Changing Networking Sector Dynamics

It is not just the HP-3Com deal that is worrying Cisco, the networking Goliath. In a recent analyst meeting, Cisco CEO John Chambers conceded that over the past 12 months, Cisco has lost market share in both routing and switching, its core franchises. In the niche area of application delivery controllers (ADC), F5 overtook Cisco in the second quarter while Alcatel-Lucent is poaching market share from Cisco in the edge router market. Let’s take a closer look at the changing dynamics in the networking sector.

According to networking and telecommunications researcher Dell‘Oro, the ADC market grew 10% in 3Q09 to $229 million. In the second quarter, F5 led the market with 38% share versus Cisco’s 26%.

F5 Networks (NASDAQ:FFIV) reported annual revenue of $653.1 million for fiscal year 2009, which is up slightly from $650.2 million in fiscal year 2008. GAAP net income for the year was $91.5 million ($1.14 per diluted share) versus $74.3 million ($0.89 per diluted share) in fiscal year 2008. Q3 coverage available here.

Q4 revenue grew 2% y-o-y and 11% q-o-q to $175.1 million while net income was $28.4 million or $0.36 per share versus $19.7 million or $0.24 per share last year. Deferred revenue grew 7.8% to $183.1 million from the prior quarter. After repurchasing 3.3 million shares for $87.4 million in fiscal year 2009, F5 ended the year with $574 million in cash and investments.

Based on its strong performance, for the first quarter of fiscal 2010, F5 has set a revenue target of $182 million to $187 million and a GAAP earnings target of $0.31 to $0.33 per share. The stock is currently trading around $52 with market cap of about $4 billion after hitting a 52-week high of $53.07 on December 10.

In 3Q09, the Ethernet switch market grew 5% sequentially to $3.5 billion, driven by continued strength in data center deployments. Fixed 10 Gigabit Ethernet revenues grew nearly 30% during the quarter, with most of the growth being driven by purpose-built Fixed 10 Gigabit Ethernet data center products. Cisco and HP lead in this segment with a combined share of almost 70% of the total Fixed 10 Gigabit Ethernet port shipments. Some analysts say that after the HP-3Com deal, HP might try to develop its data center switches in-house, putting its OEM relationship with Brocade in jeopardy. Otherwise, Brocade, which is the market leader in the $2.4 billion storage networking market with a 71% share, would have been a suitable acquisition target for HP.

Brocade (NASDAQ:BRCD) reported strong fourth quarter and fiscal 2009 results on November 23. Fiscal year 2009 revenue was up 33% to $1.9 billion. Q4 revenue was up 31% y-o-y and 6% q-o-q to $521.8 million while net income was $33.6 million or $0.07 per share versus loss of $21 million last quarter and income of $35.6 million last year. Gross margin improved to 59.5% from 58.2% last quarter. The company ended the quarter with $351.4 million in cash, up from $250 million last quarter.

Q4 sales via indirect and direct channels accounted for 35% of total revenue, up from 12% last year. OEM revenue accounted for 65% of total revenue, down from 88% last year. Brocade believes its OEM relationship for FCOE products with HP will continue despite the 3Com acquisition. Data storage accounted for 58% of revenue, down from 84% last year. Ethernet revenue accounted for of 25% revenue after Brocade’s $2.6 billion acquisition of Foundry last year.

For fiscal year 2010, Brocade expects revenue in the range of $2.25 billion to $2.45 billion and non-GAAP EPS between $0.56 and $0.61. The stock is currently trading around $8 with market cap of about $3 billion after hitting a 52-week high of $9.84 on October 9.

According to Dell‘Oro, the worldwide service provider edge router market grew 2% to $1.2 billion in the third quarter of this year. Edge routers are networking devices used to manage and deliver Internet-based services and content. Alcatel-Lucent (NYSE:ALU) recorded market share growth from 15% in Q308 to 20% in Q309, mainly due to its broad product line. Cisco leads the market with 49% share (versus 45% in Q308), while Juniper is No.3 with 19% share.

Despite its market share gains, Alcatel-Lucent reported a disappointing quarter on October 30. Q3 revenue was €3.68 billion ($5.5 billion), down 9.3% y-o-y and 5.6% q-o-q. Net loss was €182 million ($269 million) or €0.08 per share compared to a loss of $52 million last year and profit of €14 million ($20.04 million) last quarter. Adjusted operating loss was €11 million. However, the company’s cash position improved significantly to net cash of €592 million versus €28 million last quarter. Q2 coverage is available here.

By segment, Carrier revenues were down 14.6% y-o-y and 6.4% q-o-q to €2.23 billion. Applications Software revenues were €286 million, up 19.7% y-o-y and 10% q-o-q. Enterprise revenues were €250 million, down 17.2% y-o-y and 3.1% q-o-q. Services revenues were €869 million, up 2.5% y-o-y and down 0.5% q-o-q.

Alcatel reiterated its guidance for 2009 and still expects adjusted operating income of around breakeven in 2009. It expects the telecommunications equipment and related services market to be down between 8% and 12%. The stock is currently trading around $3 with market cap of about $7 billion. It hit a 52-week high of $4.69 on October 7.

In August, Alcatel entered the content delivery network (CDN) market with its acquisition of UK-based Velocix. The CDN market is dominated by Akamai (NASDAQ:AKAM), which has annual revenue of $790 million. Q3 revenue was up 5% to $206.5 million while net income was down 2% to $32.7 million or $0.18 per share. The company repurchased shares for $36.2 million and ended the quarter with $973 million in cash. Q2 coverage available here.

Owing to pricing pressure from rivals Limelight and Level 3, Akamai has brought its prices down to match the competition. It recently raised its fourth quarter guidance to revenue of $230 million to $235 million and EPS of $0.42 to $0.43. The stock is currently trading around $25 after hitting a 52-week high of $25.19 on November 16. Market cap is about $4.31 billion.

Akamai’s rival, Level 3 Communications (NASDAQ:LVLT), with annual revenue of $4.3 billion, reported Q3 revenue of $916 million and net loss of $129 million or $0.08 per share. Core Communications Services revenue was $859 million, down from $964 million in Q308. Within this segment, Core Network Services revenue declined 11% to $701 million. Communications gross margin improved to 59% compared to 59.7% last year, and the company ended the quarter with $532 million in cash. Level 3 expects consolidated adjusted EBIDTA of $900 million to $950 million for fiscal year 2009. It is currently trading around $1.5 with market cap of about $2.4 billion. Earlier coverage available here.

Akamai’s other main rival, Limelight Networks (NASDAQ:LLNW), which had annual revenue of $129.5 million in 2008, is going the acquisition route with two acquisitions this year, the latest announced just yesterday. In May, Limelight acquired video ad insertion firm Kiptronic for approximately $12 million, and yesterday it announced plans to acquire interactive digital advertising provider EyeWonder Inc. for up to $110 million. Limelight is currently trading around $4 with market cap of about $322 million.

Despite the competition, I am very bullish about Akamai. Its gross margin has been on a decline over the past couple of years, but at around 75%, it is still much higher than the 58% range for Level 3 and 55% range for Limelight. Akamai is the market leader in an industry that is going to bloom with the surge in online video as well as the recovery of e-commerce. My sentiments are reflected in the two recent analyst upgrades it received.

Is this a sector that Cisco might want to get into? Why not? Cisco has had a CDN for internal use for many years, and in April the company was said to be acquiring colocation space for a new Cisco-based content delivery network. Video is integral to many of Cisco’s growth channels, such as telepresence, and CDN services is set to become a huge market.