Be Careful What You Wish For

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

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

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

Attribute

Software Centric Data Center Operator

Traditional Telecom Operator

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

Reduce complexity

Reduce cost

Lower cost

Remove vendor lock-in

Service creation

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

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

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

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

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

Oracle Goes Telecom II

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

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

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

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

SDN And Silicon Photonics The Buzz at OFC

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

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

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

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

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

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

Telco Capex, Big IT War Chests and Optical Component Stocks

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

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

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

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

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

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.