Capex Continues Its Slow Drift Upwards

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.

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.

Are Optical Component Stocks In Trouble?

While I continue to think there is a decent chance in a capital spending recovery in 2013 that should help telecom infrastructure suppliers like Ericsson and Cisco, I am not that positive on optical component companies like JDSU and Finisar.  The main reason for this is technology dislocation risks that are surfacing that might reduce the role traditional optical component companies play in networks.

This past week, Intel announced collaboration with Facebook on its developments efforts in silicon photonics, a new technology that uses less expensive silicon rather than the traditional more specialized materials used in optical materials. Intel and Facebook see silicon photonics as a way of dramatically reducing the cost and simplifying the design of rack architecture within the data center.  A quote from the press release on the silicon photonics technologies is shown below:

“… the new architecture is based on more than a decade’s worth of research to invent a family of silicon-based photonic devices, including lasers, modulators and detectors using low-cost silicon to fully integrate photonic devices of unprecedented speed and energy efficiency. Silicon photonics is a new approach to using light (photons) to move huge amounts of data at very high speeds with extremely low power over a thin optical fiber rather than using electrical signals over a copper cable. Intel has spent the past two years proving its silicon photonics technology was production-worthy, and has now produced engineering samples.”

In addition to these efforts by Intel on silicon photonics, Cisco acquired a private company called Lightwire in March of 2012.  Lightwire was developing advanced optical interconnect technology for high speed networking and Cisco viewed the enabling technology as a way of owning more of the optical subsystem technology within their products while also using a newer, lower cost design implementation than traditional transceiver technology purchased from optical component companies.

I believe efforts by Intel (and others) in the emerging field of silicon photonics and Cisco’s efforts in owning more of the optical value chain in their products does not bode well for traditional optical component companies.  While any telecom capital spending recovery would lift all boats (including optical components companies), the technology dislocation risk posed by silicon photonics and efforts by OEMs like Cisco post longer-term risks for optical component stocks.  It will be interesting to see if traditional optical component companies seek to invest in silicon photonics to protect their traditional businesses.

Disclosure:  I currently own shares of Ericsson and Cisco mentioned in this blog post. NT Advisors LLC may currently and in the future solicit any company mentioned in this blog post for potential consulting/advisory work.

Riverbed Opts for More Network Management

On a very stormy day on the East Coast where my newly purchased standby gas generator is keeping my computer and lights humming, I had some time to listen to the conference call today where Riverbed announced its plans to acquire Network/Application Management company Opnet.  My quick take on this deal is that Riverbed is making a bold move to double down in the tangential market of Network/Application Management, but the Street is likely to take a wait and see approach on how they execute on this strategy.  I think owners of the stock were looking for a strong product refresh cycle in its core WAN Optimization business.  The story just changed, with the ultimate outcome unclear.  While the stock had a nice upward move after a good 3Q result, it likely stalls in the near/intermediate term in my view.

Overall, I can see why Riverbed is doubling down on Network and Application Management, building on its small but rapidly growing Cascade business.  Namely, the traditional WAN Optimization business that forms the vast majority of Riverbed’s sales and the core of the company is now growing slightly less than 10%.  In order for Riverbed to sustain longer-term growth of 15% or more (an unofficial metric to be perceived as a reasonable growth company in the technology industry), Riverbed needs to expand into new markets.  Since the early acquisitions in Network Monitoring/Management over the past three years are finally putting up solid growth of over 30% as Riverbed gains share, why not double down and try to be the market leader in this overall market that is very fragmented.

Riverbed dabbled in networking monitoring/diagnostics via its acquisition of Mazu back in early 2009.  It then added the acquisition of CACE in October of 2010.  These two deals, however, were closely linked to the core WAN Optimization business as the respective diagnostic/monitoring products were primarily focused on determining need and how to best deploy WAN Optimization appliances within an Enterprise.   With the acquisition of Opnet, Riverbed is dramatically expanding within the Network and Application Management market as Opnet’s products offer more broad performance data than just the WAN Optimization application.

While attending Interop NY in September of this year, I thought that the Network Monitoring and Diagnostic industry would see convergence between Test/Diagnostic companies like Ixia and JDSU and Networking/Application Management companies like Opnet, Gigamon etc…  With Ixia acquiring BreakingPoint Systems in July of this year, I had though we would see further consolidation of the entire test equipment, diagnostic, monitoring and management segments given how fragmented these industries have become.  I even thought JDSU would respond to Ixia’s acquisition of BreakingPoint and consider a larger deal in this market.  So, Riverbed’s move is not surprising given they were a niche player in the market, but one that was not so obvious to me a couple of months ago.