Sizing up the NW200

North America’s largest network companies saw collective revenue up 11%, and 70% posted profits.

Some of that growth came through acquisition. The most stunning deals last year were SBC’s $16 billion purchase of AT&T, Verizon’s $8.5 billion acquisition of MCI and Sprint’s $36 billion merger with Nextel, but consolidation wasn’t limited to telecom.

All told, mergers and acquisitions slashed 29 companies from the NW200 ranks. Other prominent deals included Sun’s acquisition of Storage Technology (which was No. 42 on the ’04 list) and CA’s purchase of Concord Communications (No. 154).

Others fell off the NW200 last year because they went private, including Enterasys Networks (No. 106), SunGard Data Systems (No. 35) and McLeodUSA (No. 74).

All this activity, coupled with the fact that IPOs are down dramatically, is altering the nature of the list. The companies up top are getting fatter while fewer newcomers are available to fill vacated slots. Whereas the smallest NW200 company last year had $32 million in sales, this year the No. 200 company reported a mere $20 million in 2005 revenue.

Slowly but surely, the industry is coalescing around a handful of strong players in four core markets: computing, network infrastructure, software and telecommunications.

Computing

HP guaranteed its spot at the dance with the 2002 $25 billion merger with Compaq. But while it achieved critical mass with that move, much work remains, says CEO Mark Hurd, who replaced Carly Fiorina early last year.

“In a few cases, there were nine layers of management between the CEO and a customer,” Hurd says in the company’s annual report of the highly matrixed organization he inherited. “And some business divisions had less than 30% of their budgets directly under their control.”

The result: slow decision-making and lack of accountability. Hurd laid off 15,000 employees and reorganized the diverse company into seven business units, the core groups including Enterprise Storage and Servers (accounting for 19% of revenue last year), Personal Systems (31%), HP Services (18%) and Imaging and Printing (29%).

Although profits for the year were down 31% to almost $2.4 billion, sales were up 8% to $86.6 billion. Bright spots included a 9% increase in revenue for industry standard servers and a 9% increase for the entire Personal Systems group, largely attributed to increased sales of laptops.

While critics say HP has too many balls in the air, Hurd says the diversified nature of the company adds to scale he can leverage to reduce costs. The future, he says, is about automated, lights-out next-generation data centers. “This … architecture will be about lowering the fundamental unit cost of computing, while increasing computing power and data capacity,” he says.

Hurd made a surprising admission about one thing he discovered: “Over the years, HP built a complicated IT architecture that carries unacceptable costs.”

What does that say about the company’s services business?

The services business, of course, is an IBM hallmark. The company’s Global Services group accounts for more than half of IBM’s total sales – $91 billion last year – and 60% of the company’s 329,000 employees. But the group stumbled in 2005.

Revenues for Global Services was up only 2% to $47 billion and the company says it is “seeing a shift to smaller deals of shorter duration.” Those deals can be profitable providing the underlying cost structure is competitive, CEO Sam Palmisano says in the company’s annual report. “We had to address both our sales model and services cost structure last year.”

Total sales for the company were down 5%, caused in part by the 2005 sale of the personal computer business to Lenovo. That sale was central to Palmisano’s bid to get IBM out of commodity businesses. “These types of businesses focus on revenue growth, but their models, based on commodity products and services, inherently do not produce superior profit margins,” he says.

His goal is to focus on solution sales, but the company couldn’t help but crow about the fact that blade server shipments were up 65% last year and mainframe revenue was the highest it has been since 1998. Middleware also now accounts for more than half of IBM’s $16 billion in software revenue. In a bit of soul searching that smacks of 1980’s business speak, Palmisano writes in the annual report that IBM “is neither a ‘computer company’ nor a ‘services company.’ We are not even ‘an IT company’…. IBM ‘is an innovation company.'”

Whatever IBM decides it is, the focus on higher-value businesses seems to be paying dividends. It generated $7.9 billion in profits last year, a 9% margin. Dell, by comparison, only earned 6%.

Dell, however, continues to set the pace for top-line growth among the large system companies. Sales for the company’s 2006 fiscal year, which ended in February, were up 14% to $55.6 billion. The $6.7 billion gain was greater than the annual sales for 176 of the NW200 companies. Although HP generated roughly the same amount of new business, it is $30 billion larger than Dell.

For the first time ever, Dell last year opened its books to show how its business breaks down. Business sales in the Americas accounted for 51% of revenue, and U.S. consumer sales 14%. Viewed by product line, the major categories are: desktops, 38%; laptops/handhelds, 25%; software and peripherals, 15%; and servers and networking, 10%.

In servers and networking, revenue was up 11% on unit growth of 20%, the company reports.

Net infrastructure

Cisco has always been forthright about the performance of its product segments, but it might come as a surprise that switching accounted for 48% of net product sales ($10 billion) in fiscal 2005 (ending in July) and routers only 26% ($5.4 billion).

In fact, Cisco only managed to grow its routing business by 1.7% in that period, whereas switch sales were up 12.5%. “Router sales in fiscal 2005 may have been impacted by new product introductions and increased competition from price-focused competition,” the company says.

Cisco’s fastest growing unit is Advanced Technologies, the group responsible for VoIP, security and optical goods. Sales for the fiscal year were up 32% to $4.4 billion and the company says it shipped its 6-millionth IP phone.

The company admits, however, that it is being squeezed. Gross margins declined for the fiscal year, Cisco says, primarily because of greater sales of “lower margin products related to switching and home networking.” And pressure is coming from all quarters: “We have continued to encounter price-focused competition, including competitors from Asia and, in particular, China.”

Cisco’s fiscal year ended in July so the NW200 charts use 12 month (TTM) data to get a calendar year view of the company’s performance. TTM data shows sales up 10% to $25.9 billion and profits up 4% to $5.6 billion.

That’s a far cry from the go-go days of the ’90s, and to keep its share price up Cisco has been repurchasing its own stock. Since it began the program in 2001 it has bought back a whopping $27 billion worth of paper.

At least Cisco’s corporate acquisitions result in more tangible gains. The company spent $8 billion in 2005 to buy 12 companies. The most notable was the uncharacteristically large acquisition of Scientific-Atlanta for $6.9 billion. This purchase, which won’t show up on Cisco’s books until 2006, gets Cisco into the market for gear used to deliver converged services to consumers.

One of the Chinese companies that might be giving Cisco trouble is Huawei Technologies, a $8.2 billion network equipment vendor with 35,000 employees. (Although Cisco has three times the revenue, it only has 3,000 more employees.)

Huawei first became known to domestic buyers when it formed a partnership with 3Com in 2003, a deal that seems to be helping the latter. Although 3Com hasn’t posted a profit in the last 24 quarters, revenues are rebounding a bit. Based on TTM data (the company’s fiscal year ends in May), sales are up 5% to $700 million.

3Com says 2005 calendar year revenue for the Huawei partnership reached $434 million and generated net income of $16 million. That’s up from $262 million and a net loss of $15 million in 2004. The next trick for new CEO R. Scott Murray, who was installed in January, will be to push the company back into the black.

Nortel also is counting on fresh blood to get it back into the game. In October, it hired its third CEO in four years, Mike Zafirovski, formerly president and COO of Motorola.

Although Nortel posted a $2.4 billion loss last year, it largely stemmed from a $2.4 billion fourth quarter expense to settle a class-action shareholder lawsuit. Revenues were actually up 11% to $10.9 billion. “We grew our business in 2005 for the first time in five years,” Zafirovski reports.

For perspective, however, keep in mind that Nortel bought Bay Networks in 1998 for $9.1 billion.

One company making hay while the old guard stumble is Juniper. Sales last year were up 54% to $2 billion (profits were up 161% to $354 million). That growth was achieved through acquisition – Funk Software, Acorn Packet Solutions, Peribit Networks, Redline Networks and Kagoor Networks – and the growth of core products.

Last year the company reorganized into three groups: Infrastructure, Service Layer Technologies (SLT) and Service. Sales for Infrastructure, which essentially embodies the company’s router business, were up 40% to $1.4 billion, while the SLT group, which includes most of the enterprise technologies, was up 23% to $403 million.

Telecom

Time will tell if all the turmoil in telecom will hurt the chances of Juniper’s Infrastructure group pulling a repeat performance in 2006. After all, integrating these giant firms must result in some redundant assets.

At the end of 2004 there were seven major telecom players – AT&T, MCI, Sprint, Verizon, SBC, BellSouth and Qwest – with collective revenues of $254 billion. It will be down to four players by this time next year – AT&T, Verizon, Sprint and Qwest – or perhaps three, if consolidation continues. It all started with Sprint announcing in late 2004 that it was acquiring Nextel (a deal consummated in ’05) for $36 billion. That seemed to light a fire under the industry because in January SBC announced it would pay $16 billion to scoop up AT&T. Not to be out done, Verizon announced in February last year a $8.5 billion deal to acquire MCI. (Verizon has yet to release consolidated numbers that reflect the MCI acquisition, and MCI didn’t report fourth quarter results, so the NW200 numbers are for Verizon only.)

Last month the new AT&T announced plans to acquire BellSouth for $67 billion, a deal that would create a $120 billion company with about 300,000 employees.

One of the ironies of consolidation is Verizon/MCI is moving the bulk of its leadership out to AT&T’s former headquarters in Basking Ridge, N.J., a huge, lavish building. If he were alive to see it, this would have brought a smile to longtime AT&T gadfly Bill McGowan, who was CEO of MCI during its formative years.

It will be interesting to see what kind of business service innovation, if any, comes out of the SBC/AT&T and Verizon/MCI deals. For the next few years both firms will be distracted by efforts to ratchet up their wireless fortunes and secure their positions in broadband.

Consider developments now driving decision making at Verizon:

Software

In the world of software, at least one company seems to share the telecom giants’ belief that consolidation is inevitable and the bigger fish will win: Oracle.

Oracle finished its long, hostile takeover of PeopleSoft in January last year, and went on to make 12 more acquisitions, roughly one a month. Some of the assets acquired will help Oracle address vertical markets, such as retail and banking, while others fill in technology gaps. Buying Oblix, for example, gives Oracle an identity management tool for this increasingly important requirement.

While Oracle has yet to integrate and account for all the new assets, the company’s revenue was up 22% on a TTM basis to $12.8 billion.

Profits were actually down 2% (presumably because of some of the acquisitions) to $2.8 billion, but even with that dip Oracle still mustered a profit margin of 22%. While impressive, that doesn’t hold a candle to Microsoft’s 32% margin.

For the fourth year in a row, Microsoft generated more profits (on a TTM basis) than any other company on the NW200, including companies twice its size. In fact, Microsoft’s $13 billion in net income is close to the combined profits of IBM, HP and Dell.

Microsoft isn’t known for acquisitions, but it does make a handful a year and one of the more meaningful ones last year was of Groove Networks. Besides getting its hands on Groove’s peer-to-peer collaboration technology, which it is building into various office tools, Microsoft captured Ray Ozzie, one of the creators of Lotus Notes. Ozzie became CTO reporting to Bill Gates.

While 2006 is still young, consolidation across the industry continues. Oracle, for example, has scooped up Siebel Systems (No. 54 in ’04) and Alcatel plans to merge with Lucent (No. 23). By this time next year we might be down to the Network World 100.

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