Analyst View: Networking Outlook 2000
By Tim Savageaux
W.R. Hambrecht, March 29, 2000
When a communications infrastructure technology conference in Silicon Valley is
sold out days in advance and people are turned away at the door at $2,000 a
head, is it a sign that the mania has peaked and the end is near, or that we are
just getting warmed up?
At Technologic Partners's annual Network Outlook Conference, held earlier in
March, the latter certainly seemed like the right answer. The conference featured
presentations by 90 emerging communications infrastructure companies. Even
after marveling over the valuations of companies such as Juniper Networks
(Nasdaq: JNPR) and Sycamore Networks (Nasdaq: SCMR) -- these companies
trade at higher-than-Internet multiples of well over 100 times forecast revenue
levels -- it appears that there may be more opportunity to invest in emerging
communications infrastructure vendors during the year 2000.
This point was dramatically underscored at the conference itself, as three of the
firms scheduled to present were forced to cancel because of pending deals. One
company, optical switch developer Xros, was bought by Nortel Networks (NYSE:
NT) for more than $3 billion, and the other two companies -- voice-over-IP
gateway and softswitch provider Sonus Networks and optical networking company
ONI Systems -- filed for initial public offerings. The extremely challenging task
assigned to me, as a member of the conference's Investor's Choice panel, was to
help identify those companies among the remaining 87 with the best potential for
success.
THE BIG DEAL
Communications networks are witnessing a confluence of technology and
regulatory discontinuities the likes of which never has been seen. Demand for
bandwidth is skyrocketing as usage of the Internet and other data
communications services increases. At the same time, the Telecom Act of 1996
has opened communications services, resulting in scores of new carriers hungry
for cutting-edge equipment to build their networks. Add to this two fundamental
shifts in communications technology -- the move from circuit-based
communications to packet-based and the move from electrical to optical
networking -- and the opportunities for the new and the established technology
suppliers are indeed robust.
All of this has resulted in a market that, according to our estimates, is the
fastest-growing technology market of its size in the world. In the U.S. alone, we
estimate that spending on networks by communications service providers totaled
more than $73 billion in 1999, an increase of 30 percent. Despite the increasing
size of the market, the growth rate has accelerated over the past three years
from the low teens and shows no signs of abating in 2000.
With a market so large and opportunities so diverse, casting a wide net would
appear to be the most sensible investment strategy. Beyond that, there are three
primary criteria that produce successful investments in the network infrastructure
space: large addressable markets, proximity to carrier revenue stream, and
migration path opportunity.
Large addressable markets are important because the public markets in
particular are rewarding the open-ended upside potential that accompanies
penetration of a multibillion dollar market opportunity. Niche markets may be
profitable in the near term but place a lid on valuations over time.
Next, you want to examine how easily a company can tap into a carrier revenue
stream. While cost reduction remains a priority for carriers, technology solutions
that drive new services and hence new revenue streams represent a greater
value-add to new, growth-oriented service providers.
The third criterion, migration path, requires networking companies to provide a
clear and effective method of transitioning to new technology. Most carriers, even
relatively new carriers, are likely to have infrastructure currently installed and
perhaps even embarrassingly old-fashioned ways of generating revenue -- selling
voice or leased-line services perhaps. Solutions that accommodate legacy
networks and services while offering a clear migration path to desired future
packet- and optically based network architectures and services are likely to be
winners.
THE WINNERS
The companies selected at the Technologic conference for top ten honors
represent a good cross-section of the communications infrastructure
mega-trends. We view the most recent trend as the convergence of voice and
data networks, which we refer to as voice-over-X. The X in this case is any
number of emerging access and switching technologies, including cable, digital
subscriber line (DSL), IP, and asynchronous transfer mode (ATM). The market
opportunity is gigantic because it essentially targets the current market for voice
circuit switches, which eclipsed $10 billion last year in the United States alone.
Companies selected for Investor's Choice honors in this category included
Coppercom, Jetstream Communications, Tachion, and Taqua Systems, all of
which are developing innovative products for the delivery of voice services and
the integration of voice and data networks.
We believe the voice/data convergence theme is the heir to one of the more
prominent trends to emerge in the communications infrastructure space in 1999,
namely broadband-access technologies. These solutions enable high-speed
access to the Internet for business and residential subscribers and include
technologies such as cable modems, xDSL, and broadband wireless.
Companies that provide equipment for the edge of carrier networking, where
these broadband technologies can be integrated into the carrier's backbone, have
become particularly interesting. Broadband Access Systems, another Investor's
Choice selection, is focused on the broadband cable access with the market. In
the IP access market, Cosine Communications is well positioned to solve a big
problem for today's carriers, namely lots of Internet traffic and little revenue
outside of basic access charges. The company is marketing a carrier-class
platform that allows carriers to provision virtual private networks (VPNs).
Optical networking is another prominent theme in the communications network
arena and accounted for three of the top ten selections. These companies run the
gamut from today's current synchronous optical network (SONET) opto/electronic
networking paradigm to emerging all-optical, or photonic, networking
technologies. While an all-optical network is alluring, we believe the evolutionary
nature of carrier networks will call for several steps along the way. Corvis has
staked out the early ground in the photonic networking space and has raised an
eye-popping $300 million to implement its vision of an all-optical core network.
Zaffire is attacking the regional or metro network with a combination of dense
wavelength division multiplexing (DWDM) technology and very high-capacity,
intelligent electronic packet-switching capability. At the network edge, Mayan
Networks is focused on evolving current SONET access and transport networks
toward more packet-centric service and switching functionality.
We expect many, if not all, of these emerging vendors to explode onto investors'
radar screens over the next year or so, offering attractive investment
opportunities much in the same way that previous Network Outlook attendees
such as Copper Mountain Networks (Nasdaq: CMTN), Juniper Networks, Redback
Networks (Nasdaq: RBAK), and Terayon Communications (Nasdaq: TERN) have
over the past year. This strong supply of new players may well translate into
greater challenges for investors over time as winners and losers begin to emerge
and some of today's fresh, exciting faces become more familiar.
Tim Savageaux is the eNetwork Infrastructure analyst for W.R. Hambrecht.
Previously, Mr. Savageaux was a senior communications equipment analyst at
Volpe Brown Whelan, Robertson Stephens, and J.P. Morgan (NYSE: JPM)
Securities. W.R. Hambrecht is an investment bank involved in the underwriting of
networking companies. At the time that this was written, W.R. Hambrecht made a
market in Terayon and Copper Mountain Networks.
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