7% share.  While HP and Dell continue to suffer from the fundamental shift from PCs to tablets and smartphones, the loss of market share to Lenovo over the past few years intensified this fundamental issue for both companies and was likely a contributing factor to Dell deciding to go private through an LBO to realign the company and pursue a more Enterprise IT and Services strategy.

 

While US Internet companies and global IT equipment suppliers such as Microsoft, Cisco, HP and others have had either difficulties succeeding in the China market, or face significant competitive pressures from China based IT global competitors such as Huawei and Lenovo, there are examples of US technology companies that have succeeded in selling in China and competing globally against Chinese based competitors over an extended period of time and who so far, have not publicly acknowledged any political pressure on their respective businesses.  Two such companies are Apple and Corning.  Apple currently generates about 15% of total sales from Greater China and its operating margin in China is generally comparable with other regions.  This level of success has been achieved with Apple not yet selling iPhones to China Mobile, the largest mobile operator in the world based on subscribers.  Apple has also been vocal and active on improving working conditions in China among its supply chain companies including conducting annual audits on its suppliers; thus, thus likely helping its reputation in the country.  Corning has been in China for 25 years and competes effectively in catalytic converter substrates, LCD glass display and fiber optic cable.  The Greater China Region represents 26% of Corning total sales and is the company’s largest country by annual sales.  Corning attributes it success in China to having a very long-term perspective, developing relationships with key leaders at the local and national level on important issues such as IP protection, investing in local manufacturing and developing extra checks and balances on potential IP protection issues. 

 

While there is no magic formula for succeeding in the China market as a technology company, there are some common threads among companies that have shown success in the market.  These include, truly showing (not saying) a long-term commitment to the country, developing key relationships (including JVs) at the local and national level to help support a fair playing field and protection of IP, local manufacturing through long lived assets and R&D, understanding the risks of reputational damage when taking legal or other public action against a local company and enacting unique processes to help ensure IP is maintained.  Having products or a distribution of products that make pirating or copying of your products difficult, is also a big plus.

 

Note: The above article first appeared in the November 2013 issue of “The Cornerstone Journal of Sustainable Finance & BankingSM

 

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.

Activist Investing In The Technology Sector

Recent earnings reports from technology powerhouses of the past couple of decades exemplify that these prior titans are all now challenged by lack of revenue growth, margin compression and/or disruptions from new technologies. In particular, Cisco, Dell, IBM, Intel, HP, Microsoft and Oracle all either suffered from weak revenue and/or margin results in their most recent respective earnings results.  Perhaps the confluence of weak results was coincident with the lack of global GDP growth and indicative that these large companies are all suffering from the “law of large numbers” as they have all become mature companies with exposure to legacy businesses (e.g. personal computers, Ethernet switching and structured relational databases etc.) that they all helped define and conquer in the prior three decades?  If true, however, the boards of these companies have to be cognizant of increasing shareholder activism in the technology industry and that more shareholder friendly actions in the form of increased capital returns to shareholders, potential company breakups and leadership changes will need to be considered in addition to traditional technology management actions such as using M&A to spur growth.   The fall from grace of HP prior to Meg Whitman being named CEO was unfortunately an example of a poor use of company cash for M&A, lack of internal investment for innovation and leadership selection choices and raises the question on whether an earlier action by an activist would have helped HP and its board make better decisions.

Recent successes of shareholder activism, which were not originally supported by company boards in large and “legacy” technology companies, have often led to favorable shareholder returns.  Such positive stock returns, will likely encourage further activism in my view from not only the traditional activists but from traditional “long only” investment funds.  The positive returns for shareholders in other “legacy” technology companies Motorola, Yahoo and Dell where activists became involved and ultimately led to a company breakup for Motorola, new leadership for Yahoo and a higher acquisition price for Dell in its planned LBO all resulted in favorable returns for shareholders.  Carl Icahn’s recent tweets regarding his recent investment in Apple, the largest technology company as measured by market capitalization, and discussions with Apple CEO Tim Cook regarding increasing capital returns for shareholders is further evidence of activism taking on the cash rich nature and relatively low valuation of large technology companies.

The recent case of Microsoft is also telling in regard to increased activism playing a role in leadership selection and potentially strategy change.  The fact that Microsoft is currently the third largest technology company in the world based on market capitalization, is not deterring activism from playing a role at this critical point in the company’s history.  In August of 2013, Microsoft offered a board seat to activist investor fund ValueAct Capital Management that had been pressing for a change of the CEO of company.  I also recall a few occasions during my career as a technology sell side analyst visiting institutional investor accounts around the same time as Steve Ballmer, CEO of Microsoft.  I found it interesting that investors would tell me how they made it a point to tell Mr. Ballmer that Microsoft needed to consider selling or exiting certain businesses, breaking up the company or other actions to enhance shareholder returns, but that such requests were falling on deaf ears.  When it was announced that Steve Ballmer would retire from Microsoft on August 23rd, Microsoft’s market capitalization rose by ~$20 billion.  After the announcement on September 2nd that Microsoft would acquire Nokia’s Device and Services business, thus doubling down on its current strategy even as a new CEO was not yet identified, Microsoft shares gave up about $13 billion in market capitalization.

Investors not only saw the Nokia acquisition as doubling down on the prior strategy, but at the time also the increased likelihood that Stephen Elop, current Nokia CEO and former executive at Microsoft, would be the next CEO of Microsoft and potentially maintain the status quo of Steve Ballmer’s tenure.  The opportunity to be heard and play a role in the future of Microsoft, however, was not going to be lost as shareholder activism led to several of Microsoft’s largest shareholders are putting pressure on the board of Microsoft to consider a CEO with “turn around” experience rather than someone who is going to just maintain the status quo.  It will certainly be interesting to see how the CEO selection of Microsoft develops and how activism will likely play a role in the CEP selection as well as the potential ongoing strategy post the selection.  The recent rally in Microsoft stock to a new 10 year high is a likely a sign that investors “smell” a positive leadership change, that will unlock value at the company.

Note: The basis for this article was originally published in the inaugural issue of the “Cornerstone Journal of Sustainable Finance and Banking” published in October 2013.

I also recently was interviewed on Bloomberg TV on the topic of Activism in The Technology Sector.  The interviewed can be viewed here

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.

 

 

 

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.

What To Do With ALU – Part 2

Over the past several months I have written often about my positive view on the communications equipment sector, particularly stocks with exposure to service provider capital spending. One of my favorite names as a play on this theme has been ALU.  I continue to remain favorable on stocks exposed to service provider capital speeding and in particular, ALU.  This week, the sector has had a strong performance, and I think the bias will likely continue to be positive in the coming months. The main drivers to the sector performance this week were: 

1. Positive earnings and outlook from Ciena on Tuesday as well as its positive commentary on the global 100G optical spending cycle

2. Positive mid-quarter bookings commentary from the CEO of Juniper at a Wall Street Investor conference on Tuesday as well as his positive commentary on the service provider router market

3. The sale of Vodafone’s stake in Verizon Wireless back to Verizon for $130 billion, of which about half will be in the form of cash.  Vodafone is likely to use part of this cash to increase capital spending in its other properties in Europe, which could form the beginning of a capital spending recovery in Europe.

Specific to ALU, there were two other perceived positives:

1. The sale of Nokia’s cell phone/device unit to Microsoft, which will add over $7 billion in cash to Nokia’s balance sheet.  Investors are hoping that once the device unit sale closes in 4Q13, the dramatic increase in cash at Nokia will enhance the probability of Nokia acquiring the wireless division from ALU.  Earlier in the year Nokia bought out Siemens’ portion of the NSNS JV and, together with other divestments in wireline infrastructure, has become focused primarily on wireless infrastructure and services.  A potential sale ALU’s wireless business to Nokia is something I have written about in the past as being a positive for ALU if it were to occur given ALU’s lack of scale in wireless.  Such a sale make ALU a more focussed company and more of a pure play on IP Routing and Optical where it has scale and technology leadership. 

2. The new CEO of ALU, Michel Combes, spoke at an investor conference and emphasized his number one priority is generating positive cash flow, in a great part through successful implementation of his “Shift” restructuring plan and generating at least $1 billion in asset sales.  I think Michel is more willing to consider a sale of the wireless unit (or part of it) than the prior CEO, but I think it is fair to say he will continue to focus on improving the wireless division’s margins and revenue growth rather than hope or depend on an asset sale as the main course of action.  Michel seems more focused on returning ALU to profitability and positive cash flow than the prior management team and less wedded to the prior strategy of keeping ALU being an end-to-end equipment supplier.  The fact that ALU hired an ex investment banker as its new CFO, also suggests “deal making” to enhance the cash position of the company may be a higher priority than in the past.

My sense is the positive spending commentary from Ciena and Juniper, the likelihood that European spending can only get better given a more cash rich Vodafone and the beginning of the 4G LTE upgrade cycle from China Mobile starting in 4Q13 will continue to provide a positive backdrop for technology companies exposed to service provider capital spending.   While Cisco’s surprisingly soft earnings report from a few weeks ago put a damper on the sector, most of Cisco’s issues were related to tough year ago comparisons in Japan, weak spending from certain emerging markets and China (which may partly be due to political issues) and a  declining set top box business.  These are not indicative in my view of the service provider spending catalysts I mentioned above.

I continue to be positive on ALU and remain long the stock but highlight that it remains a volatile stock, especially after the very strong performance of over 200% off the bottom in the past year. 

Disclosure: NT Advisors LLC may in the past, present or future solicit and/or generate consulting revenues from any company mentioned in this post.

A View Of the NY Technology Ecosystem

I recently was interviewed on Bloomberg TV to talk about the NY Technology Start-Up Ecosystem.  The interview can be seen here.   The quick summary points of the interview are as follows:

1.  While the media/press like to compare NY to Silicon Valley in terms of technology venture capital and start-ups, the comparison is probably not appropriate.  The Silicon Valley technology ecosystem began decades ago (with major milestones like the HP IPO in 1957, Intel IPO in 1971 and the Apple IPO in 1980), while the NY technology ecosystem is likely only about decade or so old.    Even so, NY ranked second only to Silicon Valley in terms of total technology venture funding and private company M&A among all major cities in the US in 2012.  Clearly, NY has enormous momentum.

2. The NY technology start-up ecosystem is developing very favorably with many successful financial exits in the past few years (e.g. Buddy Media, OMGPop, Tumblr, MakerBot, etc.).  NY has made tremendous strides in the past decade to be viewed as a place for talented entrepreneurs, engineers, venture capitalists and academics to work.  The positive impact of Mayor Bloomberg over this period has played a key role to the development of the NY Technology community and I hope the next mayor can continue the momentum.  We are also seeing homegrown venture capital firms like Union Square Ventures, FF Venture Capital, Bowery Capital etc. be an integral part of the technology community in NY.

3. A key part of the development of the NY Technology ecosystem in addition to government policy and homegrown VCs is the support of local universities for technology entrepreneurship.  We have seen increased awareness and actions by major universities locally like the entrepreneurship efforts of Columbia University and the development of the Cornell Technology campus at Roosevelt Island.  A key part of the development of Silicon Valley over the past several decades was the pro-active efforts of Stanford University to foster and promote entrepreneurship among its students and professors.  NY universities like Columbia have dramatically improved their efforts and policies towards entrepreneurship in the past several years and have implemented best practices policies towards entrepreneurship.

4. While NY is now number two behind Silicon Valley in technology venture investing, longer term it will likely be important for NY to have its own natural consolidators that are created and grew in NY.  Shutterstock, which went public in 2012, is an example of a successful IPO of a NY technology company.  Over the next decade, it will likely be better for the development of the NY technology ecosystem if other companies IPO and grow as public companies rather than NY being mostly a satellite city for traditional larger technology companies (e.g. the acquisition of NY based Tumblr by Silicon Valley based Yahoo).   While having Google, Microsoft, Yahoo, Twitter etc. open up offices in NY and seeing NY technology start-ups be acquired at healthy valuations by non-NY technology companies is great for now, longer term, I believe the broader success of NY as a technology center would be advanced if the region had its own natural consolidators.

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.