I recently wrote an article on Seeking Alpha on my views on why Juniper is currently outpacing Cisco in the router market and how this is likely to continue through most of 2014. Specifically, Cisco’s relatively older edge routing platforms vs. Juniper and the likelihood that Cisco has confused customers in the core routing market given two different product introductions in 2013 may be reasons for Cisco’s relative underperformance vs. Juniper. One key data point to watch in 2014 for both Cisco and Juniper in the router market is AT&T’s Domain 2.0 process, which is likely to be completed by mid-year. Given AT&T’s desire to maximize free cash flow given increasing investor concerns in this area (i.e. AT&T’s stock price fell the day after it reported earnings given a lower free cash flow outlook for 2014 vs. 2013), it is likely that product pricing will be a key factor in the Domain 2.0 vendor selection process, especially if Cisco continues to lose share to Juniper and Alcatel-Lucent in the router market in 2014 and it seeks to stop this trend by being more aggressive in the AT&T opportunity.
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.
I recently wrote an article on Seeking Alpha discussing my view on the potential strategic objectives of Cisco’s Insieme spin-in. Cisco plans to formally announce the Insieme product on November 6th in NY. A quick summary of the article on Seeking Alpha is as follows:
The three main strategic objectives of Insieme in my view are:
– Attack Nicira/VMware’s (VMW) pure software approach to Network Virtualization via a converged hardware/software approach to be delivered by Insieme’s Application Centric Infrastructure solution.
– Attack lower cost and “White Box” data center Ethernet switches potentially enabled by VMware and/or Software Defined Networking (SDN) as Insieme is likely to have significant improvement in price/port metrics for Ethernet switching. Its interesting that John Chambers, the CEO of Cisco, highlighted the “White Box” switch as a major threat to Cisco just a week or so ago in a Barron’s interview, knowing that the Insieme launch is just a few weeks away.
– Expand into non-traditional markets or markets with limited market share in the data center via virtual implementations of traditional security and Layer 4-7 appliances (and perhaps even some elements of flash storage given Cisco’s recent acquisition of privately held WHIPTAIL)
Over the past 18 months, Cisco has been aggressive in filling its product weaknesses via acquisitions (e.g. Sourcefire in security) and addressing the market’s concerns around network virtualization and SDN. The Insieme launch, in conjunction with prior announcements around Cisco ONE and OpenDaylight, will likely be the last Big Bang effort by Cisco in 2013 to take on the threat of VMware/Nicira and convince the market that Cisco has the right data center architecture for the future of networking as well as diminishing the threat of the “White Box” network.
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.
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.
Following up on my most recent post on July 8th, I continue to see a slow but steady drifting upward of both telecom and networking capital spending. An increasing competitive environment in the US wireless industry, the likely ramp of LTE spending in China in 2014 and the beginning signs of telecom spending bottoming in Europe should support service provider centric communications equipment stocks. In addition, while enterprise centric IT spending has not shown as vibrant of a recovery, recent results from distributors and other supply chain companies are starting to point to a recovery in enterprise networking spending.
Stocks that I have liked and continue to like in this current environment are Cisco, Alcatel-Lucent and JDSU. While I continue to like all three of these names, I think the potential returns from current levels are not as significant as the respective returns over the past year. Specifically, I am looking for returns of 10%-20% over the next several months to year for both Cisco and JDSU, while ALU may have a bit more upside, yet with more risk as well.
Both Cisco and JDSU report earnings this week. Wall Street is generally looking for Cisco to report results that are slightly better than consensus estimates, while there is a mixed view on JDSU going into its earnings. The overwhelming consensus that Cisco will report a slightly better than expected quarter is a bit concerning as there seems to be little controversy going into results as compared to prior quarters. Thus, expectations are generally positive for Cisco, which leaves little room for any disappointment in their results. Even so, however, most signs seem to be positive for Cisco going into its results, including positive data points from its supply chain in 2Q results (e.g. distributors, contract manufacturers etc.), the continued strength in telecom capital spending in the routing area (as witnessed from both ALU and Juniper results) and a generally improving IT spending environment. In addition, Cisco will be reporting its fourth fiscal report when it reports this week, which is generally a strong bookings quarter for Cisco. This should support a solid year end backlog when results are reported.
With regard to JDSU, there is a mixed view going into their results, as most of its peers in the test and measurement business (e.g. Ixia, Spirent etc.) reported disappointing results. On the other hand, optical component suppliers (e.g. Finisar, Alliance Fiber etc.) have generally reported (or pre-announced) positive earnings results. Thus, there is more uncertainty around JDSU’s upcoming results and guidance. My sense is if JDSU does offer either disappointing results and/or guidance, Wall Street will look at it as a buying opportunity as both these business segments are likely poised to improve in 2H13.
For my recent views on the security market post Cisco’s acquisition of Sourcefire, check out the following link.
Disclosures: I am currently long Alcatel-Lucent, Cisco and JDSU. NT Advisors LLC may in the past, present or future solicit consulting business or have generated consulting business from any company mentioned in this post.