Networking Stocks: "The Fires of a New DE-Capitalism"...Call 911, or
1-900-ANALYST?
04/27/97
Copyright 1997, This article may be reproduced in whole or part, by any
means, so long as this notice is included and the author is given
credit.
Part One: Networking -- Where it's Hot, and Where it's Not
First, let's define "Advanced Ethernet Switching Technology" for the
LAN; this includes 100/1000MB, and IP switching products, as opposed to
"slower, non-switch" 10MB and PC Adapter cards (NICs), which have been
falling in price due to competitive moves. Said another way, "old"
networking products are increasingly obsolete, and the decline in
margins and pricing naturally follows in the face of newer, faster ones.
For the rest of this article, we'll refer to new Advanced Ethernet
Switching Technology with the acronym "AEST", for shorthand purposes --
this contrasts with the "slower, non-switch" and hence, "non-AEST"
product and pricing changes which have dominated the news so much as to
eclipse any notion of what is truly occurring.
The "macro" issue here -- which networking analysts aren't outwardly
commenting on -- is not at all a "slowdown"; rather , the truth is that
older technology is being replaced with newer AEST. Nothing startling
about this...technology always advances, this is the very root of
American productivity. And yet, analysts have not outwardly discussed
this key trend and the impact it will have, but have focused instead on
"doom and gloom" scenarios for the entire networking industry. (Note, I
recently did a piece on networking-supply-chain analysis which provides
direct evidence of the AEST trend, see:
exchange2000.com . )
What's been ignored by analysts thus far is critical; that is, an axiom
can be applied to identify "winners" in a sector that has been
completely "dumped." Specifically, as far as the LAN, individual
companies will benefit or lose to a degree directly proportional to said companies mix
of AEST vs. "old" technologies. For example, 3Com has a
high mix of adapter card, hub, and 10MB product -- so much so, they had
to "price guarantee" non-AEST product in the distribution channel, as
mentioned in the recent conference call. So, in this case analyst cuts
were completely justified , as they reflect how 3Com saw extreme margin
pressure on their core NON-AEST products. That's not to say 3Com won't
benefit in the long-term from the trend towards AEST (since they offer p
roduct in this category) -- in fact, signs of recovery should be seen in
3Com as soon as the current quarter or next (the question remains if
3Com will ever regain lost adapter-card revenues -- but now that I think
of it, perhaps the 3Com/USRX merger provides an appropriate surrogate).
In short, the same trend which harmed 3Com recently could actually
benefit the company in the longer term. Let's examine the ramifications
of this important, longer-term trend in more detail -- after all,
investments are best based on future potential.
The issue of AEST in the LAN is an important one since it is a
multi-billion dollar market -- and the largest part of that market is
yet to be realized, since eventually non-AEST LANs will be upgraded
almost entirely to AEST LANs. Moreover, the evidence is mounting that
AEST is completely displacing ATM's small foothold in the LAN
("desktop") ; this is corroborated by several anecdotal indications:
1) Both Fore Systems (FORE) and Madge Networks (MADGF) -- the two
leading "desktop" ATM LAN companies -- have been experiencing
disappointments in ATM LAN product sales, both in the US and
Internationally. This should not be confused with ATM WAN sales; indeed,
both 3Com and Cisco have been reporting strong "core switching" sales.
The outlook in the WAN is good for ATM (as well as "hybrid" IP
approaches). Unfortunately, Fore has shown WAN market share loss, where
Cisco and 3Com have reported strength. In Madge's case, WAN business is
obviated due to simply not being there.
2) While LAN ATM solutions are not selling, there is mounting
industry-wide evidence (source: Dell Oro, et. al.) that AEST solutions
are hot...indeed "flying out the door." Moreover, specific companies
which have a high proportion of certain leading-edge AEST have reported
dramatic increases in sales demand both in the US and abroad (source:
MRV Communications).
Now as for how AEST will affect the WAN. Whereas a "speedup" is clearly
occurring in the LAN, a brief discussion of the WAN is also important
here. Mass-migration to AEST will cause an unprecedented "surge" in LAN bandwidth
of 10- to 100- fold, vs. the 3-fold annual overall average
(source: Forbes/Gilder, forbes.com ).
This will in turn cause a "bubble-up" effect, which will dramatically
impact the WAN backbone. The result of this surge will benefit almost
every WAN vendor (except those losing market share), as demand for ATM
and IP WAN solutions necessarily increases to handle the ripple. (Note,
early signs of this ripple can be found in the supply chain...once
again, see:
exchange2000.com -- the
contents of this report have been independently supported by several
experts in the networking industry.)
Part Two: Smoking in the Back Room Leads to Slow Wit...or Quick Profit,
and for Whom?
Some might ask, "If the analyst organizations have not outwardly been
identifying beneficiaries of key trends, just what have they been
doing?" For an answer to this question, I'm led to a bit of news on
which indeed explains what they have been doing in an__ahem__rather
"inward" fashion. Specifically, my attention was caught by Barron's of
April 28th, 1997 ( barrons.com ), in the section entitled
"The Striking Price" which described a derivative so-popular-of-late
being sold indiscriminately by brokerages against top holdings of growth
funds -- you guessed it, many of which are the networking stocks:
From Barron's:
<<No one we talked to would admit to buying or selling customized put
options based on the stocks of a specific fund. And few wanted to be
quoted for the record. That's not surprising, since many of these same
brokerage firms who offer sophisticated derivatives work closely with
the fund industry. ``It's a touchy subject,'' says John Braddock,
managing director of the structured products group at Oppenheimer & Co.
``You're talking about stealing apple pie from Mom and Pop.'>>
I guess the sales of the latter derivative could explain the "somewhat
confused hush-hush" surrounding what amounts to a shift in networking
rather than a slowdown -- and could explain, for example, just where
much of Cisco System's (CSCO) and other networker's wealth has gone of
late. To wit, while analysts have cut Cisco's estimates by a few
pennies, Cisco now trades at a forward P/E of around 17. I calculate a conservative
fair value for Cisco of around 70 dollars a share -- and
this figure is based on the analyst's estimates, as well as the
macro-trends which appear to be in place that can support these
earnings.
...so what it really comes down to is whether or not a "New
De-capitalism" has incarnated itself in the sophisticated derivatives
mentioned in Barron's. Is there a fire in the back rooms of many
brokerages, burning up the wealth of America's growth companies? Will
this be tolerated by investors, fund managers, CFOs, and hi-tech
employees...and if so, for how long? Indeed, what an intoxicating smoke
it must be for those who profit -- leaving so many analysts apparently
numbed and thus incapable of producing reports which reflect valuations
against future potential.
When and how will much needed buckets of water arrive to snuff the fire,
and clear the smoke? One can only speculate, but I'd think a cold splash
is overdue -- tossed, no doubt, by a brigade of institutional investors and CFOs who
are reminded of the true spirit of American "growth
capitalism"...and, that those who play with fire deserve to get burned.
[ The story that set me on fire:
exchange2000.com ] |
