Behind all the fanfare over the ongoing broadband upgrade cycle from the so-called 10G to the 100G data-transport hardware, a quieter software revolution is taking place. Gary Smith, CEO of Ciena (NYSE:CIEN), stated in its latest conference call that "...a major market shift is just beginning toward an on-demand model that's better suited to [rapidly] changing end user behavior... [It] is a fundamental market changer and, as we said before, there will be new winners and losers."
He was talking about Software Defined Networking, or SDN, which is a sweeping overhaul of how the entire Internet will be organized and operated. Ciena's competitors, including Infinera (NASDAQ:INFN), Alcatel-Lucent (UNKNOWN:ALU.DL), and Cisco (NASDAQ:CSCO), also see this shift away from providing the fastest or cheapest hardware to providing the most dynamical control over content delivery. Each company is responding in its own unique way.
How software trumps hardware
If history is any guide, the hardware of this industry will gradually become a commodity while the pricing power and resulting profit margins will migrate toward the software. Software achieves this advantage by offering unique and readily updateable services that become so thoroughly integrated into a user's processes that the user can't afford to change vendors even if they wanted to (think Microsoft Windows on PCs).
Most investors, however, still have their focus on the current hardware upgrade cycle from 10G to 100G. I believe this is a misguided focus. The future profits will be in a new generation of software that can automatically monitor, control, and adapt a provider's services to rapid changes in customer resource usage over minutes or even seconds, as well as respond robustly to the relentless introduction of novel applications and service requirements.
Such capability isn't just nice to have, it is urgently needed as the services demanded today by an escalating number and diversity of users is already dismantling the ability of service providers to respond profitably. They need the new software-driven architecture, and they're willing to pay handsomely for it because their costs under the current architecture are escalating beyond their ability to bear.
The competitors reshape themselves
Ciena has repeatedly made clear, in earnings calls and analyst presentations, its new emphasis on software to meet the new demands. It has forged a partnership with Ericsson to develop SDN control software, and it recently announced a partnership with Brocade "to enable on-demand provisioning for both computing and network resources across data centers." It intends to provide best-in-class SDN software for the new architecture based on the new industry-standard protocols called OpenFlow.
Infinera, with its emphasis on best-in-class hardware, is approaching the changes differently. It is currently more focused on the lower software levels embedded within their hardware to promote the convergence of the data transport layer with the switching layer, and ultimately with the router layer. At the Citi Global Conference in February, however, Infinera's CEO, Tom Fallon, intimated plans to enter the SDN software market as well: "The next step here can be some sort of transport SDN solutions."
After a long struggle, Alcatel-Lucent is actively striving to regain its relevance in the industry's future. A recent announcement that it will launch a "new portfolio of operations support systems... via a totally new approach to automating a service provider's operations" indicates it plans to compete for the new SDN business. The CEO's new Shift Plan is providing ample resources to become just such a contender.
Cisco is taking a defensive tack in an effort to stave off the coming erosion of its very large router business. One step, which I contend is a strategic error, is the introduction of proprietary software protocols named OpFlex in lieu of OpenFlow. Though it is trying to get OpFlex accepted into the industry standard, it is an obvious attempt to put its own ecosystem at a distinct advantage, so the industry is likely to resist.
How this unruly competition will play out remains unclear, but one thing seems sure: The future of broadband networking will be ruled by those who implement the most capable SDN software using the new open standards. Ciena is one of the first out of the gate, and it intends to take a commanding lead, making now an excellent time for investors to take a closer look.