Rumor vs. Reality in Silicon Valley

By Charles King, Pund-IT, Inc.  February 19, 2014

Like most small, inbred communities, Silicon Valley encourages and thrives on gossip, even when it’s of little substance. In popular-speak, Valley gossip has a “low signal to noise ratio”—with the resulting signal accuracy often being demonstrably weaker than the cacophonous noise surrounding and overwhelming it. Despite those shortcomings, the Valley rumor mill is vibrantly alive.

This is partly due to venture capitalists whose efforts parallel the day to day business of technology. For VCs looking to capture and monetize any opportunity, rumors are the steaming entrails of IT—worthy of close and usually messy analyses. In addition, vendors themselves spend a goodly amount of time in the rumor mill, sometimes as simple customers and sometimes as complex participants wresting value for themselves or wreaking injury on competitors.

The problem is that rather than inspiring open exchanges and dialogue, the end result of rumor mongering instead resembles an echo chamber where ideas gain credence via incestuous, self-perpetuated feedback loops. Over time, through sheer repetition, even lightweight concepts can develop a sense of gravitas far out of keeping with their actual heft.

Let’s consider a trio of ongoing rumors and attempt to discern whether any faint signals might be buried in the noise:

ODM-made servers are a tangible threat to server OEMs: The germ of this notion began in the 2008-2009 timeframe when news stories arose about how companies with hyperscale, cloud and Web 2.0 data centers, including Google and Amazon, were bypassing traditional server OEMs like Dell, HP and IBM by designing systems internally and outsourcing their manufacture to Asia-based original device manufacturers (ODMs), like Quanta, Wistron, Inventec and Compal.

The narrative gained further credence in 2010 with Facebook’s Open Compute Project, which found the company “open sourcing” a system design (developed for its Prineville, Oregon data center) and is now promoting for common use in hyperscale IT infrastructures.

In one sense, the threat this business model poses to server OEMs is quite real. According to IDC (which in December 2013 gave such products an official designation – ODM Direct), sales growth grew robustly by 45.2% YOY in Q3 2013 to $783M with unit shipments growing by 30.7%. In contrast, sales of traditional server OEMs (with the exception of Cisco) fell or saw meager growth. IDC estimated that this class accounted for just 6.5% of overall server revenues for the period (and about 4/5th of sales went to Google, Amazon, Facebook and Rackspace). At a time of generally slow IT sales growth, the hundreds of millions of dollars in server sales going to ODMs are obviously painful for OEMs.

But we don’t believe the ODM model is applicable to the vast majority of server customers. For one thing, since ODM Direct products are essentially “white box” servers, their use requires customer companies to have considerable in-house knowledge/skills in system deployment, configuration, integration, management and maintenance. That isn’t a problem for hyperscale data center owners or enterprises with similar IT infrastructures (like financial services firms and telcos), but they are the exception rather than the rule in the commercial tech market.

In addition, the benefits these systems offer correlates directly to the deployment size. In other words, the model works best with thousands of systems, not hundreds, let alone scores or dozens. Finally, the ODM Direct threat is not entirely linear. For example, since these systems are virtually all x86-based, that makes the ODM Direct market essentially unavailable to traditional Unix vendors whose sales are already under pressure. Similarly, since hyperscale customers largely utilize Linux and other open source software, proprietary software vendors, including Microsoft, are also affected.

None of this means that server OEMs and system software vendors are doomed. In fact, we expect the challenge posed by ODMs to spark efforts among OEMs to significantly enhance system solutions through the development of increasingly integrated offerings, deepened partnerships with ISVs, automated management processes (such as system updates) and expanded maintenance agreements.

In fact, that is already happening on a number of fronts. For example, Dell and HP are doing quite well in what IDC terms “density optimized” servers, which are designed to appeal to hyperscale customers and, in fact, sell into many of the companies utilizing ODM Direct systems. Such innovations are unlikely to be pursued by ODMs, which should help innovative server OEMs differentiate their solutions and value propositions from ODM Direct offerings. That said, vendors that are unwilling or unable to take such measures are likely to come under increasing pressure from more proactive competitors.

  • Amazon’s position in cloud is unassailable: This bit of perceived wisdom has been underscored by Amazon’s steady progress in expanding its Web Services (AWS), Elastic Compute Cloud (ECC) and related offerings, while most competitors tended to respond inefficiently. But a related yet less discussed issue is the degree to which Amazon and its approach to the cloud are perceived by the market and how that has aided its own efforts while punishing competitors.

To the former point, remember that Amazon’s cloud services strategy arose from a project that aimed to more fully leverage the company’s vast computing resources. Like many online commerce businesses, Amazon had provisioned its data centers to contend with high volume sales spikes, leaving much of those resources underutilized at other times. The casual requirements of many (if not most) initial AWS customers played into this scenario perfectly, allowing the company to more fully utilize (and capitalize on) that excess capacity. In contrast, the majority of competitors have tried to take on Amazon by building out dedicated compute infrastructures and suffering financially when those facilities were underutilized.

You could say that the problem is one of mismatched business models. While competitors focus on developing and delivering cloud computing solutions, Amazon approaches the situation as more of a supply chain issue. In this view, AWS is analogous to a creative, efficient and profitable utilization of shipping and transportation resources. Meanwhile, most competitors are stuck buying semi-rigs, building maintenance and storage facilities from the ground up, and keeping those trucks running whether or not there’s any cargo in the trailers.

But how Amazon is perceived by financial markets has also helped its cloud services efforts just as it has aided the company’s broader business. Amazon has always played its financial cards close to the vest, revealing as little about strategic efforts and investments as possible, pricing its services aggressively and rolling any profits into further development rather than paying dividends to shareholders. So long as investors regard Amazon as a growth company—where value is accrued by rising share price rather than the disbursement of profits—that model works pretty well.

But in a market where publicly held companies are often punished brutally for missing earnings by a few cents, it’s also a difficult approach to pursue consistently. In fact, after Amazon missed earnings targets during its most recent quarter, numerous analysts downgraded the company, and its shares pulled back by nearly 15%. Amazon responded by suggesting it might raise the cost of its popular Prime service by $20 to $40 per year but many analysts and industry watchers condemned the idea out of hand. However, other options, including raising prices across a broad range of products, could affect the company’s competitive position.

While this particular drama is playing out, some competitors are acting quickly to make up for lost time. That’s particularly the case with IBM, which is moving aggressively to position its cloud computing solutions and services (led by its July 2013 acquisition of SoftLayer) enterprise-ready out of the gate. IBM has earmarked $1.2 billion for building out additional cloud data centers and related activities. The company has also promised—and is delivering—far greater transparency into its cloud investments and operations than Amazon has ever provided.

Whether this represents a significant threat to Amazon remains to be seen, but it seems entirely possible that 2014 may mark the beginning of the company’s cloud businesses and aspirations returning firmly to earth.

  • Cisco and EMC must eventually part ways: This situation might be called a fender bender at the messy intersection of conventional wisdom and wishful thinking. To the former point, most partnerships between IT vendors have a shelf life akin to Hollywood marriages and are all too often based on similarly unaccountable attractions, unreasonable expectations and unachievable hopes.

So, many see some kind of break between the companies as likely. But to the latter point, both Cisco and EMC’s competitors must be praying that an eventual divorce is inevitable. Why? Because while few if any technology vendors have been immune to the slowdown in enterprise IT sales (particularly in once-dynamic emerging markets), Cisco and EMC are faring better than some very high profile competitors.

Both also continue to enjoy mostly unassailable leadership positions in their core networking and storage markets. For example, while revenues understandably fluctuate a bit from quarter to quarter, IDC estimates that the company’s overall share of the WW market for Ethernet switches and routers has stayed steadily above 60%. On the storage side, IDC found that despite industry-wide revenue contractions in Q3 2013, EMC grew or maintained its leadership positions in all three key segments: external disk storage, open networked storage and open SAN. Plus, EMC’s recent earning announcement noted 73% YOY growth in its Emerging Storage business.

More importantly, both companies are capturing significant benefits from associated solutions and investments. While most Tier 1 server vendors suffered lackluster to poor sales in 2013 (IDC’s Q3 tracking survey placed HP as the second brightest light with 1.5% YOY growth), Cisco’s sales of its UCS and other system solutions grew by 42.8%. Plus, the company looks ready to handily surpass Oracle for the fourth spot on the leader board. EMC’s holdings outside of storage have done very well, particularly VMware, which recently announced a significant jump in profits due to robust growth in license revenues.

Additionally, VCE, the private company initially founded by Cisco, EMC and VMware, is also showing excellent progress. The company leads IDC’s list of Integrated Infrastructure vendors, and likely drove over $1 billion in sales during 2013. Moreover, in its most recent earnings call, EMC noted that sales of VCE’s Vblock systems (which combine highly integrated/optimized Cisco Networking and UCS servers, EMC storage and VMware virtualization) are growing in excess of 50% YOY. By any measure, these are remarkable achievements for a company that began selling its Vblock Systems in late 2010.

We believe that notable success underscores the wishful thinking among those who dismiss the Cisco/EMC partnership. While we understand why many would hope the companies’ relationship would hit the rocks—and the sooner the better—that seems unlikely to us for three reasons. First and foremost, VCE pays significant dividends, server and storage sales, new strategic customer relationships and the above mentioned market momentum, for both partners that would be difficult to replicate or capture individually without large and potentially risky investments.

Second, and equally importantly, it is difficult to discern how or why becoming a standalone systems vendor would benefit either Cisco or EMC as much as leveraging their current creative partnership. The track record for such efforts—Oracle’s purchase of Sun Microsystems comes immediately to mind— is mixed, at best. Finally, as enterprises and service providers move increasingly to private and hybrid cloud computing, VCE appears, at least in our view, as a fast and reliable road to success for both Cisco and EMC.

However, the persistence of unsupportable wishful thinking is testimony to the health and popularity of IT industry rumor mongering. If only that energy were matched by any sort of accuracy, innuendo would likely earn as much veneration as innovation does in IT. But as these three examples suggest, truth is seldom if ever the raw material or result of Silicon Valley’s rumor mill.

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