I have been following the topic of Software Defined Networking (SDN) for the past three years.  Three years ago the technology was not well known by Wall Street but now is enjoying an intense level of discussion by investors and analysts. When the technology was first presented to me three years ago when I was a equity research analyst, my initial reaction was SDN would be a major risk for technology companies in the Ethernet Switching and Routing markets (e.g. Cisco and Juniper), while creating new opportunities for semiconductor companies selling merchant silicon (e.g. Broadcom and Intel) and newly created SDN start-up companies.   After visiting a few SDN private companies in the past couple weeks, talking to industry participants and reviewing recent SDN acquisitions and strategies by Cisco, Juniper and others, it is actually less clear to me now how SDN will dislocate the current networking value chain.  I am not questioning the value proposition of deploying SDN or the likelihood that it will be a significant investment cycle in the next five years, as I view that as a given.  Rather, the question whose answer has become less obvious to me is which publicly traded companies (if any) are most vulnerable to the upcoming SDN technology cycle and when will this dislocation most likely begin being reflected in these company stock prices.   Questions I ponder include:

-       Will the ultimate acceptance and deployment of SDN match my simple initial reaction that it will be negative for Cisco and Juniper as switching and routing face competition from more open oriented hardware platforms?

-       Will SDN actually require more complex and high performance hardware platforms in the data center as the real value around SDN will be operational simplicity and cost reduction rather than a focus on hardware costs?

-       Will SDN be more of a risk for Layer 4-7 companies that are selling special purpose appliances that may be made obsolete by more multi-functional and integrated software applications in the SDN application layer?

-       Will both Layer 2/3 and Layer 4-7 companies be at risk?

-       Will SDN create the opportunity for a Network As A Services (NaaS) model and disrupt the entire networking value chain?

-       Perhaps, SDN will be some combination or elements of all the above scenarios?

I will be moderating an investment panel at an upcoming SDN conference with some very smart and experienced investment professionals and hope to get more insight into these topics.  In the meantime, lets take a look at how sentiment on SDN’s impact to current publicly traded companies has changed over the past several months and why it is likely SDN developments will not be that material to public company stock prices in 2013 as they were initially in 2012.

The first major wake-up call on SDN to the public markets was July 23rd, 2012, when VMware announced it was acquiring Nicira for $1.26 billion.  Since this announcement occurred after the market close, I was curious to see how Cisco and VMware would trade the following day.  As it turned out, Cisco’s stock lost 6% of its value (about $5 billion in market value) the next day while VMware fell about 0.3% (note VMware announced earnings the same evening it announced the Nicira acquisition which likely muted the impact of the Nicira acquisition to VMware’s stock price movement the next day).  What was interesting about the market reaction was that Cisco lost $5 billion in value while VMware barely budged after spending $1.26 billion for a company that at the time was likely to generate less than $50 million in revenue in calendar 2013.   Clearly, the market at that point viewed SDN as a massive technology risk to Cisco.

Over the course of the next several months, however, Cisco formulated its SDN strategy, made a couple of SDN small acquisitions of its own (vCider, Cariden to complement prior funding of Insieme) and communicated its SDN strategy at its analyst day on December 7th, 2012.  Juniper acquired SDN start-up Contrail and communicated its SDN strategy on January 15th, 2013.  In addition, Nicira/VMware seemed quiet in terms of market penetration and customer deployments post the announcement of the acquisition in July.  So, in the span of 6 months, SDN went from a perceived significant risk factor to Cisco and Juniper to being more of an unknown entity both in terms of potential impact and timing of that impact.  Investors slowly began to realize that SDN would have little impact to 2013 financial results.  Also, Cisco and Juniper were not standing still, but rather were fighting back and will aggressively try to leverage their installed base of networking equipment to take advantage of SDN as a new revenue opportunity.

Now lets look at Layer 4-7 (e.g. security, load balancing, application delivery control, deep packet inspection etc.).  What I find interesting here is several of the SDN private company fund raising in the past several months were for companies attacking this segment of the networking value chain.  Several industry people I speak to suggest that Layer 4-7 will actually be the first area of SDN deployment in data centers given the need to provision and manage policies/applications/security at scale in the data center, which proves to be difficult when managing multiple single purpose appliances and that managing this in the application layer within the SDN model potentially provides a more flexible, elegant and scalable solution.   It might be coincidental, but in listening to the F5 1Q13 earnings conference call on January 23rd, 2013, I found the following dialogue in the Q&A portion of the call on why F5’s Technology Vertical has not been performing well in the past couple of quarters very interesting as it relates to this topic. Below is how F5 management responded to this question:

“So, on the Tech Vertical issue, you’re right. I mean, the Tech Vertical has trended down over the past several quarters for us, and we believe it’s driven really by a couple of our larger customers that are taking alternative architectural approaches in terms of how they’re building things. So, generally they’re building some basic functionality into that app. And, so we’ve been seeing that going on, and obviously we’re doing something about it.

We’ve got projects going on internally that we believe will provide this type of customer with ways that will make it easier for them to integrate our functionality into the applications [inaudible] that they’ve got.”

Source: Seekingalpha.com

What is interesting here is that the Technology Vertical within F5 results typically includes major data center and cloud providers in the category of Facebook, Apple, Google, Yahoo, Ebay etc.  While I do not know which specific customers F5 was referring to in this comment, it is valuable to see how such large-scale data center operators are already implementing certain parts of the Layer 4-7 stack on their own.  One can easily infer why Layer 4-7 SDN start-ups are getting funded at a nice clip given the potential for disruption here. Obviously, publically traded Layer 4-7 companies are not standing still as this is happening and are already offering virtual instances of their appliances, which I would imagine will ultimately be offered as applications in the SDN application layer.

Finally, there is also the scenario that SDN will create a framework for a Network As A Service (NaaS) model.  This raises the question could NaaS be a viable model and disruptive to the entire networking value chain especially if we see large players like Amazon, Google and others pursue such an offering or if a new disruptive start-up emerges to be the Saleforce.com of NaaS.

So in summary, SDN it is going to be a very disruptive technology. What was initially viewed as a technology shift that will be a significant negative for Cisco and Juniper is now potentially more complex to predict in terms of public market investing.  What is likely, however, is that SDN will have little impact to publicly traded stocks in 2013 as macro and company specific fundamentals will be more relevant to stock prices in my view.  I doubt we will see another VMware/Nicira type of deal in 2013 both in size and in its impact to publicly traded stocks like the $5 billion in lost value Cisco experienced the day after this deal was announced.  However, over the course of the next couple of years, the potential impact of SDN to publicly traded companies and how these companies either capitalize or fall victim to the adoption of SDN will be more evident.  It will certainly be fascinating to watch and I hope to learn more on this topic during upcoming SDN conferences.