What To Do With ALU?

In prior blog posts over the past few months I have been positive on technology stocks for 2013 given low relative valuations to the overall market and my view that IT and telecom capital spending will recover in 2013.  In particular, I have liked Alcatel-Lucent and Ericsson as a play on telecom capital spending and increased concern over Huawei as a security threat in the US (and some other markets), and recently Hewlett Packard given extreme negative sentiment, favorable cash flow and a low valuation, which was amplified by the Dell LBO valuation metrics.

While I remain positive on technology to outperform this year, Alcatel-Lucent has become a bit more challenging of a stock in my view.  I think the stock could still work over the course of the remainder of 2013, the next 2-3 months could be volatile and the stock could decline until after 1Q13 results are reported.  I base this on the new dynamics that have become public since the company reported 4Q12 results on February 7th, namely:

–       A new CEO was announced and he will not take over until April 1st, thus, potentially distracting the company during this interim period in 1Q13 as well as the new CEO potentially resetting expectations lower given new CEOs often seek to “lower the bar” when they take over a struggling company

–       Press reports about a potential combination with competitor Nokia Siemens Networks (NSN), which in theory could be positive but in reality may be very difficult to implement and execute

–       Press reports that the French government may take a stake in ALU to help secure the future of the company and its patent portfolio, which I think would not be in the best interest of shareholders

Positive on New Executive Announcements

I think the new CEO selection of Michel Combes seems like a good one given his background in the telecommunications industry at Vodafone and France Telecom and more importantly his reputation as a cost cutter, which is what ALU needs the most right now.  I think it is also positive that a new CEO was selected quickly, rather than long drawn out process.  I believe he will be well received by investors when he takes over the company on April 1st.  In addition, I strongly favor the selection of Jean Monty for the new role of Vice Chairman of the Board of Directors. When I was a Wall Street analyst, I found Jean Monty as an excellent CEO as he led the turnaround of Nortel in the 1990s after Nortel had underinvested in R&D and was suffering market share loss and degrading customer relationships.

While I am positive on the two new executive announcements, this first quarter could be a very challenging one for ALU.  The new CEO does not take over until April 1st.  The company could lack focus on trying to deliver the best financial results as possible given uncertainty on what the new CEO will do when he takes over on April 1st.  In addition, the first quarter of every year tends to be the most challenging for ALU and in the industry as a whole.  Thus, there could be some pressure on ALU shares until 1Q13 results are behind the company in my view given these transitory issues.

 Merger With NSN Good Theory, But Probably Difficult in Reality

The press has reported that ALU may be seeking a merger, investment or some other partnership with European competitor NSN. In theory, a merger with NSN might look attractive given both ALU and NSN are competing against much larger wireless infrastructure suppliers Ericsson and Huawei.  Combining forces would reduce competitive pricing pressure and provide more scale to compete against these two larger companies.  In reality, however, merger of equals in the telecom infrastructure usually results in 2+2=3, not 4 or 5.  The reason is that rationalizing duplicative product lines (wireless infrastructure in this case) is not easy, as customers do not typically accept products to be discontinued due to a merger. Thus, duplicative products and associated costs linger much longer than anticipated.  The other main issue in merger of equals is the cultural clashes of the two companies and political infighting that take place post the merger.  In fact, both NSN and ALU experienced these issues when each entity was formed in prior mergers (i.e. Alcatel merging with Lucent and Nokia Networks merging with Siemens infrastructure).

In addition to the challenge of achieving synergies being difficult in a merger between ALU and NSN, the appetite of NSN to go through such a restructuring effort after it is far along on its own restructuring plan would seem low to me.  NSN is well along in its restructuring into a primarily wireless infrastructure company after selling most of its other businesses and downsizing the company’s workforce by close to 25% (e.g. Access business sold to Adtran, Optical business sold to Marlin Equity Partners, Microwave Transport to DragonWave and Business Support Systems to Redknee etc.).  These restructuring efforts have paid off for NSN as it has reported solid financial results in 2012.  Merging with ALU would require a long merger process followed by another couple of years of new restructuring.

Another problem in merging NSN and ALU is that NSN is not a public company and does not have its own stock.   It seems to me that NSN, if public, would have a higher valuation than ALU and be more of the potential acquirer or investor into ALU than ALU being the acquirer or investor into NSN.  NSN is much further along than ALU in its restructuring, and as a result is much more profitable than ALU with full year 2012 operating margin of 5.6% and 4Q12 operating margin of 14.4% vs. ALU full year operating margin of (1.8%) for 2012 and 2.9% for 4Q12.  In addition, NSN has been generating positive cash flow for the past several quarters while ALU burned cash in 2012.  The better profitability, cash flow generation and further restructuring progress at NSN, would likely result in a higher valuation for NSN than the current ALU valuation.  ALU currently trades at about 0.3x EV/Sales. Ericsson, the other global, large, profitable and publicly traded telecom equipment supplier, currently trades at about 1x EV/Sales. My sense is NSN would trade closer to the valuation of Ericsson rather than ALU (maybe 0.6x-0.7x EV/Sales as an estimate).

Given NSN would have the higher valuation than ALU, but does not have a public stock currency, either NSN would first have to be spun out as a stand alone company to obtain a stock currency or NSN parent companies Nokia and/or Siemens would have to put up the cash to acquire ALU.  A spinout is certainly a possibility, but that will take months to implement and it would be highly unusual for such a spinout to do a large acquisition right after the spinout.  I also think neither Nokia nor Siemens has the appetite for using their cash to acquire ALU.  In particular, I think Siemens no longer views telecom infrastructure as strategic and would be reluctant to provide any additional cash infusion to NSN so it could acquire ALU.  Siemens is more likely looking at monetizing its potential stake in NSN (e.g. about €4-€5 billion) rather than investing more into the JV to acquire ALU.  Nokia may want to maintain an ownership in NSN even post an spinout given there are some advantages in selling both mobile devices and infrastructure to telecom operators. Huawei is using this tactic more often, and I believe Nokia views NSN as a way of countering this Huawei sales approach.  There may be some other intricate financial means for NSN to acquire ALU than the two I mentioned above, but regardless of the method, it would be a challenging integration in my view.

French Government Involvement Not Likely In Shareholders’ Interest

Press reports also suggest the French government may seek to invest directly in ALU via the government’s Strategic Investment Fund.  This fund was used in the past to invest in other French based companies (e.g. Gemalto and Nexans SA) that the government viewed as critical to French competitiveness. I am not positive on a French government investment in ALU.  I think a key motivation of the French government to invest in ALU would be for job preservation in France (ALU employees about 9,000 in France), which would oppose the whole idea around cost reduction for ALU and not be in the best interests of shareholders.  For shareholders, I think it would better to see ALU go through a restructuring program much like NSN did over the past two years, rather than take an investment from the French government to preserve French and other European jobs.   As I mentioned in prior blog posts, ALU cannot remain in all aspects of telecom infrastructure, but should follow the path of NSN and focus where the company has scale and competitive advantage. Namely, I think ALU should focus on Access, IP Routing and Optical.

Disclosure: I currently own shares of Alcatel-Lucent, Ericsson and HP although I may look to sell my ALU position in the very near term given points I mentioned in this blog.  NT Advisors LLC may currently or in the future solicit any company mentioned in this blog post for consulting services.

Does The Dell LBO Tell Us Anything About HP?

HP has been a horrendous stock in the past two years.  In my view this was due to weak fundamentals in the PC market, poor management decisions on acquisitions and a weak board of directors.  However, HP is still a company with annual revenues off about $120 billion making it one of the largest companies in the market.  HP is not going to disappear, and with some better management decisions and perhaps a better IT spending environment, it could be an interesting turnaround story.  It could, however, also be a value trap that continues to have its stock price decline.  I think HP is more likely to be a good stock performer than a value trap in the next year.  I base this on very negative sentiment and compelling valuation that is only supported by the recently announced LBO of Dell.

Below is a table showing the relative makeup of both Dell and HP.  Since each company segments it’s revenues  differently than the other, I made some assumptions in formulating this competitive table.  A more precise comparative analysis could be performed dissecting SEC filings.
 
                                                         HP  Dell
 Printing or Peripherals                   20%  16%
 PCs/Devices                                  29%  52%
 Services                                          28%  14%
 Servers Storage and Networking  17%  17%
Other                                                 6%  0%
As the table shows, Dell and HP have similar revenue compositions.  In addition, both companies have similar gross margins in the 20s and recent revenue trends of flat to declining revenues year over year.   In a sense, Dell is a smaller version of HP, without the management and board issues. The smaller size and market capitalization of Dell made an LBO possible, while an HP LBO is very unlikely.  Even though HP is not a LBO candidate like Dell, I think looking at the Dell valuation metrics at the LBO takeover price can provide insight into whether HP offers any value to investors.
 
The table below shows recent valuation metrics for HP and Dell.  As the the table shows, HP is a cheaper stock on EV/EBITDA and Price/Book while Dell is a bit cheaper on EV/Sales.  Since value investors tend to be more focused on cash flow metrics like EV/EVITDA and book value of the company, HP trades at a cheaper valuation than Dell.  While HP shareholders will not benefit from a potential LBO, any additional missteps from the current management team could lead to increased activism among shareholders forcing a change of strategy, management team, company break up or some other favorable catalyst for the stock.  If the current management team executes better, the low valuation should provide a base from which the stock can appreciate.  
 
                      HPQ  DELL
 Price/Book  1.47  2.34
 EV/EBITDA  3.40  4.86
 EV/Sales      0.47  0.37
 
Another important point I would like to make is the trend in free cash flow at HP.  HP has tended to deliver consistent free cash flow (defined as cash flow from operations less capital spending) on the order of $2 billion a quarter or about $8 billion a year.  I believe recent negative reports from tech companies exposed to HP as either an OEM, EMS or reseller (e.g. Mellanox) is reflective of HP trying to manage its cash flow to continue to show solid performance on this important financial metric.
 
Finally, the sentiment on HP is extremely negative on the street. Currently, there are only the equivalent of 2 buy ratings vs. 23 neutral ratings and 9 sell ratings.  The sell side clearly continues to view HP as a value trap given this composition of stock ratings.  Also, most IT executives I speak to view HP as a weak company with little prospects for any turnaround. This may end up being correct, but I think in this current age of increased shareholder activism, the recent Dell LBO and continued focus by HP on cash flow generation, HP is more of a Buy than a Sell.  Longer term, I am not yet convinced that HP will be a great stock or company, but in the short to intermediate term, I think the stock looks somewhat attractive.
 
Disclosure: I currently own shares of HP. I may currently or in the future solicit any company mentioned in this report for consulting services for NT Advisors LLC. 

 

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.

Telecom Equipment Dynamics Remain Favorable

As I have posted in prior blog posts over the past few months, I have been generally positive on Alcatel-Lucent and Ericsson given my view these two stocks were under valued and that a cyclical bullish trade in these two stocks was likely given a better telecom capital spending environment would materialize in 2013.  This past week, three data points came to surface that continue to make me comfortable with this thesis.

  1. Telecom Italia announced it was cutting its dividend by about half, to help fund its capital spending plan for 2013-2015 to support needed network investments in both LTE and fiber based broadband networks.  Capex in each year in the 2013-2015 period would likely remain consistent with the 2012 capex level of about 3 billion.  While cutting the dividend to help fund capex is not ideal, the fact that a large European telecom operator is committing to a reasonably healthy capital spending outlook for the next three years is encouraging, especially for a Southern European telecom operator given the weak economic condition in that region.
  2. Telecom operator KPN of the Netherlands reported 2012 capex of 2.2 billion, at the high end of its guidance of 2.0-2.2 billion.  KPN is another European telecom operator that had cut its dividend in 2012, yet actually spent at the high end of its capital spending guidance.  More importantly, KPN announced that for 2013-2015 annual capex would be in the range of about 2.2-2.3 billion, suggesting capex in each of the next three years would be at the 2012 level or slightly higher. Once again, the drivers for capital spending would be the build out of its 4G wireless network and a more robust broadband wireline network.
  3. Sprint reported 4Q 2012 results Wall Street analysts significantly raised their 2013 and 2014 capex estimates from about $5.5-$6.5 billion per year to about $7.5-$8 billion per year.    This level of capex compares to $5.4 billion in 2012.  Clearly Sprint is planning to be aggressive with its capital spending given the planned investment by Softbank and Softbank’s desire to be major force in the US wireless market.

Europe Has Been Underinvesting; New Competitive Dynamics in the US

What I infer from these data points as well as the analysis of historical capital spending trends is that most telecom operators in Europe have been under-spending given the weak macro-economic conditions in the region as well as pressure to preserve current dividend payouts.  It seems to me that the mindset of European telecom operators might be changing from “preservation” to “growth” which in some cases is supporting dividend cuts in favor of capital spending in growth initiatives like 4G and wireline broadband initiatives.  In addition, the US market could be poised for a new competitive dynamic where the virtual duopoly of AT&T and Verizon will be challenged by a newly funded and aggressive Sprint and the re-emergence of T-Mobile as another wireless operator that invests for growth.  T-Mobile may not have long term aspirations like Sprint in the US and eventually may seek to sell itself to Sprint or another entity. But in the interim period of the next two years, T-Mobile will likely be more of in the investment mode in its network rather than a harvest/sell mode.

While I Remain Favorable, Telecom Equipment Stocks are Very Risky

The telecom equipment market is still a very competitive industry with aggressive pricing pressure.  A more favorable capital spending environment is certainly a positive, but does not ensure stocks in the sector will perform well.  While this is still a risk, I continue to think the bullish cyclical trade has not run its course and remain positive on both Alcatel-Lucent and Ericsson.  Alcatel-Lucent has additional risks of turning around negative cash flow performance since the merger of the two former companies and a sub-scale business.  Thus, it is a much riskier investment than Ericsson.

 Plot Thickens at ALU With A New CEO Search and Press Reports on NSN

In the case of Alcatel-Lucent, the company also announced it is looking for a new CEO.  The outcome of this CEO search will certainly be an important factor impacting the stock performance of ALU in the future.  The WSJ sites NCR current Chairman and CEO Bill Nuti as one potential candidate.  Bill has an accomplished career and I think would be a good choice for ALU.  On the other hand, the job of turning around ALU will be challenging for any new CEO as the company has a high cost structure, especially in Europe, and needs to focus its R&D in fewer areas of the telecom equipment market.  The high cost structure in Europe is a major over-hang, as typical severance packages in France and other parts of Europe require up to three years of salary when employees are downsized.   Large severance payments in Europe will make it difficult for ALU to successfully complete its restructuring in my view.  Thus, any new CEO, regardless of talent and vision, will have to somehow overcome this restructuring over-hang.

Another interesting French corporate development to watch that may or may not have implications for ALU is how the French government deals with similar cost and market demand issues at French auto manufacturer Peugeot.  Press articles discuss that the French government might get involved in the restructuring/turnaround of Peugeot to preserve the company and jobs in France.  Peugeot, however, employs significantly more people in France (about 100,000) than ALU (about 10,000).  In addition, there is precedent in the auto industry for governments to help struggling companies (e.g. the US bailout of General Motors), but we have not seen such support in the telecom equipment market (e.g. the Canadian government did not get involved when Nortel fell to bankruptcy).

Increasing the intrigue on the CEO selection and ongoing restructuring at ALU is another recent press report from Bloomberg indicating that Siemens would like to exit its 50% ownership of the Nokia Siemens Networks (NSN) joint venture with Nokia (Nokia owns the remaining 50% of this joint venture).  NSN has shown three good quarters in a row and is well down the road in its own restructuring plan.  Thus, it is not a surprise that Siemens would want out of the JV as Siemens has been exiting its telecommunications businesses over the past several years and NSN is now more of a stable entity.  Nokia likely wants to stay in the wireless infrastructure business as smartphone competitor Samsung is attempting to win business by bundling smartphones and wireless infrastructure equipment in several of Nokia’s markets.  According to the Bloomberg article, Nokia is considering buying Siemens’ stake directly or in a partnership with ALU.   If in-fact ALU would end up being a part owner of NSN, this would likely be a positive for both ALU and NSN as they would be partners rather than competitors in the wireless infrastructure and services markets.   Given both are distant players behind Huawei and Ericsson in the wireless infrastructure market; a partnership between the two would help both companies. This of course assumes, that ALU is able to fund a purchase of a partial ownership in NSN and the ability for both ALU and NSN to implement further restructuring in their respective wireless equipment and services businesses that would likely result from a partnership between NSN and ALU.  The other interesting angle in a potential partnership between ALU and NSN would be whether NSN would begin favoring ALU for IP routing equipment instead of Juniper Networks, its long time partner for IP routing.  That could be another positive for ALU to come out of such a partnership, besides better competitive dynamics in the wireless infrastructure and services markets.

Disclosure: I own shares of Alcatel-Lucent and Ericsson mentioned in this blog post.  I currently and in the future may solicit any company mentioned in this blog for consulting or advisory board 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.