Convergence Emergence, Part 1: Ubiquity [Fool on the Hill] August 7, 2000

FOOL ON THE HILL: An Investment Opinion
Convergence Emergence, Part 1: Ubiquity

Today's Fool on the Hill is the first in a series on the emerging post-PC marketplace born of the intersection of networking and telecommunications technologies. While the "convergence" catchword has been batted around in the media for the past few years like a cheap cat toy, the relevance of this secular trend has been ill-examined from an individual investor's viewpoint. This series aims to fill that void, but not by way of a broad technical overview or a compendium of all the players. Rather, we hope that these articles will serve as an introduction for investors to the dominant business models utilized by the companies competing in the converged network sphere.

By Brian Graney (TMF Panic) and Bill Mann (TMF Otter)
August 7, 2000

Welcome to the future!
Over the past few years, investors have watched as the PC-centric world that had so dominated the business environment throughout the 1980s and much of the 1990s has given way to a new world revolving around the increasingly singular area of networking and telecommunications technologies. The unabashed catalyst of this movement has been the Internet, which has tilted the investing spotlight today toward those connectivity technologies that act as the underpinnings for the Web-induced push for digital data by both businesses and consumers. Whether perceived as an evolution or a revolution or something else entirely, few can argue that the investing environment has changed.

Over the next four days, Bill Mann and I will examine some of the major business models that have emerged in networking, starting today with "Ubiquity," and following later this week with the "Sunk-Assets," the "Standards," and the "Agnostics." By focusing upon the business models rather than the technologies themselves, we hope to add some insight into how companies seek to turn their intellectual and physical capital into a competitive advantage and enduring profitability.

Ubiquity: Judging connectivity equipment firms
Just as in the PC-centric world, some companies are basing their entire transition into the Connectivity Age on their own innovative technology, a competitive advantage that can allow even an upstart firm to reap early market share gains. For the layman, however, judging the relative edge bestowed by this or that company's technology is difficult to impossible.

This is important to note as you read through each company's breathlessly optimistic literature, peruse the world-beating claims typical of Internet discussion boards, or even one of the hundreds of journals dedicated to these technologies. If you lack direct experience with a company's technology, you are at a distinct disadvantage to determine its relative merit. However, an investor can glean clues by focusing upon a company's positioning, understanding its business model, and looking for clues of future domination through current performance.

In the Ubiquity model, companies select a portion of the converged network and focus upon being the dominant, if not sole provider in that area. Ubiquity in networking is not the same thing as consumer ubiquity -- for example, seeing a McDonald's (NYSE: MCD) at every exit on an interstate, seeing its ads on TV, on the radio, and so on. Rather, in the converged network with its absence of vertical integration, we find heightened levels of specialization, both from equipment and service providers. Companies achieve ubiquity by selecting a single network requirement and dominating it through technological superiority, functionality, and differentiation.

The value of a technological edge
Companies interested in determining best-in-class technology can often resort to bakeoffs to compare different products; investors have no such luxury. Outside of obtaining scuttlebutt from sources "in the know," the major way to ascertain a technological competitive advantage is to wait for it to manifest itself in a company's financials. Without a clear understanding of what the Open System Interconnection model is or even how electricity works, a quantitative-minded investor could have seen Cisco Systems (Nasdaq: CSCO) taking market share in the data router market last decade based simply on the absolute size and relative pace of its top-line growth compared to its rivals.

In this way, Cisco's early technological advantage was able to flow directly through to its income statement, which in turn carried over into other areas of the business in a circular manner. This leads to a value creation ability as illustrated in the following flow chart:

Technological advantage

supra-industry returns

higher market multiple

strong stock currency for acquisitions

new technological advantages

Afterburner: Building a customer focus
Another way that a technological advantage can be used to build value is through its usefulness as a way to promote customer loyalty. Having the right products and services on hand when customers need them (or, even better, before they realize they need them) and then following through with tailored customer support has been a great model for building customer value. Recent examples can be found not only in the router world with the Cisco experience but also in the data storage sector and the rocket-like rise of EMC Corp. (NYSE: EMC).

Traveling along the component continuum
Regardless of the technological innovation in question, there is a very real risk in the Connectivity Age of commoditization over time. With the network as the final end-market, almost every single piece of connectivity equipment can be reasonably viewed as a component of some sort. That may sound bad, but it doesn't need to be. Exactly where an equipment company's products end up along the component continuum illustrated below -- a carryover from the PC Era, by the way -- will be a central determinant of that company's overall value creation ability in the Connectivity Age:

Commodity or Price-Based <—> Specialty or Value-Added

The further a connectivity equipment maker's technology can gravitate toward the extreme right of this continuum, the better from an investment point of view.

Such a continuum is far from new, but the absolute size of the market opportunity for various specialty/value-added components has arguably never been greater. The pump lasers and other optical devices sold by the likes of a JDS Uniphase (Nasdaq: JDSU) seem at first glance to be just the kind of equipment that would compete on price on the leftmost edge of this continuum -- if it wasn't for the fact that they are quite often no greater in size than a grain of salt, making them a highly specialized item that has the double advantage of being critical to the network and incredibly hard to produce.

Afterburner: Time to market and functionality
Once a company develops the right value-added component, time-to-market can come into play in a major way. That's exactly what happened to Brocade Communications (Nasdaq: BRCD) when it introduced the right product -- a Fibre Channel switch -- first, while its rivals were all bringing lower value-added hub technologies to market. In some instances, having the penultimate value-add product doesn't even matter, so long as it functions properly and can be implemented quickly. That's what allows a company such as CacheFlow (Nasdaq: CFLO) to state that its customers "mainly are looking for products that work" in the short-term. In the nascent markets of the Connectivity Age, function over form is the rule of the day and having the right solution on hand has become a prerequisite for gaining early as well as lasting market share.

Implications for investors
As more connectivity equipment -- be it of the wireless, terrestrial optical, or enterprise networking variety -- appears on the scene in the days and months to come, investors should look for those companies that best combine the features of technological advantage, customer focus, specialty/value-add components, time to market, and product functionality.

A firm exhibiting all of these traits would be well on its way toward the Holy Grail of product ubiquity and creating consistent long-term shareholder value. Needless to say, there may be other ways to skin the connectivity business model cat. We'll continue our look at the Convergence Emergence tomorrow and examine a second emerging model: the Connectivity Age's variation of the sunk-asset business model.

Related Links:

  • StockTalk With CacheFlow, 7/06/00
  • StockTalk With Brocade Communications, 5/15/00
  • StockTalk With JDS Uniphase, 5/7/99
  • StockTalk With Cisco Systems, 3/9/99
  • StockTalk With EMC, 1/26/99