The Tale of Three Vendors

There’s no denying that networking is changing, but different people or companies see the change differently.  For consumers, it’s mostly about replacing wireline phones and maybe cable TV with the Internet and wireless broadband.  For network operators it’s about sliding profits on basic connection/transport services and growing competition from traditional and non-traditional sources.  For network equipment vendors it’s (so they say) about “deferred spending”.

Well, you are what you invest in, and so networking is the sum of network infrastructure.  We’ve had three network vendor quarterly announcements this week, and it’s interesting to try to synthesize reality from their raw data.  That reality might then give us some indication of where the industry is moving, in the broadest sense.

Let’s start with the biggest.  Ericsson had a bad quarter that surprised nearly everyone.  Revenues were up y/y by nearly 13% but their EPS was off and the stock took an 8%-or-more hit as a result.  Ericsson blames sluggish sales to US carriers for their problem, and obviously if your biggest business source is slow you’ll be impacted.  But any seller can say “I’d do better if my customers bought more.”  It’s not a helpful analysis.  Why do sales matter if they’re up 13% y/y?  Because in adjusted currency form they were off by 9% for networks and 2% for services.

Move on now to Juniper.  Of the three companies who released this week-to-date, they turned in the best results from a Street perspective.  Juniper beat in EPS by a cent and beat earnings by a similarly small amount.  Their guidance was mid-range, contrasting to the other vendors we’re discussing.  The issue for Juniper is that their results beat estimates but they’re still running behind relative to past quarters.  Year over year, they were off in all three of their product categories (routing, switching, security).  Regionally they were up in EMEA and off elsewhere.

F5 also reported, and while it beat a big on revenue and EPS, its guidance for revenue was light.  Interestingly, much of their revenue positive was attributable to the very North America/US market that Ericsson said was “sluggish”.  According to them, the problem is exchange issues—foreign currency headwinds.  Their fundamental trends in ADC and security are strong.

When you look at the three together, it’s clear that there is no clear secular trend driving them all.  We’re not seeing economically or systemically driven demand suppression, but rather a shift in spending that in some areas probably represents a decline in perceived operator ROI potential and in others potential for a gain.  Operators are doing what’s profitable, and that’s changing.

A specific point here is Ericsson’s sluggish wireless spending lament.  Wireless has historically been the bright spot in capex, but for the last five to ten years we’ve seen increased pressure on wireless ARPU.  Couple that with the fact that most operators don’t have a large unpenetrated prospect base, and you have a formula for profit stagnation or even decline.  The operators, like vendors, respond by cutting costs (Ericsson plans that, for example).  An operator cutting cost equals an operator with lower capex.  Mobile has fallen from grace, at least relative to its glory days, because it’s not as profitable.

Roaming regulations in the EU and neutrality in the US conspire to increase future risk.  Reductions in roaming charges mean less mobile revenue and (worse to some operators) loss of a means of avoiding churn in a very competitive market.  An operator usually has the best coverage and performance in their home area, and if they have to share their network with competitors even at home and at minimal incremental cost, then they risk competition.  In the US, neutrality rules on mobile could stymie a lot of broadband usage plans, particularly if “content-pays” is an illegal model.

In contrast, pretty much all future service revenue gains are seen as coming from services whose features are hosted in data centers.  It follows that data center equipment and network equipment associated with hosting points would do well—F5’s ADC and security portfolio for example.  Add to that the fact that unlike Ericsson, F5 gets only about a quarter of its revenues from service providers and you see some good reasons why F5 is different.  The stock was off initially on light guidance but popped back with the announcement (expected) of the new CEO (replacing the retiring McAdams).  The pop is more justified in my view based on the fact that there will be a lot more data centers down the line.

Juniper is (as often is the case) a kind of interesting dilemma.  If you look at their trend line relative to the other vendors, their results are worse.  The Street has rewarded them for not being worse than expected.  But in fundamentals Juniper still has strong assets.  Their security stuff is in the top tier for CSP/NSP buyers.  They have good data center switching credentials.  They have less exposure to mobile than Ericsson, meaning that mobile’s slide from grace won’t impact them as much.  They are what CEO Rahim describes as “maniacally focused on IP networking.”  For all the changes in the industry, we still have to push bits.

Overall, I think we’re seeing an industry in transition, and I doubt many disagree.  The view I hold that vendors in particular might not like is that I think the transition is from connection/transport dependency to higher-layer dependency.  F5 won because it was more higher-layer than the others, less exposed to segments that are in decline.

If you know your current business model isn’t working and you know what the future holds, you’d shift on a dime to fund the new.  If you knew the former and not the latter, you’d withhold spending on the old and wait to see what develops.  That’s where I think we are.  Operators know that pushing bits won’t be rewarded, but they don’t know for sure what will.  They currently can see only that hosting and data centers will have a lot to do with it.  So they trim their sales on traditional products and watch for signs of a clear future direction.

For the network vendors, the question is whether that future direction intersects with any path they can hope to take.  Ericsson wants to bet on professional services, but you need a goal to need a route-planner.  Juniper wants to bet on business as usual, a bet that I think is least likely to pay off in the long run.  F5 wants to bet on the cloud and data center, and that’s the only winning bet available.  Their risk is that NFV and SDN will combine to create a more definitive future path that will subsume their ADC/security mission.  F5 really doesn’t play a convincing role in either.

The situation with these three vendors illustrates the risk Alcatel-Lucent and Nokia face in combining.  If you’re consolidating based on current conditions or even current established trends, you’re shooting behind the duck.  The fundamental problem in networking is benefits to drive new spending.  For operators, that’s revenue from new services.  For enterprises, it’s new productivity gains.  As an industry we’ve come to see offering more bits for less money as a gain; it’s a path to commoditization.  We have to make bits more valuable, and that’s the simple truth that vendors and their customers must all face.