By David Sterman
The first rule of investing: Always keep learning.
If you don't stay ahead of the key trends and themes developing in various sectors, you'll be investing in yesterday's technology. And though many industry changes are modest in scope, impacting investing strategies on the margin, a few are monumental.
Lately, I've been researching a monumental change in the information technology sector that will have a $50 billion effect in annual spending. That's the size of the networking equipment market, dominated by firms like Cisco Systems (CSCO), Juniper Networks (JNPR), F5 Networks (FFIV) and Brocade (BRCD).
That major change: a shift to software-defined networking (or SDN).
It's a seemingly simple name for a remarkably complex set of changes in how information gets routed across networks. Let's try to boil down the complexities of SDN into a few key issues.
Better, Faster, Stronger
As a consumer, you'll never come into contact with SDN. It will instead be used as a strategic tool by the chief information officers who run large corporate networks. These CIOs have a very tough job, making sure that all of the hardware and software components interact smoothly, and keeping a focus on the rapid delivery of network packets (which can carry voice, video and data) across the country and worldwide.
Those two tasks -- network management and proper data routing -- have always been seen as one task. But SDN breaks them into two tasks, enabling CIOs and their IT departments to have much deeper insight into where data traffic starts, how it moves, and where it arrives.
Let's use Netflix (NFLX) as an example. The video-delivery firm spends thousands of man-hours every month trying to optimize its network by adjusting the loads on its server, routers and switches that attach to the Internet backbone. Using SDN, these IT personnel can much more quickly adapt to changing traffic loads, without making major hardware changes.
Just as important, IT departments can make major changes in a network's operations, without worrying about unintentional hiccups in the flow of traffic. In the current hardware/software hierarchy, any new hardware or software additions can lead to big headaches if other systems fail to be properly configured. SDN is a "virtual" controlling mechanism, meaning it can change traffic delivery patterns without disrupting any existing systems.
The Spending Impact
As IT networks are currently run, roughly 80% of tech funds are spent on personnel that manage these complex systems (with the other 20% going to hardware and software purchases (that is, capital expenditures, or capex). The use of SDN will enable IT departments to do much more, but with fewer workers, yielding solid savings in terms of overhead.
And speed is another benefit: "SDN implementations (will) reduce application deployment time from weeks to hours or less, resulting in significant operational savings," note analysts at Goldman Sachs. Companies will also save on hardware purchases as they will no longer need to build a lot of redundant network capacity to account for inefficient allocation of resources.
2014: The Breakout Year
Companies are going to proceed slowly, considering the tectonic shift in network management that SDN entails. So it's unlikely to have a big effect on the industry for several years. In the year ahead, look for companies to begin their SDN trials, figuring out how the process works on a small scale before placing large orders in 2015 and 2016.
Yet the mere fact that this will become a dominant topic in IT circles in 2014 makes this a timely investment opportunity. By the time SDN is all over the financial media, share prices will have already started to respond to the eventual winners and losers.
UBS held a conference on SDN in the spring, and after hearing industry comments, concluded that "the value proposition of SDN around capex/operational expenditure savings and increased automation and agility is real to customers and we expect this architectural shift to play out over time."
Considering that Cisco Systems is the overwhelmingly dominant player in network hardware, many tech strategists figured the company had the most to lose from the switch to SDN.
Yet in recent months that view has flipped: Thanks to a string of acquisitions and internal investments, Cisco is now seen as a clear beneficiary, with a comprehensive set of SDN offerings that outpaces its smaller rivals. A key part of Cisco's SDN strategy entails long-term software and service contracts, which is a key pillar of Cisco's long-term business model shift, as I noted recently.
Analysts at Goldman Sachs, which has Cisco on its "conviction buy" list, concur: "With Cisco enabling software programmability to its vast $180 billion installed base, we believe it has an opportunity to transition from a 'box' company to a platform company."
Analysts at UBS agree that Cisco is in the driver's seat in this niche, but caution: "Cisco can't be complacent as the world evolves from hardware-defined to software-defined, likely requiring business model changes (software monetization vs. hardware) and an increasing role for software and services in Cisco's portfolio."
Other winners: Broadcom (BRCM), which is building a set of communications chips that facilitate SDN, and VMWare (VMW), thanks to its $1.3 billion purchase of SDN pioneer Nicira in 2012.
Yet for every SDN winner, a rival will lose market share. Goldman's analysts are concerned that rivals Juniper, F5 and Brocade lack the scale to show technology leadership, and the SDN transition may cause them to lose some legacy customers.
Brocade and Juniper Networks have already made acquisitions in the SDN niche, and if F5 Networks want to quickly become relevant, it may look to acquire PLUMGrid or Jeda Networks. BigSwitch or OpenDaylightProject, all of which are privately held but garnering considerable industry buzz.
Risks to consider: By the time the SDN revolution gets under way in a year or two, many players will have already completed their acquisition strategies, and incumbent telecom equipment and networking firms may already have lost the battle before it began.
It's hard to overstate how massive this shift will be. SDN threatens to turn hardware components into commodities, leading to rapid price declines for traditional networking switch vendors. In coming months, you'll be hearing a lot more about SDN, and it behooves you to track the moves of Cisco and others as they jockey for position in what will become a $50 billion market.
Disclosure: I am long CSCO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of CSCO in one or more of its "real money" portfolios.