Successful Networking M&A Keeps Optical and Data Separate

In an industry with so many new technologies, and so many companies with limited internal R&D resources, M&A strategy is central to long-term success. And while many acquisitions become clear winners or losers in the years that follow the deals, there are signs of trouble that can be spotted at the time any transaction is announced, independent of revenue or earnings multiples.

One of the most noticeable signs of trouble is when an acquired business has significantly different gross margins and inventory turns. This typically means the manufacturing processes will produce few cost efficiencies when merged, because they are so different from each other. Additionally, this also signals an expertise in vastly different technologies at the acquired company, which makes retention of key personnel critical to the deal. These risks do not exist when like companies get together, which happens when data networkers stick to buying other data networkers, and optical manufacturers stick to buying other optical manufacturers. Contrast the successes of Ciena (CIEN)-Lightera, Juniper (JNPR)-Unisphere, and Cisco (CSCO)-Kalpana, to the failures of Ciena-World Wide Packets, Cisco-Monterey, and Nortel (NT)-Bay.

Some optical vendors have sought data products for the gross margins they bring, without considering the product development and manufacturing processes behind the numbers./ /Sales volume, software, and inventory turns are the three main reasons why gross margins for data equipment are so much higher than they are for optical equipment. While some might argue that longer sales cycles at carriers compared to enterprises contribute to optical vendors inventory needs and lower gross margins, there is little data to support this. Juniper gets over 70% of revenue from service providers, yet it ships nearly 100 times as many line cards a year to carriers as Infinera does. Like most technology products, network equipment has high fixed costs, but relatively low variable costs. With much lower volumes, optical hardware simply cannot match the unit costs achieved by the data products whose traffic it often aggregates.

Another big factor in data products better margins is software. While both data and optical vendors employ their fair share of software engineers, the operating system of a data networking device often holds most of the vendor’s proprietary features, because most of these devices are assembled with merchant silicon. One example of this is F5 Networks, which has explicitly stated that its strategy is to combine software-based products with commodity hardware. Its gross margins are near 80%.

Cisco has built its near-monopoly on routers and switches through a number of proprietary technologies, including EIGRP (Enhanced Interior Gateway Routing Protocol), CDP (Cisco Discovery Protocol), and VTP (VLAN Trunking Protocol). Not one is implemented in hardware. Meanwhile, Infinera’s PIC technology is built around a proprietary glass, Hydex.

Pure software companies can achieve gross margins of over 90%, Citrix (CTXS) and Check Point (CHKP) often come in over this level, and their contribution margins can be even higher than that. There is virtually no unit cost when simply selling additional licenses, and this is a major factor in why data equipment has higher gross margins than optical hardware.

In addition to sales volume and software, data products get out the door much faster than optical products. Ciena and Infinera (INFN) both report inventory turns near 4, while Cisco’s are over 11. Unlike data products, which often ship straight from the contract manufacturer to the customer, optical equipment typically needs additional assembly and testing, which stretches the production cycle and forces the vendor to hold on to inventory for a longer time.

The fact that data products have better gross margins does not necessarily mean that data vendors will fare better economically, rather that the processes of designing, manufacturing, and selling these platforms require a series of internal activities that are very different from those associated with optical products, and that the two do not mix well under one company’s roof. Never mind Nortel’s challenges trying to sell a very broad product line, this is also why Cisco has struggled with its optical business, and why Ciena has struggled in its data business.

With R&D, production, and inventory management processes differing greatly between WDM and Ethernet hardware, Infinera and Juniper have held off larger competitors by keeping optical and data separate. As we head to 40 and 100 Gigabit networks, tomorrow's market leaders will do the same.

Comments

[Eve Griliches:]

David,
Great points on data and optical. Within the companies each area loves it's technology but rarely seems to understand the other technology well enough. Only ALU has suceeded, but with the IP group remaining seperate. We'll see how long that lasts this year!
Eve

Apr 01 09:41 AM

[Ricard:]

Very interesting article, thank you.

Apr 01 02:32 PM