“Quien Es Mas Macho”: Software Or Optics?

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Last week I attended an Optical/SDN conference in NY while I also moderated an SDN user panel at another conference in Silicon Valley.  In attending such conferences, I always look forward to learning how traditional service providers (e.g. Verizon) and content providers (e.g. Google) utilize or plan to utilize SDN to address major operational pain and cost points in their networks.  For example, major content providers speaking at these conferences have already begun to utilize internally developed software-based load balancing and security applications within the SDN framework.  As an example, one major content/hosting provider told me at one of these conferences that they no longer add appliance based load balancers to one of their network services as they have developed and utilize their own internally developed virtual load balancer.  The virtualization of some basic functionality typically found within security and application delivery controller appliances, is now an initial use case within the SDN framework by content providers like Amazon, Azure, Facebook, and Google.

When it comes to service provider wide area connectivity, however, it is striking for me to hear how Google has achieved up to 90% utilization on their data center to data center WAN links in their current SDN deployment, while traditional telecom operators like Verizon, CenturyLink etc. continue to echo that their respective optical transport networks remain dramatically underutilized given these networks were designed for peak traffic load rates and up to 50% of the networks were constructed as spare, idle capacity to address various failure scenarios (e.g. fiber cuts, human error when servicing equipment etc.).  So, is the SDN software development expertise of content companies like Google so superior that it allows them to achieve such a high WAN utilization rate vs. traditional telecom operators?

Certainly software centric content companies like Google have significant resources that allow them to develop SDN based network optimization software to achieve such high WAN connectivity rates, but they also have the advantages over traditional telecom operators in the type of traffic they carry across their WAN and that they don’t typically deploy their own national fiber network.  For example, when one thinks of the main end user Google applications, Gmail, YouTube and Search come to mind.  While these are important services, users do not typically pay directly for such services given the advertising model and Service Level Agreements (SLAs) are not likely as comprehensive as what a carrier like Verizon has with its customers.  Also, when an end user experiences a slow/choppy video experience with YouTube, the user usually blames its broadband service provider, not Google.  Separately, Google probably does not utilize its SDN network optimization software down to the optical layer as it likely utilizes carriers like Verizon for national optical transport.   Finally, since carriers like Verizon in the US are not permitted to use Deep Packet Inspection (DPI) techniques to prioritize traffic to help improve transport utilization (which could be especially useful during failure scenarios), the solution for a carrier like Verizon to improving and maximizing transport utilization is not likely to be via a software-based SDN solution alone.

With this is a backdrop, it seems that there is an opportunity for equipment suppliers to traditional telecom operators to “marry” SDN software and optics while also using utilizing other tools like the GMPLS and network analytics to dramatically improve optical network utilization across the WAN and within the optical transport network while also maintaining a high level of service assurance.  Optical transport is a huge cost for network operators, and if the effective average optical transport utilization rates are in 15%-25% range, that seems like a pain point that is ripe for a solution.  The start-up company Plexxi is “marrying” optics, SDN control and mathematical algorithms to address scale and service agility to tackle pain points within the data center. If successful, Plexxi may end up being “Mas Macho” in the data center given this vision.   I would not be surprised if Cisco data center switching spin-in Insieme may also be looking at some level of SDN control and optics integration for the data center as part of their product solution.  We will likely formally hear about Insieme’s product this summer.

As for the WAN, however, VCs, are not typically enthusiastic about funding service provider equipment companies given long sales cycles with Tier1 carriers and customer concentration issues.  Throw in the word optics to business case and that makes for strike three.  Thus, traditional optics and/or router equipment companies may have an opportunity to differentiate themselves in solving the high cost, low WAN optical transport utilization rate problem.  While SDN is about separating the control plane and data plane and using software applications and network virtualization to achieve service creation and network agility, its initial focus was for Layer 2/3 switches with an “electrical” based fabric within the data center. Optimizing expensive WAN links for traffic flows that span both electrical fabrics within the data center and optical wavelengths across the WAN while dealing with vendor specific optical intricacies such as Forward Error Correction (FEC), amplifier settings, modulation techniques etc. is not likely to be solved by SDN software control alone.  To be “Mas Macho” in solving the optical WAN utilization challenge, the solution is likely to require multiple ingredients, including, SDN software control, multi-vendor element management system support and visualization, network analytics, a strong optical pedigree and the use of industry protocols (e.g. GMPLS, Openflow etc.).

It is no surprise that Cisco has acquired both SDN software and optical sub-system companies (e.g. CoreOptics and Lightwire) over the past couple of years.   While silicon photonics will play a critical role in achieving single chassis, highly dense routers with 400G interfaces, is Cisco also looking beyond next generation 400G port routers and the broader issue of low WAN utilization rates?   Alcatel-Lucent, another company with core competencies in routing and optics also recently announced its Nuage Networks SDN Virtualized Services Platform solution. While Nuage offers some innovative WAN features in service provider MPLS VPNs, it does not address utilization issues in the optical transport domain.  Will Alcatel-Lucent seek to leverage its initial Nuage SDN software solution with its traditional competency in routing and optics to address the optical transport utilization issue?  Time will tell whether Alcatel-Lucent, Cisco and/or other vendor(s) will be “Mas Macho” marrying software with optics in solving perhaps one of the most significant cost pain points today in service provider WAN transport.

I Continue To Be Positive On Technology for 2013

Following up on my blog post in the beginning of the year, I continue to expect the technology sector to outperform the overall market (S&P 500) in 2013.  This opinion is based on three years of underperformance of the technology sector given a depressed level of telecom and enterprise capital spending which has compressed valuations for technology stocks vs. other sectors like consumer discretionary which as been a strong relative performer over that three year period.  I continue to believe we will have some recovery on capital spending in both telecom and enterprise networks in 2013, which together with lower relative valuations, should allow the technology sector to outperform in 2013.

So far in 2013, the technology sector is up around 4.5% vs. the 2.5% return of the S&P 500.  While it is still very early in the year, this initial outperformance and strong stock performance from IBM and Google (two large components in the technology sector index) today after their reporting their earnings (both are up about 5%-6% so far this morning) are very good signs.   The depressed level of technology stocks has also been supported by recent discussions in the press of Dell being a potential LBO candidate, and HP potentially being broken up to create shareholder value if the company does not show signs of a turnaround in 2013.

The biggest potential risk to technology outperforming in 2013 in my view is the performance of Apple as it makes up to 20% of technology index given its large market cap.  I am not particularly positive on Apple as it is losing momentum (see my prior blog post on Apple for more details) and does not play into the theme of recovering capital spending for technology stocks.  However, the stock has declined close to 30% off its high and is discounting many of the negative fundamentals I discussed in my earlier blog on the stock.

Disclosure:  I am currently not long or short any stock mentioned in this blog post (i.e. Apple, IBM, Google, Dell or HP).  I also do not plan on taking a position on any of these stocks in the next couple of days.  I am long the technology ETF ticker VGT.

Addendum – With the selloff in tech shares today 1/24/13, I am considering purchasing shares in technology stocks mentioned in this post.

Technology Sector Likely to Outperform S&P 500 in 2013

While the Information Technology sector had a reasonably good year in 2012 with a 14.0% return, the sector still underperformed the S&P 500, which returned 16.0%. In fact, the technology sector has underperformed the S&P 500 for three consecutive years.  While 2013 could prove to be another volatile year for the stock market given ongoing uncertainty on the global economy and the ultimate outcome regarding the U.S. fiscal cliff, I believe the three-year trend of underperformance of the technology sector will reverse, and the technology sector will likely outperform the S&P 500 in 2013.

In looking at the following table, one can see how in the past three years the consumer discretionary sector has been a consistent outperformer as compared to the S&P 500 while the technology sector has been an underperformer.  In fact, the consumer discretionary sector has been the best cumulative performer in the past three years among the ten market industry sectors.  One question is why has consumer discretionary outperformed the overall market while technology has underperformed for three straight years after the 2009 recession when normally both consumer discretionary and corporate capital spending recover nicely post a recession?

2012 2011 2010
Consumer Discretionary 24.6% 3.7% 30.6%
Information Technology 14.0% 0.5% 12.7%
S&P 500 16.0% 2.1% 15.1%

One could argue the outperformance of the consumer discretionary sector made some intuitive sense as the U.S. consumer started to gradually become more confident in 2010 post the 2008/2009 Great Recession and began to gradually spend more on discretionary items while at the same time taking advantage of record low interest rates to repair their personal balance sheets post the deb crisis.  On the other hand, corporate and telecom services capital spending growth have been lackluster in the past three years.   The ongoing economic slowdown and uncertainty in Europe combined with anxiety over U.S. economic/tax policy has led to cautious capital spending.  Thus, consumer discretionary spending has rebounded more strongly in the past three years and corporate/telecom capital spending.

While it is anyone’s guess how spending trends will fare in 2013, my view is corporate/telecom capital spending has underperformed for too many years relative to consumer discretionary spending and will show more robust growth in 2013.  We already have some encouraging signs in this regard by strong 2013 capital spending plans by major global telecom operators like AT&T, Deutsche Telekom and Sprint as examples.  I think this relative recovery in corporate/telecom spending will allow the technology sector to outperform in 2013.

The strong outperformance of consumer discretionary stocks relative to technology stocks in the past three years has also been evident when one looks at valuation metrics between the two sectors.   While valuation metrics like price/book and price/sales for the consumer discretionary sector have expanded nicely in the past three years, the same valuation metrics have actually contracted for the technology sector.  Thus, one could argue that the outperformance of the consumer discretionary sector was not only driven by better relative spending by consumers over corporates/telecoms, but also expansion of valuation metrics.  I think 2013 will be a catch up year for technology stocks in terms of valuation metrics, which should also help the technology sector outperform the S&P 500.

The table below shows the top eight stock holdings of the Vanguard Consumer Discretionary ETF (ticker VCR) and Information Technology ETF (ticker VGT).  The two tables below the list of stocks show how the valuation metrics for these 16 stocks have changed since the beginning of 2010 through the end of 2012 (i.e. over the three year period of underperformance of the information technology sector).

Consumer Discretionary (Ticker: VCR)

Information Technology (Ticker: VGT)

Comcast (CMCSA) Apple (AAPL)
Home Depot (HD) International Business Machines (IBM)
Amazon.com (AMZN) Microsoft (MSFT)
McDonalds (MCD) Google (GOOG)
Walt Disney (DIS) Oracle (ORCL)
News Corp. (NWSA) Qualcomm (QCOM)
Time Warner (TWX) Cisco Systems (CSCO)
Lowes Cos. (LOW) Intel (INTC)

 

Consumer Discretionary Valuation Metrics 12/31/09 vs. 12/31/12

Price/Book

12/31/2009

Price/Book

12/31/2012

Price/Sales

12/31/2009

Price/Sales

12/31/2012

Comcast 1.12 2.02 1.34 1.62
Home Depot 2.32 5.26 0.68 1.29
Amazon.com 11.08 15.02 2.38 1.98
McDonalds 4.80 6.41 2.96 3.24
Walt Disney 1.59 2.12 1.66 2.11
News Corp. 1.44 2.26 1.16 1.78
Time Warner 1.01 1.51 1.34 1.58
Lowes Cos. 1.49 2.85  0.64 0.79
AVG Increase

63%

28%

Information Technology Valuation Metrics 12/31/09 vs. 12/31/12

Price/Book

12/31/2009

Price/Book

12/31/2012

Price/Sales

12/31/2009

Price/Sales

12/31/2012

Apple 5.33 4.22 4.09 3.19
IBM 7.56 10.10 1.80 2.09
Microsoft 6.11 3.25 4.61 3.10
Google 5.46 3.4 8.32 4.87
Oracle 4.10 3.70 4.90 4.31
Qualcomm 3.62 3.14 7.33 5.51
Cisco 3.2 1.98 3.70 2.23
Intel 2.70 2.10 3.21 1.92
AVG Increase

-19%

-22%

In summary, technology has lagged the S&P 500 for the past three years while consumer discretionary has dramatically outperformed. In doing so, consumer discretionary valuation metrics have expanded dramatically, while technology valuations have contracted.  With the potential for a corporate/telecom capex recovery in 2013 and relatively low valuations, the technology sector is poised in my view to finally outperform the S&P 500 in 2013.