Data Center Consolidation
This deal might come as a surprise for Wall Street (Brocade Communications Systems shares fell 10% this morning) or for any distant observers of the IT industry, but it should not be. In reality this is a straightforward reaction to HP’s competitors’ moves on its core competencies.
This marks a new step in an abundant year of M&A’s despite dull forecasts and persistently weak economy. While Oracle is trying to finalize its acquisition of computer and software maker Sun Microsystems for U$7.4 billion, on Sept 21, Dell announced a U$3.9 billion acquisition of technology services company Perot Systems, and a week later, Xerox bought the services company Affiliated Computer Services for $6.4 billion. In the meantime, IBM had expanded relationships with Cisco, Juniper and Brocade in an attempt to put a foot in the networking door.
On the other hand, Cisco, the networking leader, announced on Jan 21, 2009, that it would enter the server market, upon which HP's infrastructure and sales are exclusively built on, and broadcasted the imminent availability of a new data center platform – the Unified Computing System – also a direct competitor of the likes of HP.
More recently, Cisco linked up with EMC and VMware in a partnership (a JV called Acadia), ready to sells products which tightly integrates storage with easy-to-manage virtualized data center bundles called V-Blocks, and using networking gear from Cisco, computer storage equipment from EMC, and VMware’s virtualization software. This better-than-a-deal move has cut the persistent rumors of an acquisition of EMC by the San Jose headquartered company, at least for now.
A close look at the above diagram should make it clear that the large IT players are now competing in the four stacks of the Data Center space, and they are taking full advantage of over-weighed balance sheets, ready to use cash and affordable targets in a run for vertical consolidations.
Few years ago it used to be a clear cut: Cisco was specializing in networking equipment, Dell in personal computers, Oracle in enterprise software, and HP in PCs and printers.
Now it becomes intensely blurry: Dell is moving to Service (Perot Systems), Cisco to Hardware and Software (deal with EMC, VMware), Oracle to Hardware (Sun) and HP to Service (EDS) and Networking (3Com).
“We don't sell boxes any more, we combine servers with networking with storage -- we sell business process change.” – Cisco CEO John Chambers.
"To be competitive these days, a company has to fully commit to each element of the stack [...] You can't be in any one of them as a hobby." – HP Chairman and CEO Mark Hurd.
“The goal now is to sell complete systems made of chips, computers, storage devices and software.” – Oracle CEO Larry Ellison.
3Com (whose name comes from COMputers, COMmunication and COMpatibility) was founded by Bob Metcalfe in 1979 to commercialize Ethernet networking gears and was a reference until Cisco took over in the ‘90s. After many unsuccessful acquisitions, the company was forced in 2000 to spin out its Palm Computing unit to appease Wall Street, and has been since then a troubled company. It moved from California to Massachusetts, abandoned the enterprise market and off-shored its entire engineering operation to China. In October 2007, the company tried to be sold to China’s Huawei Technologies and Bain Capital, but the deal fell apart over national security concerns due to 3Com’s Tipping Point security technology.
Today 3Com has three global brands:
- H3C, a joint venture company with Huawei Technologies, the market leader in China for networking equipments with switches, routers, wireless, security and management solutions.
- 3Com, a brand dedicated to sell outside China, networking equipments to SMEs, with a portfolio of switches, routers, wireless, security, network management and IP telephony products.
- TippingPoint, an enterprise security solution based on network-based intrusion prevention systems and network access control solutions to enterprises both large and small.
The global 5,800-employee company has a 2,400-engineer R&D center in China, holding nearly 180 Chinese-issued patents and has another 1,050 patents pending there, while in the United States, it has more than 1,400 patents.
According to Ann M. Livermore, an executive vice president of HP, “Half of its $1.3 billion in sales comes from the Chinese market. 300 of the largest 500 companies in China, and 70 percent of government agencies, use 3Com equipment”
Since April 2008, under CEO Robert Mao and COO Ron Sege, and thanks to the Huawei Technologies partnership, 3Com began to finally gather some momentum. 3Com has won a sizable share of the Chinese networking market, having now 32% of the Ethernet switch local market and 33% of the local router market. Its products are priced 25% to 40% below competition, and the company has become a viable alternative to Cisco in China. 3Com's H3C brand is now widely deployed in China, helped nonetheless by a company low-cost structure.
But all of these numbers have a hard time to mask 3Com’s reality of weak worldwide reseller channels, no significant growth outside China, and a challenged brand in North America and Europe. 3Com has been on sale for a while.
What’s In It for HP?
HP has a history of growing its products and services through acquisitions. In 2001, HP bought Compaq in a $25 billion deal to expand its market share of server and desktop computers, in 2008 the company purchased the IT services provider EDS for $13 billion becoming the 2nd in the IT service industry behind IBM. With over $13 billion in cash sitting on its balance sheet, HP decided to acquire in order to solidify its data center networking portfolio and to offer a comprehensive end-to-end solutions for large customers in markets where they have a fairly thin or minimal presence.
- Product Line
By acquiring 3Com, HP is buying a product portfolio, filling a gap in the core switching in the data center network, which HP needed to do if it wanted to be considered in large public bids.
For example, 3Com's H3C 12500 switch will give HP a new core switch to put against the Cisco's Nexus 7000. 3Com’s MSR line features a Linux-based server blade for running open-source applications (such as IP-PBX, Security software and WAN optimization), a direct competition to Cisco's ISR series platforms. Also, HP gets a VoIP product with the 3Com NBX, VCX IP PBX and handset lines.
HP’s ProCurve series never really had routers, and were not really designed for application building blocks. 3Com can now fill this gap with more scalable switch that is a better fit for high-end data center and cloud networking initiatives.
- Market Share
According to the Yankee Group , Cisco owns about 52% in revenue of the $40 billion networking market, with HP at 11% and 3Com at 9%. When it comes to units shipped, the combined HP and 3Com will have a share of more than 40%, combined to 54% for Cisco, according to Gartner. Upon completion of the deal, the new conglomerate will be a clear distant second from the pack of multiple vendors, offering finally a credible challenger to Cisco.
- Chinese Exposure
With half of 3Com’s $1.3 billion in annual revenue coming from China, HP is expanding overnight its footprint in one of the world’s fastest-growing network equipment market (growth driven uniquely by the almost unlimited Chinese government spending on technology and communications infrastructure). HP is well positioned to snap a major edge in the Chinese market against its Western rivals.
- Chinese R&D
HP has also access to a well-organized 2,400-engineer R&D center in China lowering its operational cost and therefore, offering products and services at a cheaper price point to gain market share against rival Cisco.
In summary, 3Com could use HP’s distribution channel and re-brand itself while HP gains a new product line, a global market share and a Chinese exposition.
Of course the deal is not as rosy as what Wall Street analysts are telling us.
HP is paying a 40% premium, and the price seems to be a bit on the high side for a company that earns less than ¼ of HP's operating margin and isn't growing as fast as HP's expected five-year growth rate. It might be because 3Com is essentially distributing in China but the company is not as profitable as HP, even with an entire R&D in China.
Some product rationalization will have to occur especially in the low-end Ethernet switch product line, a large segment of the portfolio. Even though 3Com and HP have been developing their products based on an open standard, the lifetime warranties could make it difficult to manage an exploding products catalogue. There is also a product offering overlap in the wireless LANs. HP bought Colubris a couple of years ago and is expected to continue on with the Colubris product line while 3Com has an OEM arrangement with Trapeze Networks. This complex financial and marketing exercise should be completed just in time for the next upgrade cycle for companies in the next couple of years.
Upon deal approval (we have yet to hear from the regulators) synergies will have to be organized and vital energy will be lost trying to find room for 3Com’s 6,000 employees in the HP 300,000-employee organization. This short-term managerial distraction from the day-to-day business may be certainly shortened by HP’s experience acquired over the past years in M&A of large IT entities.
The number one complaint of the Chinese organizations is to resolve the question regarding the acquisition and retention of talent. With an entire R&D workforce in China HP will have to learn fast the intricacies of talent competition in the Middle-Empire for its benefit or its harm.
3Com's biggest challenges have always been brand and sales channel, but HP's brand and distribution capabilities can surmount those difficulties in this latest assault to propose a good and strong alternative (not competition yet) in the global networking equipment market to Cisco.
But the game is not over yet, with major IT players having accumulated billions of dollars on their balance sheets ready to be used, and with precarious smaller vendors in a still tight credit market, the imbalance is too wide to stop today. More deals will come soon. In the role of the hunter: Oracle, Microsoft, Cisco and certainly IBM – and in the role of the hunted: Juniper, Teradata, Informatica, Riverbed Technology, Brocade Communications Systems, F5 Networks, or Polycom.
All of theses deals should not distract anyone from the real contestants in the long term in the networking market. With its almost unlimited funding (backed by the Chinese government), its large internal market stimulated by the CNY 4 trillion (U$ 600 billion) in infrastructure and social welfare stimulus package, and its constant supply of engineers (over 600,000 produced per year in China), the first “global” Chinese brand could soon be Huawei Technologies.