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.