How Internet Traffic is Increasing Network Equipment Spending, Part II

In the second part of our series, we take a closer look at the network equipment industry, in particular the edge router segment which is experiencing robust growth driven by carrier demand as convergence spurs demand.

Within the service provider segment, the trend towards convergence is the foremost growth driver. The goal for carriers is to create a complete suite of all-encompassing services for both the consumer and enterprise markets. We've long argued that the future of the telecommunications industry will be dominated by companies able to produce a converged product on a single platform.

Verizon (VZ) and AT&T (T) are moving into cable's turf at an aggressive pace, offering a quadruple play suite of services (data, wireless, TV, voice). Both are building out fiber-optic networks at a great expense. Verizon's FiOS service has been enormously successful, outpacing AT&T's in terms of video adoption, making a meaningful contribution to the company's near and long-term growth.

The carriers have the competitive (ability to add wireless service) and infrastructure (cable's coaxial cable backbone vs. carrier fiber-optic networks) advantage, a  fact we think puts the carriers on top over the long term. But regardless of who remains standing, the competitive pressure to keep up with user demand, take advantage of market opportunities, and bring new technologies to market will drive demand for equipment. 

Equipment Vendors - Focus on the Edge

The communications equipment market is broad reaching in scope and scale. Most think of the market in terms of routers and switches. This is a good place to start. Switches are viewed as the basic movers of data packets through electronic networks. Routers are essentially the brains of the network that control and direct traffic.

The routing market has evolved enormously over the past few years as manufacturers develop technologies to capture new emerging growth opportunities including converged networks, triple play services, and VPN services. Routers have developed from being viewed as "boxes" into intelligent solutions.

The carrier router market is one of the most attractive due to its limited competition and rising demand. It's expected to grow in the double-digit rates through 2011, according to industry experts. The market is dominated by Cisco (CSCO) with 60% share, followed by its long-time rival,  Juniper Networks (JNPR), which is one-tenth the size and controls 35%.

The carrier edge router market, which helps deliver services over the Internet, accounts for three-quarters of the total carrier router market. This subgroup is controlled by four companies: Cisco with a 62% share, Alcatel-Lucent (ALU) with 14%, Juniper with 12%, and Ericsson/Redback (ERIC) with 4%, according to Synergy Research.

The carrier edge market is expected to grow by 20% over the next two years, swelling by $25 billion by 2008. The main drivers include residential broadband demand, including the addition of video on the network, coupled with the migration from legacy data networks to IP protocol networks in the enterprise.

The network layer consists of the core, access, aggregation and edge segments.

Accelerating Growth Rates

The worldwide service provider router market in Q1 grew 29% over the prior year, according to the Dell'Oro Group. The router segment is divided into access, aggregation, access and core. In the first quarter, strength was centered on the edge router segment of the market, which grew at 2x the rate of the core router segment.

In the first quarter of 2007, year-on-year growth for the majors was: Cisco +26%, Juniper +6%, Alcatel +81%, Huawei +136%, and Redback Networks +25%.

The edge market is expected to produce robust growth rates over the next few years. Carrier edge equipment is estimated to rise in the mid-to-high 20% year-over-year for the next few years with a 15% CAGR through 2011, according to Morgan Stanley. Within the edge segment, the Ethernet and Aggregation segment is the next big growth opportunity, generating double-digit growth rates. 

In our next segment, we'll break down the router market, focusing on the edge market by equipment providers. Our favored stock remains IP-equipment dominator Cisco. We also have an increasingly optimistic view on Juniper due to a massive rollout of new products and its operational improvements. Other stocks that will be covered include Alcatel, Ericsson, and Extreme Networks (EXTR).

While the majors control the bulk of the routing market, there are many players in the broader communications equipment market which encompass both hardware and software, such as ADC Telecom (ADCT), which makes equipment needed to bring the fiber-optic cable into the home; Corning (GLW), which makes fiber optical fiber and cable; and Netgear (NTGR), which makes wireless networking routers that allow customers to transfer video and sound files between their computers and TVs.

Application traffic management vendors including F5 Networks (FFIV), which makes software that eases the flow of video over the Internet, and Foundry Networks (FDRY) are benefiting from enterprise adoption of Web 2.0 technologies.

--Kimberly DuBord, Briefing.com