Cisco’s Chambers Sends Messages on Canada, ZTE

Cisco Systems reported its fiscal first-quarter earnings yesterday. While the market responded favorably, both in after-hours trading and in regular trading early today, some analysts questioned whether Cisco has embarked on an extended period of smooth sailing or is merely experiencing calm before further storms.

That particular vein of prognostication, while interesting, is not what I want to address today. Instead, I want to draw attention to comments made in the last couple days by Cisco CEO John Chambers, both in interviews and on Cisco’s earnings call. 

As we know, Cisco possesses a vast cash hoard, most of which sits offshore.  It’s no secret that Chambers and the Cisco board of directors would like to see the U.S. government provide a repatriation-tax holiday. That was unlikely to happen before a U.S. presidential election, but now that the voting has occurred and the ballots have been counted, Cisco and other U.S.-headquartered companies with massive amounts of offshore cash might be anxious for some near-term tax relief.

Oh, Canada? 

In a series of interviews this week, Cisco’s Chambers repeatedly extolled the virtues of Canada as a potential destination for a large portion of Cisco’s cash holdings.  Chambers says Canada is the world’s “easiest place to do business,” citing the country’s federal corporate-tax rate of 15 percent and its “great education system.” 

Now, Chambers could sincere about what he says about Canada — as a Canadian, I certainly have nothing against the place, and I would welcome Cisco investments in the country — but I think Chambers has other motives. He’s talking about moving money to Canada, but he hasn’t done it yet. When people talk before they do something, they’re often sending messages, either explicit or implicit. In this case, Chambers is speaking to the U.S. government. He’s saying: “Hey, if you don’t give me my tax holiday, I’m not going to repatriate my cash to the U.S. Instead, I’m going to take a huge pile of it to Canada, where I get a better deal from the government.”  

If the U.S. government doesn’t budge, would he actually follow through on a Canadian cash expedition? It’s possible, I suppose, but Canada, while offering lower federal levels of corporate taxation and an education system that Chambers lauds, doesn’t match the U.S. in the range of investment opportunities it would offer. How many Canadian companies, for example, would Cisco wish to acquire?  Answer: Not many — and, no, Research in Motion (RIM) would not be among them. 

China Questions

Yes, Cisco could hire some Canadian engineers, provide early-stage funding to startup companies, and spend some money on relevant research initiatives at Canadian universities. But that would not require tens of billions of dollars. So, while Chambers is talking about Canada, he’s actually talking to his own government in Washington, D.C. 

Now, let’s shift our focus to China, another country mentioned by Chambers on the Cisco earnings call. Cisco’s sales in China were flat in the first quarter, but the company’s leadership team knows that China will be critical to Cisco’s future growth. Despite the national-security concerns that have inhibited expansion by Huawei and ZTE in the United States, Chambers does not foresee a trade war with China, which has amplified recent rhetoric about what it perceives as Western protectionism. 

ZTE: Back in Cisco’s Good Books?

As for Huawei, Chambers said Cisco is more than holding is own competitively against China’s largest networking company. What’s more — and this is the interesting part — Chambers said he sees ZTE as more a partner than a competitor, and indicated that he’s open to “expanding that relationship.” If one considers ZTE’s product portfolio in relation to Huawei’s, what Chambers says make sense. But there’s another aspect to this story (as there often is). 

Some of you with relatively good intermediate-term memory will recall that Reuters reported on October 8 that Cisco had ended a longstanding sales partnership with ZTE “after an internal investigation into allegations that the Chinese telecommunications equipment maker sold Cisco networking gear to Iran.” What’s more, Cisco spokesman John Earnhardt issued the following unambiguous statement to Bloomberg: “Cisco has no current relationship with ZTE.” 

Then again, the Guardian reported the following day that Cisco had “curtailed” its seven-year partnership with ZTE. So, you know, things change, and perhaps they are changing again.  

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For Huawei and ZTE, Suspicions Persist

About two weeks ago, the U.S. House Permanent Select Committee on Intelligence held a hearing on “the national-security threats posed by Chinese telecom companies doing business in the United States.” The Chinese telecom companies called to account were Huawei and ZTE, each of which is keen to expand its market reach into the United States.

It is difficult to know what to believe when it comes to the charges leveled against Huawei and ZTE. The accusations against the companies, which involve their alleged capacity to conduct electronic espionage for China and their relationships with China’s government, are serious and plausible but also largely unproven.

Frustrated Ambitions

One would hope these questions could be settled definitively and expeditiously, but this inquiry looks be a marathon rather than a sprint. Huawei and ZTE want to expand in the U.S. market, but their ambitions are thwarted by government concerns about national security.  As long as the concerns remain — and they show no signs of dissipating soon — the two Chinese technology companies face limited horizons in America.

Elsewhere, too, questions have been raised. Although Huawei recently announced a significant expansion in Britain, which received the endorsement of the government there, it was excluded from participating in Australia’s National Broadband Network (NBN). The company also is facing increased suspicion in India and in Canada, countries in which it already has made inroads.

Vehement Denials 

Huawei and ZTE say they’re facing discrimination and protectionism in the U.S.  Both seek to become bigger players globally in smartphones, and Huawei has its sights set on becoming a major force in enterprise networking and telepresence.

Obviously, Huawei and ZTE deny the allegations. Huawei has said it would be self-destructive for the company to function as an agent or proxy of Chinese-government espionage. Huawei SVP Charles Ding, as quoted in a post published on the Forbes website, had this to say:

 As a global company that earns a large part of its revenue from markets outside of China, we know that any improper behaviour would blemish our reputation, would have an adverse effect in the global market, and ultimately would strike a fatal blow to the company’s business operations. Our customers throughout the world trust Huawei. We will never do anything that undermines that trust. It would be immensely foolish for Huawei to risk involvement in national security or economic espionage.

Let me be clear – Huawei has not and will not jeopardise our global commercial success nor the integrity of our customers’ networks for any third party, government or otherwise. Ever.

A Telco Legacy 

Still, questions persist, perhaps because Western countries know, from their own experience, that telecommunications equipment and networks can be invaluable vectors for surveillance and intelligence-gathering activities. As Jim Armitage wrote in The Independent, telcos in Europe and the United States have been tapped repeatedly for skullduggery and eavesdropping.

In one instance, involving the tapping  of 100 mobile phones belonging to Greek politicians and senior civil servants in 2004 and 2005, a Vodafone executive was found dead of an apparent suicide. In another case, a former head of security at Telecom Italia fell off a Naples motorway bridge to his death in 2006 after discovering the illegal wiretapping of 5,000 Italian journalists, politicians, magistrates, and — yes — soccer players.

No question, there’s a long history of telco networks and the gear that runs them being exploited for “spookery” (my neologism of the day) gone wild. That historical context might explain at least some of the acute and ongoing suspicion directed at Chinese telco-gear vendors by U.S. authorities and politicians.

What Cisco and Huawei Have in Common

Cisco and Huawei have a lot in common. Not only has Huawei joined Cisco in the enterprise-networking market, but it also has put down R&D roots in Silicon Valley, where it and Cisco now compete for engineering talent.

The two companies have something else in common, too: Both claim their R&D strategies are being thwarted by the US government.

Cisco Hopes for Tax Holiday

It’s no secret that Cisco would like the Obama Administration to deliver a repatriation tax holiday on the mountain of cash the company has accumulated overseas. The vast majority of Cisco’s cash — more than $40 billion — is held overseas. Cisco is averse to bringing it back home because it would be taxed at the US corporate rate of 35 percent.

Cisco would prefer to see a repatriation tax rate, at least for the short term, of a 5.25-percent rate. That would allow Cisco, as well as a number of other major US technology firms, to bring back a whopping war chest to the domestic market, where the money could be used for a variety of purposes, including R&D and M&A.

Notwithstanding some intermittent activity, Cisco’s R&D pace has decelerated.  Including the announced acquisition of collaboration-software vendor Versly today, Cisco has announced just four acquisitions this year. It announced seven buys in 2010, and just five each in 2009 and 2008. In contrast, Cisco announced 12 acquisitions in 2007, preceded by nine in 2006 and 12 in 2005.

Solid Track Record

Doubtless the punishing and protracted macroeconomic downturn has factored into Cisco’s slowing pace of M&A activity. I also think Cisco has lost some leadership and bench strength on its M&A team. And, yes, Cisco’s push to keep money offshore, away from US corporate taxes, is a factor, too.

Although Cisco is capable of innovating organically, it historically has produced many of its breakthrough products through inorganic means, namely acquisitions. Its first acquisition, of Crescendo Communications in 1993, ranks as its best. That deal brought it the family of Catalyst switches, a stellar group of executive talent, and eventual dominance of the burgeoning enterprise-networking market.

Not all Cisco acquisitions have gone well, but the company’s overall track record, as John Chambers will tell you, has been pretty good. Cisco has a devised cookbook for identifying acquisition candidates, qualifying them through rigorous due diligence, negotiating deals on terms that ensure key assets don’t walk out the door, and finally ensuring that integration and assimilation are consummated effectively and quickly.  Maybe Cisco has gotten a bit rusty, but one has to think the institutional memory of how to succeed at the M&A game still lives on Tasman Drive.

Acute Need for M&A

That brings us to Cisco’s overseas cash and the dilemma it represents. Although developing markets are growing, Cisco apparently has struggled to find offshore acquisition candidates. Put another way, it has not been able to match offshore cash with offshore assets. Revenue growth might increasingly occur in China, India, Brazil, Russia, and other developing markets, but Cisco and other technology leaders seem to believe that the entrepreneurial innovation engine that drives that growth will still have a home in the USA.

So, Cisco sits in a holding pattern, waiting for the US government to give it a repatriation tax holiday. Presuming that holiday is granted, Cisco will be back on the acquisition trail with a vengeance. Probably more than ever, Cisco needs to make key acquisitions to ensure its market dominance and perhaps even its long-term relevance.

Huawei Discouraged Repeatedly

Huawei has a different sort of problem, but it is similarly constrained from making acquisitions in the USA.  On national-security grounds, the US government has discouraged and prevented Huawei from selling its telecommunications gear to major US carriers and from buying US-based technology companies. Bain Capital and Huawei were dissuaded from pursuing an acquisition of networking-vendor 3Com by the Committee on Foreign Investment in the United States (CFIUS) in 2008. Earlier this year, Huawei backtracked from a proposed acquisition of assets belonging to 3Leaf, a bankrupt cloud-computer software company, when it became evident the US government would oppose the transaction.

Responding to the impasse, Huawei has set up its own R&D in Silicon Valley and has established a joint venture with Symantec, called Huawei Symantec, that structurally looks a lot like H3C, the joint venture that Huawei established with 3Com before the two companies were forced to go their separate ways. (H3C, like the rest of 3Com, is now subsumed within HP Networking. Giving HP’s apparent affinity for buying companies whose names start with the number 3 — 3Com and 3Par spring to mind — one wonders how HP failed to plunder what was left of 3Leaf.)

Still, even though Huawei has been forced to go “organic” with its strategy in North America, the company clearly wants the opportunity to make acquisitions in the USA. It’s taken to lobbying the US government, and it has unleashed a charm offensive on market influencers, trying to mitigate, if not eliminate, concerns that it is owned or controlled by China’s government or that it maintains close ties with the China’s defense and intelligence establishments.

Waiting for Government’s Green Light

Huawei wants to acquire companies in North America for a few reasons.  For starters, it could use the R&D expertise and intellectual property, though  it has been building up an impressive trove of its own patents and intellectual property. There are assets in the US that could expedite Huawei’s product-development efforts in areas such as cloud computing, data-center networking, and mobile technologies. Furthermore, there is management expertise in many US companies that Huawei might prefer to buy wholesale rather than piecemeal.

Finally, of course, there’s the question of brand acceptance and legitimacy. If the US government were to allow Huawei to make acquisitions in America, the company would be on the path to being able to sell its products to US-based carriers. Enterprise sales — bear in mind that enterprise networking is considered a key source of future growth by Huawei — would be easier in the US, too, as would be consumer sales of mobile devices such as Android-based smartphones and tablets.

For different reasons, then, Cisco and Huawei are hoping the US government cuts them some slack so that each can close some deals.

Taking Aim At Enterprise Networking, Huawei Adds to Cisco’s Woes

Now that Cisco Systems has managed to placate Wall Street at least temporarily by slightly exceeding diminished expectations for its fourth-quarter earnings and first-quarter guidance, some observers have suggested that perhaps the worst is over for Cisco.

It’s possible, of course, that the Good Ship Cisco has weathered the storm and is slowly regaining its equilibrium, steadying its course, and preparing to reclaim its hegemony over networking’s high seas.

Calm  . . . or the Calm Before a Perfect Storm?

That said, it’s also possible that what we’re seeing is the calm before a potential tsunami. It’s possible, in fact, that Cisco could struggle for years to come, worn down by a veritable perfect storm comprising a competitive war of attrition; market and technology changes that play more to the strengths of its rivals; an increasingly budget-conscious customer base that is less inclined to buy Cisco solutions at a premium; and the disaffection of a fickle channel.

That’s a Cisco dystopia that easily could come to pass, though it isn’t predestined by any means. Cisco can change. It can adapt to new realities and alter its strategic course, its philosophy, its product mix, its marketing messages, and its channel programs.

As we look ahead, though, let’s not underestimate the challenges. In the long run — as opposed to the myopic vista of day traders and stock flippers — Cisco confronts a number of unprecedented trials and tribulations.

No Irrational Exuberance These Days

Although Cisco successfully vanquished an array of enterprise-networking competitors in the 1990s, times have changed, and so has Cisco. It’s not the same company it was back then, not in size and not in culture, and our macroeconomic climate today — what some have called the “recovery-less recovery” — is a long way from the effervescent exuberance of the late 90s. (There’s no threat of Alan Greenspan having to warn us about “irrational exuberance” these days.)

One challenge Cisco faces is on the competitive front, where many of its rivals seem more attuned to the economic and technological zeitgeist. While Cisco has been content to demand its usual premiums and ample margins, competitors with lower cost structures, decent products, and aggressive pricing have been chipping away at  the networking behemoth’s market share in enterprise switching and routing. Meanwhile, nimble high-end rivals, outpacing Cisco in organic innovation, are presenting compelling data-center solutions to customers in networking’s most lucrative vertical markets.

Cisco is being squeezed from above and below. Even in converged infrastructure for data centers, where Cisco thought it could establish a competitive edge, it isn’t clear that the company will thrive. It doesn’t have its own storage component, and it’s not obvious that Cisco can maintain an edge on options that are more open.

What About Huawei?

Then there’s Huawei, a still-opaque company that nevertheless has amassed $28 billion in annual revenue and has aspirations to become a $100-billion powerhouse within a decade. Still capturing as much carrier business as it can find with its telecom-equipment product portfolio, Huawei now is expanding into other areas, including smartphones — where it wants to be a top-five player — and enterprise networking.

Huawei doesn’t just want to be an enterprise-networking purveyor in China. No, it plans to compete vigorously worldwide, following the script it used so successfully in the telecommunications world. It will target developing markets and Europe first, leaving resistant North America as a last course. As reported by Bloomberg, Huawei aims to double annual sales at its enterprise group to $4 billion this year, from $2 billion last year. Within three to five years, Huawei forecasts enterprise-networking revenues of $15 billion to $20 billion.

For Cisco, the question is, how soon and how much will Huawei cut into its revenue and its margins? There’s no definitive answer yet. Much will depend on how well Huawei executes and how well Cisco responds to the threat, but a couple data points are worth noting.

First, Huawei is looking beyond just pushing low-priced boxes into the enterprise market. While I’m sure Huawei will compete and win its share of business on price, it also will be promoting a networking narrative that encompasses solutions for private and public cloud computing, security services, and mobile computing.

Engineers and R&D Galore

It will be interesting to see how the vision evolves and how the company executes on it. Remember, though, as Gartner’s Mark Fabbi pointed out, unlike many of its competitors these days Huawei is a private company with a vast R&D budget. To quote Fabbi:

 “You can’t throw 1,000 engineers at a problem that might bear fruit five years from now. Huawei can.” 

Finally, I’m hearing that Huawei  is preparing to launch (or may have launched) a competitive trade-in program targeted at Cisco enterprise switches, much like HP Networking’s “A Catalyst for Change Trade-in Promotion.” I’m still trying to learn more about the specifics of this program, though.

All considered, Huawei’s foray into enterprise networking looks set to add to Cisco’s mounting woes.

Bit-Business Crackup

I have been getting broadband Internet access from the same service provider for a long time. Earlier this year, my particular cable MSO got increasingly aggressive about a “usage-based billing” model that capped bandwidth use and incorporated additional charges for “overage,” otherwise known as exceeding one’s bandwidth cap.  If one exceeds one’s bandwidth cap, one is charged extra — potentially a lot extra.

On the surface, one might suppose the service provider’s intention is to bump subscribers up to the highest bandwidth tiers. That’s definitely part of the intent, but there’s something else afoot, too.

Changed Picture

I believe my experience illustrates a broader trend, so allow me elaborate. My family and I reached the highest tier under the service provider’s usage-based-billing model. Even at the highest tier, though, we found the bandwidth cap abstemious and restrictive. Consequently, rather pay exorbitant overages or be forced to ration bandwidth as if it were water during a drought, we decided to look for another service provider.

Having made our decision, I expected my current service provider to attempt to keep our business. That didn’t happen. We told the service provider why we were leaving — the caps and surcharges were functioning as inhibitors to Internet use — and then set a date when service would be officially discontinued. That was it.  There was no resistance, no counteroffers or proposed discounts, no meaningful attempt to keep us as subscribers.

That sequence of events, and particularly that final uneventful interaction with the service provider, made me think about the bigger picture in the service-provider world. For years, the assumption of telecommunications-equipment vendors has been that rising bandwidth tides would lift all boats.  According to this line of reasoning, as long as consumers and businesses devoured more Internet bandwidth, network-equipment vendors would benefit from steadily increasing service-provider demand. That was true in the past, but the picture has changed.

Paradoxical Service

It’s easy to understand why the shift has occurred. Tom Nolle, president of CIMI Corp., has explained the phenomenon cogently and repeatedly over at his blog. Basically, it all comes down to service-provider monetization, which results from revenue generation.

Service providers can boost revenue in two basic ways: They can charge more for existing services, or they can develop and introduce new services. In most of the developed world, broadband Internet access is a saturated market. There’s negligible growth to be had. To make matters worse, at least from the service-provider perspective, broadband subscribers are resistant to paying higher prices, especially as punishing macroeconomic conditions put the squeeze on budgets.

Service providers have resorted to usage-based billing, with its associated tiers and caps, but there’s a limit to how much additional revenue they can squeeze from hard-pressed subscribers, many of whom will leave (as I did) when they get fed up with metering, overage charges, and with the paradoxical concept of service providers that discourage their subscribers from actually using the Internet as a service.

The Problem with Bandwidth

The twist to this story — and one that tells you quite a bit about the state of the industry — is that service providers are content to let disaffected subscribers take their business elsewhere. For service providers, the narrowing profit margins related to providing increasing amounts of Internet bandwidth are not worth the increasing capital expenditures and, to a lesser extent, growing operating costs associated with scaling network infrastructure to meet demand.

So, as Nolle points out, the assumption that increasing bandwidth consumption will necessarily drive network-infrastructure spending at service providers is no longer tenable. Quoting Nolle:

 “We’re seeing a fundamental problem with bandwidth economics.  Bits are less profitable every year, and people want more of them.  There’s no way that’s a temporary problem; something has to give, and it’s capex.  In wireline, where margins have been thinning for a longer period and where pricing issues are most profound, operators have already lowered capex year over year.  In mobile, where profits can still be had, they’re investing.  But smartphones and tablets are converting mobile services into wireline, from a bandwidth-economics perspective.  There is no question that over time mobile will go the same way.  In fact, it’s already doing that.

To halt the slide in revenue per bit, operators would have to impose usage pricing tiers that would radically reduce incentive to consume content.  If push comes to shove, that’s what they’ll do.  To compensate for the slide, they can take steps to manage costs but most of all they can create new sources of revenue.  That’s what all this service-layer stuff is about, of course.”

Significant Implications

We’re already seeing usage-pricing tiers here in Canada, and I have a feeling they’ll be coming to a service provider near you.

Yes, alternative service providers will take up (and are taking up) the slack. They’ll be content, for now, with bandwidth-related profit margins less than those the big players would find attractive. But they’ll also be looking to buy and run infrastructure at lower prices and costs than did incumbent service providers, who, as Nolle says, are increasingly turning their attention to new revenue-generating services and away from “less profitable bits.”

This phenomenon has significant implications for consumers of bandwidth, for service providers who purvey that bandwidth, for network-equipment vendors that provide gear to help service providers deliver bandwidth, and for market analysts and investors trying to understand a world they thought they knew.

How Cisco Arrived at the Crossroads

As reports of Cisco’s impending layoffs intensify and spread, I started thinking about how the networking giant got into its current predicament and whether it can escape from it.

One major problem for the company is that the challenges it faces aren’t entirely attributable to its own mistakes. If Cisco’s own bumbling was wholly responsible for the company’s middle-life crisis, one might think it could stop engaging in self-harm, right the ship, and chart a course to renewed prosperity.

Internal Missteps Exacerbated by External Factors

But, even though Cisco has contributed significantly to its own decline — with a byzantine bureaucratic management structure replete with a multitude of executive councils, half-baked forays into consumer markets about which it knew next to nothing, imperial overstretch into too many markets with too many diluted products, and the loss of far too many talented leaders — external factors also played a meaningful role in bringing the company to this crossroads.

Those external factors comprise market dynamics and increasingly effective incursions by competitors into Cisco’s core business of switching and routing, not just in the telco space but increasingly — and more significantly — in enterprise markets, where Cisco heretofore has maintained hegemonic dominance.

If we look into the recent past, we can see that Cisco saw one threat coming well before it actually arrived. Before cloud computing crashed the networking party and threatened to rearrange data-center infrastructure worldwide, Cisco faced the threat of network-gear commoditization from a number of vendors, including the “China-out” 3Com, which had completely remade itself into a Chinese company with an American name through its now-defunct H3C joint venture with Huawei.

Now, of course, 3Com is part of HP Networking, and a big draw for HP when it acquired 3Com was represented by the cost-effective products and low-priced engineering talent that H3C offered. HP reasoned that if Cisco wanted to come after its server market with Unified Computing System (UCS), HP would fight back by attacking the relatively robust margins in Cisco’s bread-and-butter business with aggressively priced networking gear.

Cisco Prescience

HP’s strategy, especially in a baleful macroeconomic world where cost-cutting in enterprises and governments is now an imperative rather than a prerogative, is beginning to bear fruit, as recent market-share gains attest.

Meanwhile, Cisco knew that Huawei, gradually eating into its telecommunications market share in markets outside North America, would eventually seek future growth in the enterprise. It was inevitable, and Cisco had to prepare for the same low-priced, value-based onslaught that Huawei waged so successfully against it in overseas carrier accounts. In the enterprise, Huawei would follow the same telco script, focusing first on overseas markets — in its home market, China, as well as in Asia, the Middle East, Europe, and South America — before making its push into a less-receptive North American market.

That is happening now, as I write this post, but Cisco had the prescience to see it on the horizon years before it actually occurred.

Explaining Drive for Diversification

What do you think that hit-and-miss diversification strategy — into consumer markets, into home networking, into enterprise collaboration with WebEx, into telepresence, into smart grids, into so much else besides — was all about? Cisco was looking to escape getting hit by the bullet train of network commoditization, aimed straight at its core business.

That Cisco has not excelled in its diversification strategy into new markets and technologies shouldn’t come as a surprise. Well before it make those moves, it had failed in diversification efforts much closer to home, in areas such as WAN optimization, where it had been largely unsuccessful against Riverbed, and in load balancing/application traffic management, where F5 had throughly beaten back the giant. The truth is, Cisco has a spotty record in truly adjacent or contiguous markets, so it’s no wonder that it has struggled to dominate markets that are further afield.

Game Gets More Complicated

Still, the salient point is that Cisco went into all those markets because it felt it needed to do so, for revenue growth, for margin support, for account control, for stakeholder benefit.

Now, cloud computing, with all its many implications for networking, is roiling the telco, service provider, and enterprise markets. It’s not certain that Cisco can respond successfully to cloud-centric threats posed by data-center networking vendors such Juniper Networks as Arista Networks or by technologies such as software-defined networking (as represented by the OpenFlow protocol).

Cisco was already fighting one battle, against the commoditizing Huaweis and 3Coms of the world, and now another front has opened.

Pondering an Information-Age Depression

I have been busy lately. That’s good, because when I have had lulls in the action recently, I’ve been assailed by dark visions of a dystopian economy. These gloomy presentiments have been sufficiently jarring to induce hyperventilation and panic attacks.

Then again, I’m probably neurotic . . . and I use the word “probably” as a weak qualifier.

Still, the economic outlook is tenebrous. The difference between best- and worst-case scenarios isn’t pronounced, with the best-case scenario an extended period of stagnant or low growth. The worst-case scenario? If one gives credence to the ruminations of Gluskin Sheff economist David Rosenberg, we’re looking at an information-age, 1930s-style Depression (Big D).

Prone to Optimism

As Rosenberg notes, human beings are prone to economic optimism. We’re hardwired to perceive every evanescent blip as a sign of recovery. That keeps our hopes up, but it doesn’t change the fundamental economic reality, which reasserts itself like a marauding interloper at a dinner party.

So, I got to thinking — as I am inclined to do — about what this means for the technology industry, particularly for enterprise and data-center spending. If we’re about to scuffle along the floor of the Valley of Despond for a lengthy period, what is it likely to mean for IT budgets?

Obviously, they will be severely constrained, under the unrelenting jackboot of austerity. Nonetheless, a plausible case can be made that enterprises will be looking at technology investments as vehicles that can help them ride out the storm. The focus, in IT as in much else, will be on mechanisms and tools that help reduce, or at least contain, capital and operating expenditures.

Mumbo-Jumbo Won’t Work

Virtualization, in its many guises, can help with the former, but it will need to be assisted by improved data-center automation and centralized management if it is to have anything meaningful to contribute to the latter. As for cloud computing, it should gain favor gradually, but it will meet strong resistance from enterprises concerned about security and privacy issues. As for the private cloud, it’s like a twisted Rorschach test: each vendor sees it differently and tries to persuade their customers to see it the same way. Customers, as always, need to focus on business benefits and not get distracted by the marketing mumbo-jumbo.

That sort of thing, by the way, is less likely to work than it has in the past. Somewhere along the enterprise chain of command, somebody holding the purse strings will be asking tough questions about value, investment protection, and ROI. Vendors that hide behind buzzwords, and can’t provide specific answers to direct questions, won’t get their share of what business there is to be had.

I’m spending some time really thinking about how a prolonged period of economic turbulence and uncertainty will affect the industry. If vendors haven’t made the adjustment already, they’ll have to adapt to a new normal that doesn’t feel like anything we’ve experienced before.

Sometimes a Deal is Just a Deal

What I think we see today at The New Times is an instance of a writer and his editors trying to find a pattern where none might exist.

The muddled result is reflected in the headline: “Are Mergers Back? Well, Sort Of.” The writers tries a variety of hypotheses, but his main thrust is to find confidence and optimism among an alleged tumult of M&A activity during the month of August.
However, as comments from prominent investment bankers quoted in the body of the story make clear, sometimes a deal is just a deal. Each one happens for its own reasons, and sometimes its significance doesn’t extend further than its own narrow specificity and frame of reference.

Seeing What We Want to See

As humans, we all like to see associations and patterns in what happens around us, whether we’re observing events in business, economics, politics, or technology. Occasionally, however, we see what we want to see, not what’s really there. I think that’s what happened in the New York Times today.

The writer wanted to see a new wave of market confidence in a putative surge of M&A activity.  There are two problems, though: The supposed surge might be nothing more than an uncoordinated spasm, and the confidence might not exist.

Reading the comments of the industry luminaries cited in the story, one could make a case that many of the latest mergers are driven as much by considerations of efficiency and savings as by any anticipation of robust market growth.

Why I’ve Been Quiet

What happened? Where did I go?

Some of you were asking those questions, and some of you weren’t. For those inquisitive souls who were curious, if only fleetingly, about my active status and whereabouts, I can report that a combination of professional workload and personal injury has kept me away from the blogging keyboard these last few days.

Although my synapses are firing and many thoughts — some of more merit and value than others — have arisen in the caverns of my mind, I haven’t had enough time to commit them to this forum.

Regrettably, I don’t know when the situation will change. Commerce calls, obligations impinge, and time is always an enemy. I don’t have enough time. I wish I could manufacture more of it. If I had a functioning time-generation machine — or even an applicable patent on the invention that I could defend successfully in an East Texas courtroom — I’d be a less-anxious man.

Instead, I am anxious, harried, pressed for time. I provide paid consulting services, of course,  but most of you aren’t in the market for that sort of thing, and I sympathize. I wish I could write here as often as I’d like.

So, for now, I’ll have to put off an analysis of Cisco’s latest financial results and the riddles they contain. I’ll have to refrain from writing about what might or might not be occurring in the post-acquisition landscape of HP Networking. I’ll have to defer commentary on how the persisting global economic malaise will impact virtualization and cloud computing.

I’ll keep thinking about the big questions — and many smaller ones, too — but I won’t be able to write about them with the frequency to which I have become accustomed. For that, I apologize.

Guarded Optimism on Alcatel-Lucent

Since being created as a result of the 2006 merger of the two companies that confer its name, Alcatel-Lucent has struggled unsuccessfully to reach profitability. It’s still struggling for financial stability, but some market watchers and analysts believe there’s light at the end of the tunnel. What’s more, they believe the light in question isn’t coming from an onrushing train.

There is reason for guarded optimism. Operationally and strategically, Alcatel-Lucent is on firmer ground than it has been for quite some time, even in the face of stiff macroeconomic winds and a chronic component shortage that has affected the company’s ability to deliver products.

You’ll notice, though, that I employed a qualifying adjective in the first sentence of the preceding paragraph. Alcatel-Lucent still has work to do.

The company depends on the sustainability of a real broad-based recovery in the global economy — carriers will constrain their network-infrastructure spending if they believe smartphone-toting consumers will curtail their consumption of data-rich applications and data services — and it must work harder to make headway in emerging markets. In the latest quarter, North America carried the day for AlcaLu, and numbers everywhere else were down.

Moreover, as Ray LeMaistre notes and documents at Light Reading, Alcatel-Lucent needs better growth from its Applications and Services divisions, which are strategically important to the company’s long-term prospects. AlcaLu is looking to differentiate itself from lower-cost Chinese network-equipment rivals such as Huawei and ZTE by providing software-led value with its Application Enablement strategy, buttressed by its Developer Platform and its Open API Service.

By bringing developers and carriers together, and providing integration services bridging the two camps, Alcatel-Lucent hopes to make itself more valuable to both. There’s still time for the strategy to play out, but higher rates of growth from those parts of the business would be encouraging.

Maintaining Perspective on China’s Rising Labor Costs, Currency Moves

I don’t disagree with the basic facts presented in John Boudreau’s article at the San Jose Mercury News’ SiliconValley.com website, but I think the piece overstates the degree and significance of recent developments in China.

Boudreau correctly notes that labor costs are rising in the coastal region where most of China’s electronics and technology products are manufactured. At some point, those rising costs will result in decreased margins for product vendors or in higher prices for consumers and businesses that buy products from those vendors.

It’s also true that contract manufacturers operating in China’s main manufacturing hub will begin or have begun exploring alternative arrangements. Options include setting up factories further inland, in China’s less-developed interior, or shifting some types of manufacturing to automated facilities in Taiwan or to other low-wage countries, such as Thailand or Vietnam.

But those moves will not happen overnight. We should recognize that, even though the cost of Chinese labor is increasing, it’s still low. What’s more, China offers other advantages — such as a ready supply chain and access to plentiful raw materials (such as rare-earth metals essential to the manufacture of many kinds of technology hardware). Additionally, China still has that low-cost interior mentioned above, where there’s more than enough labor available to provide a helping hand.

Let’s also consider the appreciation of the Chinese yuan, also known as the renminbi. China’s authorities are allowing the currency to appreciate relative to the dollar, but the yuan won’t be allowed to skyrocket. China is not a so-called “invisible hand” market-based economy; its government retains firm control over the trading range of the country’s currency. Don’t expect a dramatic rise in the near-term valuation of the renminbi to the dollar. It’s not going to happen. Instead, advances and declines will be  controlled, incremental, and measured.

Finally, there’s the question of whether, and to what degree, increased Chinese wages might result in more consumer spending on imports from the U.S. and other countries. The assumption is that Chinese workers who assemble and  build Apple iPhones and iPads — not to mention HP and Dell PCs — now will be able to buy them, too.

To a degree that might happen, but bear in mind that China wants to move up the technology industry’s value chain. China won’t be happy functioning merely as foundry and consumer market for Western brands. China’s long-term objective is to architect and develop major technology companies of its own, Lenovo and Huawei being notable examples.

Those familiar with the term “indigenous innovation” know that Chinese companies will receive government support and encouragement as they increasingly compete against major Western companies across China’s technology landscape. We in the West need to exercise caution in assuming that China’s consumer market will function similarly to its counterparts in market-based economies. Not only does China’s government actively assist domestic companies — often through direct or indirect state control — but many Chinese consumers will actively and purposefully purchase goods and services from Chinese companies instead of those offered by Western companies.

What we’re seeing in these developments — the rising labor costs, the gradually unpegging of the yuan to the dollar, the country’s desire to ascend the technology value chain — are signs of a growing, maturing economic and industrial powerhouse. I don’t think they should be construed as symptoms of Chinese volatility or weakness.

Why ODM Evolution Puts HP and Dell at Risk

The mounting suicides at Foxconn have put that company squarely in the media spotlight, and not in a good way. Those deaths are human tragedies, and one can only hope that the factors that contributed to them will be identified and addressed so that similar incidents can be prevented.

As the vast size of Foxconn’s manufacturing plants and campuses attest, contract manufacturing has grown into an enormous business, one that continues to evolve far beyond its humble origins. In the past, contract manufacturers built or assembled finished products on a third-party basis for brand-name consumer-electronics companies. In recent years, however, their mandate has expanded.

At first, the business bifurcated between those delivering outsourced electronics manufacturing services (EMS) and those categorized as original design manufacturers (ODMs). As the names suggest, the former restricted itself to providing traditional contract manufacturing whereas the latter offered design and development as well as manufacturing services.

Until  recently, as Joseph Wei wrote last year, Foxconn, Flextronics, Jabil, Sanmina and Celestica were classified  as EMS vendors, while companies such as Compal, Quanta, Wistron, Pegatron (ASUSTek),  and Inventec were deemed ODM vendors. Increasingly, though, the distinction between the two classifications has blurred.

The aforementioned companies are extending and expanding their capabilities. Acer founder Stan Shih has noted that bare-bones EMS companies eventually will disappear or transition into what he called design manufacturing services (DMS). That’s a transformation Foxconn and others are undergoing, strengthening their R&D and design services to offer more value to consumer-brand clientele.  In adding design and development to their services portfolio, companies formerly in the EMS business mitigate distinctions between themselves and their ODM counterparts.

Although many of these firms originated in Taiwan, nearly all have Chinese operations, which are growing quickly. Like China itself, these companies are eager to ascend the value chain. Cut-price manufacturing of consumer electronics has been a good business for them, but the margins are wafer thin and the competition is fierce. (Then, of course, there are the dispiriting and sordid issues relating to sagging employee morale.) The more value a company can offer its consumer-brand clients, the more margin and profit it can make.

Now let’s turn this around, and look at it from the perspective of shareholders in the brand-name consumer-electronics companies availing themselves of the services of Foxconn, Wistron, and Quanta. For a Dell or an HP, the obvious appeal of doing business with a DMS vendor is that it reduces your development and engineering costs, especially as you outsource a greater proportion of design and development to a third party.

As that happens, however — at least in PCs, netbooks, tablets, and even smartphones — the value of the brand-name consumer-electronics firm increasingly inheres in the commercial appeal of the brand. But in little else. If HP or Dell ceases to design and develop many of its products, what is its value in the marketplace? Moreover, what is its competitive differentiation or barrier to competitive entry? Such companies, at least in these particular markets, are only as strong as their brands.

After all, a competitor can easily contract with ODMs or DMSs to have similar, if not identical, products brought to market. As the ODM assumes a greater share of value creation in its bid to attain better margins, it effectively gains more power in the broader ecosystem. Brand names will depend on it to provide designs and development as well as manufacturing. But that design and development is not exclusive; it can be provided to any company willing to do business with it.

This is one reason why Stan Shih said earlier this year that American PC vendors HP and Dell might eventually be rendered extinct within the next 20 years. (Conceivably, it could take less time than that.)

Said Shih:

“The trend for low-priced computers will last for the coming years. But U.S. computer makers just don’t know how to put such products on the market. U.S. computer brands may disappear over the next 20 years, just like what happened to U.S. television brands.”

There’s a real danger that, at least in the realm of PCs and related products, America’s top vendors have sacrificed long-term viability for a short-term reductions in operating expenditures. In transferring design and development overseas, increasingly to China, what defenses do they have against lower-priced offerings that essentially will be the same as their own products. Their only defense will be provided by their marketing departments, which will promote brand identity and equity. The care and feeding of those marketing departments, paradoxically, will result in higher corporate cost structures than those incurred by their Asian (increasingly Chinese) rivals.

It’s a daunting dilemma, one that Apple has been keen to avoid. While Apple uses contract manufacturers such as Foxconn, it has been careful not to outsource its storied design and development to companies overseas. Unlike its North American PC rivals, Apple sees design and development as integral to the value of its brand. For Apple, the brand isn’t just, well, the brand. Instead, the brand derives its power at least as much from design and development (R&D) as from advertising and marketing prowess, though Apple is undeniably skilled in those dark arts, too.

Apple knows that product differentiation, based on the technological innovation, still matters. HP and Dell might have to learn that lesson the hard way.