Archive for 2010

Enterprise IT Spending: Worry About the Government

If enterprise IT spending were to follow closely to historical precedent, we might expect the rebound from the exceptionally weak 2009 to accelerate going forward.  Strong corporate earnings and modest economic growth ought to be enough to signal a pick-up for tech.  However, we believe that several unusual conditions may yield unexpectedly slow spending.  First, government spending in most geographies and levels appears to be under unprecedented pressure that may take years to abate.  Second, political uncertainty and weak employment may dampen corporate spending despite strong earnings.  Third, a sea change underway in the technology landscape raises stakes for IT investment decisions, prompting caution.  As such, we are pessimistic for a near term rebound in enterprise technology growth, particularly for companies with disproportionate exposure to the PC value chain or to government spending.   Near term growth is more likely from consumer-driven tech, particularly related to portable platforms, wireless broadband, and high performance delivery of cloud-based applications

Over time, changes in enterprise IT spending have shown close correlation to changes in the overall economy and to corporate earnings.  To that end, projected 2010 U.S. GDP growth of 2.6% and global economic growth forecasted at 4.8%, coming after economic contraction during the official recession of 2008-2009, should be a bullish sign.  Similarly, year over year S&P500 EPS growth of 55.6% during the first 3 quarters of 2010 reverses a decline of 19.9% over the same period in 2009, establishing a historic peak in large cap profits.  Ordinarily, this would presage accelerating tech spending

However, government spending, roughly 18% of the enterprise IT market, presents a major problem.  Years of deficit spending, at every level and in nearly every corner of the developed world, has raised the stakes to crisis level in municipalities (e.g. Detroit, MI and Harrisburg, PA), states (e.g. California, Illinois, New York and New Jersey), and countries (e.g. Greece, Ireland, Portugal and Spain).  Even governments without risk of insolvency strain under the burden of unprecedented indebtedness, and potentially, assumed responsibility for the troubles of constituent states and municipalities, or of other countries affiliated through economic union.  With battle lines drawn by labor, looking to protect jobs, pensions and benefits, discretionary government IT spending would appear at serious risk.  As governments have historically accelerated their IT investment at moments of economic weakness, a strong downturn would weigh heavily on the technology industry

We fear that an environment of government austerity, political instability and stubborn unemployment will also have a detrimental effect on corporate IT investment.  We note that government tax policy, such as allowing technology investments to be expensed rather than depreciated, could work to counteract spending caution

At the same time, the IT industry is at its own crossroads, as thin devices, wireless networks and network hosted applications are just beginning to displace the PC-centered client server architecture that has dominated enterprise IT for more than 20 years.  This tectonic plate shift is reminiscent of the late ‘80’s, when the denouement of the dumb terminal, departmental mini-computer, corporate mainframe gave way to the PC era.  Then, as now, the large cap champions of the older architecture struggled, while spending on the new generation fueled fast growing upstarts, but was yet insufficient to prop up the whole sector.  We expect IT managers to be cautious during the transition, stanching spending on desktop upgrades while taking only measured steps toward clouds, netbooks and tablets

We expect market conditions to be particularly vexing for companies with disproportionate exposure to government spending and to the now traditional PC-centered client server architecture.  Amongst large cap companies, PC oriented firms like Hewlett Packard, Dell, Intel, and Microsoft are positioned in this way

In contrast, we prefer companies with less than average exposure to these markets, particularly if they have focus on key elements of the emerging portable/cloud computing paradigm and critical mass in addressing the more vibrant consumer market.  We see smartphone/tablet device architecture, wireless broadband, content delivery networks, distributed public data centers, and cloud applications and infrastructure as the most important building blocks.  Against this, Apple, Google, Qualcomm, Amazon, Salesforce.com, and other similar companies all appear well positioned

4G – The Cure for the Common Cord

4G technology is following a 10 year roadmap toward download speeds that will allow wireless carriers to successfully compete for broadband and video with traditional cable, satellite and telco operators.  With the added advantage of mobility, the ability to launch service to areas of up to 50 square miles with the investment of a single base station, and a flood of new spectrum likely to be made available over the next decade, 4G is the alternative that will make cord cutting the rule rather than the exception.  Meanwhile, the march toward true 4G performance will further enhance the appeal of portable computing platforms – e.g. tablets, smartphones and netbooks – and cloud applications, hastening the demise of the traditional PC

While the new services being touted by US carriers as “4G” may not meet the ITU definition as offering at least 100Mbps mobile download speeds, the >5Mbps speeds offered are a step function improvement vs. the previous generation, adding greatly to the utility of smartphones and tablets by giving them wide-area wireless performance comparable to what is typically realized by residential wired broadband users.  Moreover, these new services are a step forward on a long-term roadmap that is expected to bring speeds of 100Mbps to mobile users and up to 1Gbps for residential applications within the decade.  These speeds will be more than sufficient for wireless networks to compete directly for residential broadband and video, particularly given the Government’s intention to make 100’s of MHz in new spectrum available for commercial use

Sprint (WiMax) and T-Mobile (HSPA+) have ballyhooed their recently launched networks as 4G, although the roughly 5Mbps peak speeds available on these carriers is obviously short of the ITU definition of 100Mbps+ download speeds to mobile users and 1Gbps+ for semi-mobile users.  Verizon and AT&T are 6-12 months behind with their LTE networks, but will have advantage with 6-12 Mbps speeds, scale economies given the global dominance of the standard, and superior industry resources devoted to push LTE down its technical roadmap to true ITU 4G performance as quickly as possible

In 2011, these pre-4G networks are roughly a 4x improvement over 3G and will be a significant enabler in the likely success of portable devices – e.g. smartphones, tablets and netbooks – and cloud-based applications – e.g. streaming video, social networking, etc. – that rely on high speeds and fast response times.  However, as the technology progresses over the next decade through future upgrades toward achieving the ITU goals, new applications, such as HDTV for mobile AND residential consumers, will be enabled.  In particular, we believe residential wireless broadband – at speeds of 1 Gbps or more – could threaten the hegemony of wired broadband and hasten the demise of traditional channelized video

The long-term threat to wireline broadband will be amplified by new spectrum likely to be made available for commercial purposes.  This week, the US NTIA identified 115 MHz currently used for government purposes that could be made available within 5 years.  This is in addition to 300 MHz called out in the FCC’s National Broadband plan for the same timeframe, which included 120 MHz of prime 700 band spectrum currently licensed to TV broadcasters.  Finally, The NTIA notes nearly 2 GHz in further spectrum bands – some recommended for global broadband use by the ITU and some subject to agreement with neighboring nations – that could be made available on longer term basis.  While most of this spectrum is at higher frequencies with limitations for in-building penetration, it would be viable for line-of-sight residential broadband and cell site backhaul applications

We expect the combination of new spectrum, advancing technology, and government policy favoring competition to spur greater rivalry amongst wireless carriers and by these carriers against wired broadband operators.  The American market has the 2^nd highest wireless prices amongst developed nations, we believe, due in part to the superior spectrum holdings of the dominant leaders Verizon and AT&T.  New spectrum auctions, which could more than double the spectrum allocated to commercial use, might enhance the viability of industry also-rans and/or attract powerful new entrants

We expect LTE, which was specified by the 3GPP organization, to be the predominant wide-area wireless technology world-wide, as both GSM/WCDMA and CDMA technologies will converge to it as a single standard.  The process by which the standard was established favored traditionally dominant wireless technology providers, with Qualcomm the biggest patent holder at 28%, followed by Interdigital (25%), Ericsson (15%) and Nokia (14%).  A further study by Informa suggests that 60% of Qualcomm and Nokia’s patents are likely to be deemed essential to the standard, compared to 33% for Ericsson and significantly less than that for Interdigital

We believe that the winners in 4G will likely come from patent licensors (e.g. Qualcomm), chip vendors (e.g. Qualcomm, Broadcom, ARM, etc.), tower companies (e.g. American Tower, Crown Castle, SBA, etc.), mobile software platforms (e.g. Google, Apple, etc.), and leading mobile applications (e.g. Apple, Google, Amazon, Facebook, etc.).   While the market for LTE network equipment is quite concentrated amongst Ericsson, Nokia Siemens Networks, Huawei and Alcatel-Lucent, the history of these companies and their inability to monetize similarly strong positions in 3G lead us to be cautious about their potential looking forward

November 1, 2010 – Streaming On-line, On-Demand Video: Over-the-Top, On the Way

We believe that it is inevitable that internet delivered video entertainment will eventually replace traditional channelized television.  However, there are significant technology, infrastructure, behavioral and industry economic hurdles that must be surmounted before “over-the-top” becomes a widespread reality.  While many suppose that these obstacles will protect businesses dependant on the channelized model, we see evidence that the barriers are rapidly deteriorating and that market forces, already in play, will likely drive change faster than expected by most investors

The most obvious hurdle has been network speeds.  While almost all US households have access to the 1Mbps sufficient for broadcast quality TV, only 12% are able to get the ~10Mbps necessary for HDTV and less than 1% have access to the 50Mbps+ needed for 1080p BluRay quality.  The FCC’s goal of 100M US households with access to 100Mbps by 2020 is, in part, dependent on capex by cable operators under threat in their core business by Internet video.  While these MSOs have obvious incentive NOT to make these investments, we believe that the industry would face severe consumer backlash and onerous regulation were it to take an obstructionist tack

Furthermore, we believe that the long-term potential of wireless networks for residential broadband is unappreciated.  The FCC has targeted 500MHz of spectrum for auction, including 120MHz of broadcast TV frequencies to be cleared near term.  While initial 4G deployments top out at ~5Mbps, the technology roadmap targets 100Mbps within 10 years, with fixed-point speeds of up to 1Gbps technically viable.  We expect 4-6 4G networks to be built out in the US, and that these carriers will successfully compete for residential broadband market share by the end of the decade

Content delivery networks (CDNs) now cache most popular content in geographically dispersed data centers around the country, drastically cutting delay (latency) and disruption (errors) by reducing the number of routers that packets must pass between server and user.  This highly effective architecture is asset intensive and favors scale operators with greater numbers of well coordinated data centers, most of which gain critical mass from their own popular consumer sites – Google, Amazon, Microsoft, etc

Until recently, most American TVs were hardwired to a cable provided set-top-box without access to the Internet.  This is changing.  Many new television models now integrate WiFi and Ethernet connections.  28 million households with game consoles from Sony, Microsoft and Nintendo are also connected with links to video content providers.  New BluRay/DVD players and alternative set-top-boxes like Apple TV and Logitech’s Google TV offer a third alternative.  Finally, the FCC has proposed that cable MSOs begin to provide cheap termination devices, with security but not navigation or DVR functions, for all new installations and equipment upgrades.  Thus, nearly 40 million new households annually would be free to choose internet connected devices

Tablets are also emerging as a significant alternative for video viewing, both in and out of the home.  These devices are inherently connected and are not tied to the channelized entertainment model.  As channel owners work feverishly to exclude their content from the assault on the family TV, the tablet is an effective back-door to the living room couch, and a gateway drug for couch potatoes to get hooked on on-line video

Content availability may be the most contentious issue.  Cable TV is a chain of aggregators, with content owners, networks, and system operators each leveraging their highest value programming to sell bundles at the highest possible price.  As such, users typically find themselves interested in only a small fraction of the programming for which they are asked to pay and fledgling content producers find it very difficult to elbow in amidst all of the bundling.  A benefit of the on-line model is a closer relationship between the content that users actually want and the fees that they pay

As on-line TV rises, the strong hand of the cable industry will weaken and content owners will be tempted to risk its wrath by going directly to the consumer.  A positive cycle has begun by which the growing on-line audience is attracting advertisers, which attracts more and better content, which in turn attracts a larger audience.  With much of the most valuable programming – e.g. sports, American Idol, etc. – not “owned” but contracted by networks, content owners will have increasing leverage, driving up costs for the channelized model and increasing the potential for Internet defections.  First mover advantage in establishing an on-line brand creates an enormous incentive to break ranks, and makes the current industry attempts to control Internet video inherently unstable

We believe that Internet meta-aggregators will gain advantage in the next 2-3 years by giving users tools to find and buy content of their liking, and advertisers the ability to accurately target audiences.  While it will be tempting for companies in control of compelling content to restrict access and to form joint ventures to gain critical mass, we do not think that closed arrangements can gain sufficient scale.  Rather, users will likely distribute their loyalty across multiple providers, requiring navigation and other content management tools provided on an overarching basis.  Given the rivalry amongst the major video programming networks and systems operators, it seems likely that this valuable role will fall to third parties, like Google, Apple and Amazon, who can also leverage their expertise in content delivery.  We also favor CDNs, like Akamai, Limelight, and Internap, and independent content producers, like 19 Entertainment and Lions Gate.  We are concerned about companies with disproportionate exposure to the channelized television model