Looking at the Big Picture and Connecting the Dots

14/06/2011

I am sitting at my desk looking at several reports on various technology companies.  I think investment research; especially sell side research is often wonderfully optimistic about the future.  Thematic reports on new technologies and market adoptions are almost universally bullish.  No firm writes an investment research report entitled “Cloud Computing Set to Disappoint,” rather the investment community gets 30-40 reports on cloud computing being the next big thing.  Apple is a pretty simple company from a product and business line perspective.   They have six product lines and Wall Street has 40+ analysts who cover it.  I understand the need for a firm to have an Apple note to use for marketing, but 40 analysts plus another 20 or more boutique research firms and we are talking 60, 70, maybe 80 reports on Apple.  Many firms publish weekly notes on Apple.  Do we really need so many reports and is there anything relevant or differentiated in these reports, but I digress from the topic at hand.

I like to go through what I call a framing exercise.  Readers of the T&G blog from 2006-2007 know where I am going.  I like to layout a number of facts as well as suppositions and create some conclusions.  Here are few frames:

05.09.11: David Yen, EVP and GM of Juniper’s fabric and Switching business unit leaves for CSCO.

05.11.11:  CSCO Reports Q3 FY11 Earnings:  Cisco is one of the first companies in tech to report on the month of April and the first to give expectations for May-June-July.  Stock down big on the forward view of the business.

05.14.11: Barron’s positive on JNPR.  JNPR stock @ $39.12 on the Monday 05.16.2011 close.  It closed at $29.91 yesterday.

05.17.11: HPQ reports and lowers forward guidance.

05.25.11: Auriga downgrades JNPR due to slowing enterprise business and Openflow concerns.

05.27.11: Transmode (TRMO) prices IPO

06.01.11: JNPR CEO is reported to offer cautious comments on backend loaded quarter at the BofA/ML Conference in NYC.  The business pace of the quarter that the CEO spoke about was precipitately reported by Sanjiv Wadhwani of Stifel on May 31.

06.09.11: CIEN Reports Q2 FY11 Earnings: CIEN is reporting an April quarter end, heavily levered to service provider CAPEX and guiding for the months of May-June-July.  Ciena missed street expectations and lowered their guidance as well.

Catch-up Spend: I wrote about the catch-up spend several days ago, but it is even clearer when you layout the operating models for a good sample size (~15) of companies that are in the technology market.  The spending catch-up (started Q2 2009) from the credit crisis spending collapse is over.  Many companies benefited from this event because they cut their operating models in the 2H 2008 expecting a prolonged downturn.  The downturn was deep, but brief lasting 2-3 quarters and then spending came back and accelerated into 2010 year end.  Many good things happened because of this 21-24 month recovery: (1) margins recovered and then (2) earnings peaked, (3) IPO window opened for companies like CALX, TRMO, Avaya (4) M&A returned with a vengeance: DDUP, STAR, COMS, CIEN/NT, CALX/OCNW, Telecordia (today), etc, (5) large public companies refinanced debt and (6) private companies were able to fund.

My supposition is that the negative impact of the spending cycle catch-up is it fooled companies as to the direction of the market.  Because of their size and global reach, CSCO is a key indicator in the technology world and in some ways the tip of the sword.  They had it all figured out.  They were going to have ~15 billion+ business units.  They went aggressively into the downturn planning to use their balance sheet to take share.  For awhile, it worked and they put up the best numbers in the company’s history in the 1H of 2010.  When they saw the underlying business deteriorating they tried to buy their way out: STAR, Tandberg, etc.  Here are two charts showing CSCO’s quarter revenue trends.

The onset of the global credit crisis enabled CIEN to buy Nortel’s Optical Business Unit all because NT’s North American business unit went bankrupt because the company kept too much capital off shore and the tax to repatriate made funding the business a challenge.  CIEN was able to correct two significant errors with the NT deal.  (1) The had completely missed the 40G/DQPSK cycle preferring to focus on 100G and (2) there were a large number of global service provides that were not CIEN customers.  Now both of those errors are fixed at the cost of $1B.  My point is that CIEN is now set in their product plans.  They know who they are and their ability to alter their product offerings is limited because they are going to be really busy for next 30-36 months consolidating their customer base and sorting through the product roadmaps of two companies.

It appears, that looking at companies missing in 1H of 2011 that the miss is 7-9% from plan.  Meaning that the market is growing, but it was linear from Q4 2010 to Q1-Q2 of 2011.  I think this is a re-composition period.  The spending catch up is done, now consumers of technology are putting more thought into what is next.  If you accept the emerging three pillars of (i) centralized control-plane, (ii) software defined ecosystem and (iii) lower priced storage-compute-switching power pack, then I think several companies will have challenges.

Technology leadership in the network is coming from unfamiliar places.  I wrote about this recently.  I am interested in understanding how these new leadership entities are affecting spending entities for 2012 and what new technologies are they adopting for specific applications?  What spending entities will lead the adoption of the three pillars?  Some of this is cloud a discussion, but I really dislike the term cloud.  To me the data center/cloud evolution is four segments:

1. Warehouse scale (GOOG, AMZN, AAPL, MSFT, Defense/Intelligence)
2. High performance compute (HPC) clusters (Financials, Energy, R&E and select enterprises)
3. Private DCs (Bulk of the market who can afford to own their on DC and will outsource small portions for replication etc)
4. Hosted DCs (SMB market)

The data center/cloud market is going to be big, but I think there are multiple points of entrance and multiple strategies to employ. Here is my short summary of access to each of the four segments:

1. Warehouse Scale: As I discussed before, this is the evolution to all photonic switching starting with the removal of the aggregation switches, then the TOR switches go away and eventually blades to switches and Openflow is important.  Need to focus own on how the network element interfaces into the virtualized I/O on the blade server.
2. HPC Clusters: This is another place in the network where technology changes are afoot. This is your higher end, high transaction compute centric enterprise.
3. Private DC:  I think this is the bulk of the market.  Most companies can afford to own their own data center and will continue to do so, but outsource varying elements to cloud providers.
4. Hosted DC: This is the long tail of the market.

When I read research reports and transcripts of earnings calls, I am not surprised to see CxOs and analysts using expressions like “history repeats itself” or back in 2001 or 1994 we did X so this time around we are going to do X because X worked then.  That is a bunch crap.  History does not repeat itself.  We say and think those things because we are often lazy and it makes us comfortable to associate events in the present with memories from the past.  There are five behavioral characteristics we see in the market as well as in corporate leadership:

• Need for Thought Anchors: The process of making decisions is most comfortable when we can associate the decision to that which is familiar.  We tend to justify a decision by saying, “this is just like when we made the decision to do X last year.”  We begin with what is familiar and try to associate future with the past.  John G. Stoessinger described this action as image transfer because “…policy makers often transfer an image automatically from one place to another or from one time to another without careful empirical comparison,” [see Nations in Darkness, John G. Stoessinger, 1971, page 279].  Dr. David D. Burns described this behavior as “all-or-nothing thinking” or “labeling” behavior [see The Feeling Good Book, David D. Burns, 1989, page 8-11].  It is much easier for humans to use thought anchors to build their decision making process around – rather than pursue unfamiliar thought positions.

• Power of Story and Legends: Decision making based on story and legend often motivates more than facts and research.  We are emotionally driven people.  That is why revolutions are emotionally draining events.  The power of story and legends is the act of basing decisions on simple reasons and not investigating and understanding the complexities of the decision criteria.

• Overconfidence and Ignorance: There is a tendency for humans to be overly confident on subject matters on which they are enormously ignorant.

• Herding Behavior: The power of the crowd.  The power of revolution.  In the absence of facts, or when facing a daunting amount of work to justify a decision, it is easier to follow the crowd.

• Denial – Failure to Accept Mistakes: Humans rarely admit, or learn from, their mistakes.  Mistakes are a natural byproduct of being human.  Admitting and learning from mistakes is an unnatural human activity.

Putting it all together I think:

• The catch up spend is done.  A number of companies are starting to realize they made some architecture mistakes and failed to realize the effect of the three pillars of (i) centralized control-plane, (ii) software defined ecosystem and (iii) lower priced storage-compute-switching power pack.

• A number of big companies got trapped by the catch-up phase like CSCO, JNPR, CIEN, etc and they are now in a negative product cycles.  I experienced this at XCOM in the early 1990s against CSCO in the switching market and it really sucks.  You never have enough capital to spend your way out; it keeps deteriorating.

• The leading edge of the market is beginning to move.  You want to be building in the leading edge of the market.  Companies with nimble product development teams are already focused on the emerging entities affecting the technology selection.  I like to think of technology selection as Darwinism.  Anytime you hear a person talk about Darwinism and survival of the fittest they are quoting urban myth.  Darwin’s theory was about selection – not survival. Going forward technology selection will choose the winners – the biggest is not necessarily a survivor (ask DEC, WANG, Nortel, etc).

If you are a generalist PM I would guess you have no idea what I just wrote in the prior 1800 words.  Most sell side analysts are probably scratching their head thinking I am nuts and wondering what this has to do with their price target and forward multiple on their outperform rated stocks.  Any executive reading this in a networking company is wondering how I know what their forward sales funnel looks like and what customer feedback has been of late.  History is not repeating itself.  The technology ecosystem is changing and evolving everyday and the underlying forces driving that change are coming from unfamiliar places.  We can all jump with the herd on the cloud rush.  We can believe in the stories of the internet breaking and exafloods or we can accept what is really going on.  By the way…did FB just peak too?  I would not know, left it more than a year ago.

/wrk

* It is all about the network stupid, because it is all about compute. *

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