What Does Cisco Have Up Its Sleeve With Insieme?

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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.

 

 

 

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.

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.

What (if Any) Part of the Networking Value Chain Will Be Disrupted by SDN?

I have been following the topic of Software Defined Networking (SDN) for the past three years.  Three year ago the technology was not well known by Wall Street but now is enjoying an intense level of discussion by investors. When the technology was first presented to me three years ago, my initial reaction was SDN would be a risk for technology companies in the Ethernet Switching and Routing markets (e.g. Cisco and Juniper), while creating new opportunities for semiconductor companies selling merchant silicon (e.g. Broadcom and Intel) and newly created SDN software companies.   After visiting a few SDN private companies in the past couple weeks, talking to industry participants and reviewing recent SDN acquisitions by Cisco, Juniper and others, it is actually less clear to me now how SDN will dislocate the current networking value chain.  I am not questioning the value proposition of deploying SDN or the likelihood that it will be a significant investment cycle in the next five years, as I view that as a given.  Rather, the question whose answer has become less obvious to me is which publicly traded companies (if any) are most vulnerable to the upcoming SDN technology cycle and when will this dislocation most likely begin being reflected in these company stock prices.

– Will the ultimate acceptance and deployment of SDN match my simple initial reaction that it will be negative for Cisco and Juniper as switching and routing face competition from more open oriented hardware platforms (Arista and Pica8 are examples of privately held open hardware platforms)?

– Will SDN actually require more complex and high performance hardware platforms in the data center as the real value around SDN will be operational simplicity and cost reduction rather than a focus on hardware costs (data center privately held platform companies include Arista and Plexxi)?

– Will SDN be more of a risk for Layer 4-7 companies that are selling special purpose appliances that may be made obsolete by more multi-functional and integrated software applications in the SDN orchestration layer?

– Will both Layer 2/3 and Layer 4-7 companies be at risk?

– Will SDN create the opportunity for a Network As A Services (NaaS) model and disrupt the entire networking value chain?

– Perhaps, SDN will be some combination or elements of all the above scenarios?

I will be moderating an investment panel at an SDN user conference in a couple weeks with some very smart and experienced investment professionals and hope to get more insight into these topics, which I plan to share on this blog.  In the meantime, lets take a look at how sentiment on SDN’s impact to current publicly traded companies has changed over the past several months and why it is likely SDN developments will not be that relevant to public company stock prices in 2013 as they were in 2012.

The first major wake-up call on SDN to the public markets was July 23rd, 2012, when VMware announced it was acquiring Nicira for $1.26 billion.  Since this announcement occurred after the market close, I was curious to see how Cisco and VMware would trade the following day.  As it turned out, Cisco’s stock lost 6% of its value (about $5 billion in market value) the next day while VMware fell about 0.3% (note VMware announced earnings the same evening it announced the Nicira acquisition which likely muted the impact of the Nicira acquisition to VMware’s stock price movement the next day).  What was interesting about the market reaction was that Cisco lost $5 billion in value while VMware barely budged after spending $1.26 billion for a company that at the time was likely to generate less than $50 million in revenue in calendar 2013.   Clearly, the market at that point viewed SDN as a massive technology risk to Cisco.

Over the course of the next several months, however, Cisco formulated its SDN strategy, made a couple of SDN acquisitions of its own (vCider, Cariden and funded Insieme) and communicated its SDN strategy at its analyst day on December 7th, 2012.  Juniper acquired SDN start-up Contrail and communicated its SDN strategy on January 15th, 2013.  In addition, Nicira/VMware seemed quiet in terms of market penetration and customer deployments post the announcement of the acquisition in July.  So, in the span of 6 months, SDN went from a perceived significant risk factor to Cisco and Juniper to being more of an unknown entity both in terms of potential impact and timing of that impact.  Investors slowly began to realize that SDN would have little impact to 2013 and maybe even 2014 financial results.  Also, Cisco and Juniper are fighting back and will aggressively try to leverage their installed base of equipment to take advantage of SDN as a new revenue opportunity.

Now lets look at Layer 4-7 (e.g. security, load balancing, application delivery control).  What I find interesting here is several of the new SDN private company fund raising in the past several months were for companies attacking this segment of the networking value chain.  Companies that might fall into this category include Embrane, LineRate, PLUMgrid and Pluribis.  Several industry people I speak to suggest that Layer 4-7 will actually be the first area of SDN deployment in data centers given the need to provision and manage policies/applications/security at scale in the data center, which proves to be difficult when managing multiple single purpose appliances and that managing this in the orchestration layer within the SDN model potentially provides an elegant and scalable solution.   It might be coincidental, but in listening to the F5 earnings call this week, I found the following dialogue in the Q&A portion of the call on why F5’s Technology Vertical has not been performing well in the past couple of quarters very interesting as it relates to this topic. Below is how F5 management responded to this question:

“So, on the Tech Vertical issue, you’re right. I mean, the Tech Vertical has trended down over the past several quarters for us, and we believe it’s driven really by a couple of our larger customers that are taking alternative architectural approaches in terms of how they’re building things. So, generally they’re building some basic functionality into that app. And, so we’ve been seeing that going on, and obviously we’re doing something about it.

We’ve got projects going on internally that we believe will provide this type of customer with ways that will make it easier for them to integrate our functionality into the applications [inaudible] that they’ve got.”

Source: Seekingalpha.com

What is interesting here is that the Technology Vertical within F5 results typically includes major data center and cloud providers in the category of Facebook, Apple, Google, Yahoo, etc.  While I do not know which specific customers F5 was referring to in this comment, it is valuable to see how such large-scale operators are already implementing certain parts of the Layer 4-7 stack on their own.  One can easily infer why Layer 4-7 SDN start-ups are getting funded at a nice clip given the potential for disruption here. Obviously, publically traded Layer 4-7 companies are not standing still as this is happening and are already offering virtual instances of their appliances, which I would imagine will ultimately be offered as applications in the SDN orchestration layer.

Finally, start-up Pertino appears to be focused on using SDN as a framework for Network As A Service (NaaS).  While they are not likely to be the only company pursuing such a business plan (perhaps some of the companies mentioned above), it does the raise the option that NaaS could be disruptive to the entire networking value chain especially if we see large players like Amazon, Google and others pursue such an offering or if a new disruptive start-up emerges to be the Saleforce.com of NaaS.

So in summary, SDN it is going to be a very disruptive technology. What was initially viewed as a technology shift that will be a negative for Cisco and Juniper is now potentially more complex to predict in terms of public market investing.  What is likely, however, is that SDN will have little impact to publicly traded stocks in 2013 as other macro and company specific fundamentals will be more relevant to stock prices in my view.  I doubt we will see another VMware/Nicira type of deal in 2013 both in size and in its impact to publically traded stocks like the $5 billion in lost value Cisco experienced the day after this deal was announced.  However, over the course of the next year or two, the potential impact of SDN to publically traded companies and how these companies either capitalize or fall victim to the adoption of SDN will be more evident.  It will certainly be fascinating to watch!

Disclosure:  I currently own shares of Cisco mentioned in this blog post.  NT Advisors LLC may currently or in the future solicit or have as clients any company mentioned in this report.

Tucci Says “No” To Networking; Chambers Says “Yes” to Software

While reading a few earnings releases today and listening to a couple of earnings calls, two items stuck out to me from a strategic standpoint that I thought were interesting.   In particular, it seems more likely that Cisco will acquire software companies in the future rather than EMC/VMW acquiring hardware based networking companies.  

As discussed in a prior blog post, I did not think EMC would acquire Juniper even with VMware acquiring Nicira.  Well today on the EMC earnings conference call, Joe Tucci put a nail in the coffin regarding the EMC/Juniper speculation when he went out of his way in his prepared remarks to say EMC will not acquire a hardware networking company and that the VCE partnership with Cisco remains important and strategic to EMC.

Even though it was likely that Cisco competed with VMware for the acquisition of Nicira, the fact that VMware prevailed does not necessarily imply that EMC/VMware also want to enter the actual hardware element of data center networking.  Nicira is a Software Defined Networking (SDN) company that operates in the control plane layer of the SDN hierarchy.  It is a pure software company whose business model mirrors that of VMware, thus, the two together make a lot of sense (although the price paid for the acquisition is another story).   Going down the stack in the SDN hierarchy into the actual data plane where Cisco, Juniper, Arista, Brocade and others reside is not a necessary or smart outcome for VMware in my view.  So, kudos to Joe Tucci for drawing a line in the sand and staying out of a market segment he could continue to partner for today and in the future when SDN becomes more prevalent.

The other interesting item I saw today was an excerpt from an interview by Gartner of John Chambers, CEO of Cisco in Network World Magazine.  The excerpt is as follows:

 “We are going to move on multiple fronts with software,” Chambers said. Cisco’s goal is to double software revenue over the next five years, Chambers added. “The industry is set up for an open software player that integrates with every device.”

Typically when John says he wants to double revenues in an area that is small for Cisco, it typically means acquisitions.  Over the years the two companies I have heard people in the industry and press discuss the most often as potential software acquisition candidates for Cisco are BMC and Citrix.    Both are probably unlikely in my view right now.  Even though BMC has been reported by the press to be actively looking for strategic buyers, and its Enterprise Value of about $6B and forward P/E of about 11x put in the reasonable size range for Cisco, I doubt Cisco would acquire BMC as it would likely be viewed as “too legacy” of an acquisition.  Cisco needs to figure out how to get out of the low single digit organic growth rate and acquiring BMC would likely not help in that regard.  While Citrix would be a more appropriate strategic fit for Cisco given it fits it in well with Cisco’s Virtualization and Data Center priorities, Citrix has an Enterprise Value of about $11B and a forward P/E multiple of about 20x.  Add to that current valuation a reasonable take out premium of at say 20-25% and you have an expensive acquisition.  Cisco also has never acquired a company so large either in absolute market capitalization or as a percentage of its market capitalization. So while Citrix would be a nice fit, probably too big/expensive for Cisco to pursue right now.

So if not BMC or VMware, then who?  There is a multitude of small (public and private) and mid-size software companies that Cisco could pursue so guessing the right one is not easy.  In the telecommunications market, one that seems like a reasonable logical and size fit is BroadSoft. The market capitalization of about $1B and complementary aspects to Cisco’s unified communications focus would make this possible in my view.  Anybody have any other ideas on who Cisco might acquire in Software?

 

 

 

EMC/JNPR? Seems A Long Shot To Me.

In the past week I have read press articles suggesting EMC might be considering an acquisition of Juniper Networks.  It seems today the potential for this deal happening has made its way into the financial markets and is now impacting the stock price of Juniper.  While I can see how the ongoing rift between Cisco and EMC over the past few months (e.g. EMC/VMWare acquisition of Nicira, Cisco’s funding of start-up Insieme, Cisco’s expanded partnership with Citrix etc…) could lead some to conclude that EMC wants to further take it to Cisco by acquiring its primary networking competitor Juniper Networks, I think such a deal is a long shot.  In particular, I think that if EMC wanted to add Ethernet Switching to its Data Center products and move away from Cisco for such products, it would be more practical for them to consider less complicated acquisitions such as Arista, Brocade and others that are smaller in size and more focussed on the Data Center Ethernet Switch market.  Juniper on the other hand derives the majority of its revenues and vast majority of its profits (and likely its current value as a company) from its Service Provider Router business.  Does EMC want to be a Service Provider router vendor?  What would EMC do with the struggling Security business at Juniper?   So while there is always a chance such a deal could happen and the rift between Cisco and EMC moves towards all out war, I just don’t see it happening….