Cloud Convergence - Zacks Investment Research

[Pages:42]March 17, 2015 COMMUNICATION AND CLOUD

Timothy Horan, CFA 212-667-8137

Tim.Horan@

Jonathan Michaels 212-667-8416

jonathan.michaels@

EQUITY RESEARCH

INDUSTRY UPDATE

Cloud Convergence

And the Googlization of Networks

SUMMARY We believe that Internet companies are looking to more vertically integrate communications and cloud infrastructure and over time offer a fully integrated suite of applications to control the customer relationship. This is occurring both in the consumer and enterprise markets. We see Google as wanting to dominate every aspect of consumers' daily life. Currently the carriers control the customer relationships and critical last-mile infrastructure. Carriers will need to invest in new virtualized and a dozen other technologies to retain this leadership. Luckily these investments should leverage existing infrastructure and dramatically lower costs from an automated network and end-user experience. Regardless, companies with unique infrastructure--spectrum, towers, fiber, carrier-neutral datacenters, and managed service--are well positioned.

KEY POINTS

We believe Google is looking to create a fully integrated, low-cost wireless/ cloud service. Google announced two weeks ago that it is entering the wireless market as an MVNO after expanding its fiber rollout. Initially with tablets, but we see the smartphone as the primary integrator of this converged world, with the ability to enable true over-the-top communications and aggregation of the Internet of Things. This will place pressure on the networks that were not designed to handle upstream traffic, and massive video over-the-top, which we now see as starting to cannibalize paid TV. The cloud is the nexus for this real-time communications and computing, something that has never occurred before. There will clearly be standalone applications like Uber and Netflix, but the ability to integrate these applications into an intelligent bundle will be a huge competitive advantage. Internet companies are driving the transformation of communications/cloud in a more vertical way as the suppliers have been lagging, which is usual for a new industry. Google and others are building their own networks (leased fiber/built datacenters) with their own virtualized optronic and switching equipment. The largest Internet companies with the most scale have been doing this for some time within and between datacenters. The incumbent telcos' core competency is control of critical last-mile infrastructure, but they are using partially outdated technology. We believe to retain their dominance they need to deploy the same virtualized open-source equipment, and become more horizontally structured. Positively, we see the telcos' infrastructure as highly undervalued, but this needs to be managed under a better capital structure. We see TMUS, EQIX, CCOI and AKAM as the main beneficiaries of this network transformation within our coverage universe. We believe that mobility is the primary driver of this convergence; TMUS has considerable M&A and can leverage its spectrum, and AKAM/EQIX can efficiently deliver traffic. Last, this is consistent with Opco analyst Jason Helfstein's Perform rating on GOOG, based on a pattern of continued infrastructure investments that will likely weigh on margins.

Oppenheimer & Co. Inc. does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. See "Important Disclosures and Certifications" section at the end of this report for important disclosures, including potential conflicts of interest. See "Price Target Calculation" and "Key Risks to Price Target" sections at the end of this report, where applicable.

Oppenheimer & Co Inc. 85 Broad Street, New York, NY 10004 Tel: 800-221-5588 Fax: 212-667-8229

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Disruptive Technologies Driving the

Googlization of Networks/Services

We believe that networks are now converging with cloud computing and there will be a battle to control the customer. Currently this relationship is controlled by the carriers with the combination of network and billing, but this is under threat. We believe that Internet companies are looking to converge their cloud applications with networks to dominate every aspect of a consumer's daily life--social, entertainment, information, commerce, etc. with a fully integrated platform. They are seeking to use automated customer care and integrated real-time cloud data to create a unique, new Uber-like cloud service.

Internet companies (Google, Apple, Facebook, Amazon, NFLX) have virtualized computing to enable the cloud and want to do the same with network technology. The second half of this report goes through much of the expected changes in network technology, essentially virtualization (SDN/NFV) enabling on-demand network and customer functionality, but also fiber closer to customers with small cell sites. The first half of the report looks at the new services and expected response from the incumbents. Positively, the incumbent telcos can use these same technologies to greatly improve network quality/capacity and automate provisioning and care on a much lower cost basis. Ultimately, everyone's goal is to create an Uber-like on-demand service for cloud and communications, and the network to do so will need to emulate GOOG's (highlighted in the Appendix section of this report). Regardless of the outcome, companies in our coverage universe with unique infrastructure should continue to benefit from strong volume growth and pricing power. These include AMT, EQIX, CCOI, and AKAM, among others.

Essentially we see Google looking to create a high-quality, low-cost converged wireless/cloud service that will lock in and expand its customer relationships. Google announced its intent to enter the wireless market as a service provider two weeks ago in Barcelona, although this is still in very early stages. We see the smartphone as the primary integrator of this new converged world, with applications global and primarily mobile and truly over-the-top communications and video. As the smartphone becomes an aggregating device of upstream traffic, it also will be the driver of the Internet of things, which will increase demand for a more intelligent, predictive converged service for consumers.

The cloud is the nexus for this real-time communications and computing, something that has never occurred before. There will clearly be standalone applications like Uber and Netflix, but the ability to integrate these applications into an intelligent bundle will be a huge competitive advantage. There are a dozen or more technology/services companies looking to do the same thing. The holy grail of cloud computing will be the ability to be the dominant operating system that every application and piece of hardware is standardized around, but the winner of this operating system, if there is just one, is not yet clear.

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Exhibit 1: The Battle for the Consumer

Commerce

(AMZN)

Hardware

(AAPL, Samsung)

On-Demand Apps

(Uber, NFLX)

Consumer

COMMUNICATION AND CLOUD

Wireless

(T, VZ, TMUS, S)

Cable

(CMCSA, CVC)

Source: Oppenheimer

Social Media

(FB, TWTR)

Software

(GOOG, MSFT)

There have been many examples of Internet companies attacking the consumer from different angles, attempting to bundle services, and drive consumer-facing applications. AMZN has released hardware (phone, tablet) to drive its e-commerce platform and ondemand apps (customer receives one year free of AMZN prime and unlimited cloud storage for photos with a purchase of the AMZN Fire phone). FB has attempted to release a phone on HTC hardware that drives its social media platform, and its division Whatsapp is set to launch an over-the-top voice service. MSFT has introduced hardware (tablets, Lumia phones with the NOK acquisition) to drive its operating system and attract application developers, as well as drive its own applications and cloud storage. APPL has the hardware, software, and is moving toward on-demand apps with its iTunes/TV offering. However, the most evident of companies attempting to bundle the consumer experience is GOOG. GOOG's open operating system (software) approach allowed it to be placed in hardware devices (driving smartphone pricing down, i.e., Moto for $180 subsidized), alleviating the need for it to build its own. Having the hardware relationships along with the software, it has created a platform to drive its search engine, on-demand applications (GOOG Now/Android TV in set-top boxes in France with Iliad), social media (GOOG +), and is now looking to completely drive its applications through a wireless/wireline integrated offering.

The Internet companies are moving much faster than the service providers and are looking to acquire basic fiber/datacenters and possibly even spectrum to be made compatible with their own equipment. The largest Internet companies with the most scale have been doing this for computing, datacenters and transport within and between datacenters using virtualized technologies and are clearly looking to do this on a fully integrated basis through to the customer connection.

The incumbent telcos' primary core competency is that they do control the critical last-mile infrastructure (and customer billing), but they are using outdated technology in some instances. To retain their dominance in infrastructure, we believe they need to focus on being the low-cost, high-quality network providers through a more horizontal structure. We believe that the Internet companies will drive them to this new structure and technologies faster than most observers believe. Positively, we see the telcos' infrastructure (specifically their spectrum) as highly undervalued as currently operated and capitalized, but this still needs to be managed.

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Internet Companies Driving Convergence

Anyone who has gone from using a traditional taxi or car service for transportation to Uber, or from linear viewing of television to Netflix, understands the transition that we will see throughout the economy. This will be a highly organic process, but the broad trends are in line with our long-held horizontal segmentation thesis. We think we are entering the sweet spot of this industrywide restructuring, and we expect to see more change in the communications/cloud industries in the next five years than we have seen in the last 15. As usual, this is being driven by technology; right now wireless broadband is seeing an explosion in productivity, but the same is happening in wireline optronics and switching.

We believe that new communications companies (Internet companies) are using the power of the cloud and wireless broadband to drive their ecosystem of applications to deliver a superior on-demand end-user experience to take full control of the customer relationship. The next stage in the evolution will be seamless integration of these assets bundled with some services at a low price. For example, GOOG's applications and products, from YouTube to Google Docs, Google Games and Television, are further driven to the end user through its (open) Android wireless operating system, whether on smartphones, Chromebooks, or set-top boxes (i.e., with Iliad in France). Having taken control of the customer experience through applications, what better way to further penetration of applications and brand equity than taking direct control of the network by operating as an MVNO, where the consumer interacts solely with GOOG for access/application needs?

We think this is a threat to the wireless carriers longer term, and believe other Internet companies (AMZN, AAPL, FB) with consumer-facing applications will eventually head down the same path, leveraging their superior capabilities in compute, storage and networking to drive customer engagement and lock in. This competitive threat, in our opinion, will force the incumbent carriers to upgrade their networks to offer the most capacity and best coverage either to compete on the consumer side or act as wholesale connectivity providers in the long term. Given the threat to their business models, we do not believe that the wireless carriers would be willing to wholesale their networks in a way where Google could use software-defined networks to switch between different networks. We discuss the battle for the consumer in more detail below.

Disruptive Technologies

Ultimately, technology is driving this process, with competition and regulators having impacts on the trajectory at the margins. We see the combination of very high-speed wireless and wireline broadband enabling true cannibalization of legacy voice, data, and video applications for the first time. The communication networks have historically been built using purpose-manufactured hardware with integrated software. This is set to move to standardized white boxes with the software layer separate from the hardware. This is an extremely difficult transition for incumbents, which is why it is being driven by the Internet companies, which have lower quality/regulatory requirements.

We are in the third major wave of new access technologies, dial-up, wireline broadband and currently wireless broadband. Each new wave of access technologies has created a few new dominant content companies and has been more positive for certain segments of the communications food chain than others. Wireline broadband speeds have doubled about every three years or so in a fairly consistent manner over the last 20 years. Similarly, wireless broadband speeds have also been doubling every three years, but

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more recently in a major step-function fashion, with speeds increasing about 10x in the last two years. This productivity growth is consistent with Moore's Law, and we believe this is set to continue with major network improvements driving cloud and communications convergence:

Major Improvements/Developments Will Drive Communications Convergence

1. Cloud--Shared virtualized computing 2. Internet of Things 3. Integrated Circuits of Optical Components by Infinera (optical multiplexing)

OFDM 4. 100 Gig wavelengths to metro upgrades with standardized boxes 5. LTE DAS (small cells are much more efficient than expected), using

unlicensed spectrum with advanced carrier aggregation 6. Shutdown of 2G and 3G spectrum to migrate to LTE (only 30% of spectrum

has been built out for LTE) 7. Broadcast spectrum auctions (game changer for Sprint/TMUS or Dish) 8. Voice over LTE enabling lower cost handsets and higher quality 9. Remove cloud-based LTE radio access devices (RADs) 10. OTT Unified Communications and integration of wireless and wireline 11. DOCSIS 3.1 12. VDSL using vectoring 13. Video OTT and multicast video on wireless networks 14. Virtualization of networking 15. Open compute of network hardware

With continuous improvements on the wireless side, we believe wireless broadband, leveraging the capabilities of the cloud, is driving new applications and content focused on the real-time flow of information among people and devices. The access to real-time data flowing in both directions is an economy-wide game changer, allowing for the Internet of Things and affecting every vertical of the economy from health care to financial services.

Exhibit 2: Three Major Waves of Access Technologies

Access Technology Network Providers:

Dial-up Incumbent Telcos

Dominate Internet Companies: New Applications: Disrupted:

AOL, YHOO Second Lines, E-mail, Web Browsing, Instant Messaging

Traditional mail services

So urce: Oppenheimer

Wireline Broadband Telcos and Cable companies GOOG, FB Social Media, Search, Streaming

Dial up internet service providers

Wireless Broadband Telcos, Cable, and possibly Internet Cos AAPL, GOOG, NLFX, Uber

On-demand apps, OTT Video

Traditional Linear Content Provi ders

The legacy telecom operators benefited from the addition of second phone lines, and the Internet was born with new companies such as AOL and Yahoo benefiting. When wireline broadband arrived, new Internet companies such as GOOG and FB were able to leverage faster speeds and more ubiquitous connectivity. In the current wave, wireless broadband, we see the on-demand, over-the-top applications as well as the basic infrastructure

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providers benefiting the most, such as AAPL, AMZN (AWS for infrastructure), Uber, etc. For the wireless carriers there is strong demand for their services with limited supply. Pricing has been aggressive by Sprint and TMUS in the last year, but we do not believe that they can reduce prices further.

These new applications are stressing the legacy wireline networks, and they need to be able to deliver on-demand broadband virtually anywhere in a similar way that AWS has delivered on-demand computing and Netflix on-demand video. Given recent advances in network access technology over the past couple of years (wireless broadband/LTE, dual SSID wireless routers/WiFi hotspots, and SDN/NFV), we believe the communications industry is poised for a tectonic shift in terms of both broadband deployment and video consumption.

In this report we go over these overarching impacts and also discuss how the incumbent broadband providers (AT&T, Verizon, Comcast, etc.) can partially offset rising competition by leveraging wireless technology and software-defined networking (SDN). It also touches upon the viability of OTT video and how the rising costs of linear TV (outpacing inflation by ~4x) are creating pent-up demand for lower cost Internet video. The success of OTT video is more of a wild card given that the content providers hold all of the cards and have incentives to keep the status quo (specifically $3B in annual re-trans fee; expected to grow to $6B by 2018). That being said, if the FCC forces the content providers to sell programming to the OTT video providers without discrimination, it could open the floodgates for the entire OTT video industry. We discuss this possibility further below.

Incumbent Response

Over the next year we will be examining the reaction of each incumbent and each segment of the market in more detail. There are almost too many variables to give an accurate prediction to this organic process, but here are a few thoughts:

The structure of the wireless market could largely be determined by outsiders--Dish and Google and possibly cable. Cable companies will need some mobile capabilities, and they will need to offset declines in video revenue with business and broadband, which will be a challenge. We have written about Dish's options with its spectrum, and where this ends up will largely dictate future industry profitability. However, Google's entry into wireless is equally important. Google, as discussed, is creating essentially a smartphone than can elect to roam on the best wireless network (in this case, Sprint, TMUS, or WiFi), and could be highly deflationary to the wireless industry.

The response of T and VZ to this trend will be interesting. T is trying to create a converged product on its own with the digital home/car/video over-the-top, but as mentioned, we believe an Internet company with a global reach will be able to implement this better. At some point the incumbent telcos will come to this realization, and we believe they will look to break themselves up into several companies; as we have written previously, their spectrum alone could represent the value of the entire company. In the meantime, we look for them to aggressively deploy new virtualized technologies to enable more seamless consumer interactions and dramatically lower operating/capex costs.

Ultimately, we see these advances having major impacts to the industry, including:

1. The demand for truly converged/integrated services, not just applications

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2. The fight between seven sub-segments of the market to create this converged service

3. The encroachment of cable/Internet companies into the wireless space

4. Some consumers replacing wireline broadband with wireless broadband

5. The proliferation of over-the-top services/the Internet of Things with cannibalization of the paid video market

6. Transformation of legacy networks using more fiber and LTE combined with SDN/NFV to better leverage compute and storage capabilities, effectively driving convergence between cloud and the network

7. Continued telco spin-out of assets but also further consolidation. The most important consolidation for the industry is Sprint/TMUS, but we expect more datacenter and fiber consolidation also.

Wild Cards for the Industry

1. Does Dish build a wholesale wireless network, or does it lease spectrum to the telcos, cable or Internet companies to build?

2. Are Sprint and TMUS willing to separately wholesale their networks to GOOG?

3. If GOOG enters the wireless space as an MVNO, do other Internet companies need to follow suit?

4. Does Google or Apple look to use smart SIMs to have instant roaming between different cellular networks and WiFi?

5. Can the telcos update their networks to enable the "Uberization" of the customer experience before Internet companies take control of the network to drive a superior end-user experience?

6. Does AWS get spun out and/or acquire AKAM as cloud computing begins to mature and content delivery, acceleration and security become even more crucial?

These trends will have an outsized impact on the P&L statements of the communications industry, with scale being the dominant factor. On the revenue side, we expect to see pricing pressure in voice and video applications driven primarily by over-the-top providers (RingCentral in business voice, Netflix, etc.), helped by the FCC's net neutrality order, which will in turn drive growth from innovation/new applications. On the cost side, we see SDN, virtualization, cheaper optronics and LTE technologies (which are seeing massive productivity improvements) driving lower procurement and operating costs.

We expect to see increasing competition in video similar to what we've seen with voice over the past ten years. Initially, we saw the wireless cellphone gradually substitute and then altogether replace home phone lines as we moved from regional 1 and 2G networks, to nationwide coverage on 3G and LTE networks. More recently, we have seen the impact of cloud computing on the voice industry, where Skype, RingCentral, and other VoIP providers have entered the market with lower price points, but like Uber, dramatically improved automated/integrated services and a simplified business proposition. These business models were able to rely heavily on cloud computing and improved last-mile wired and wireless broadband, enabling them to provide services running over the public Internet, instead of having to spend heavily on upfront CAPX

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related to on-premise PBX or spending on a home phone line for consumers. In this regard, legacy voice revenue of the carriers has continuously been declining in the 7-9% range in the last decade.

The virtualization of applications and networks and seamless integration with cloud computing needs to happen, which will be the most dramatic change since the Internet started to become adopted by consumers 20 years ago. Positively, we estimate that the industry could save 20% or more off its CAPX spending and 40% off its OPEX if it automates network and customer care. The question is whether the incumbents can do this themselves or will start up Internet companies do it.

At this point it is too early to say whether the carriers can offset cost savings from network productivity enough to outweigh the effects of OTT competition, but this will largely be determined by the number of players in the industry. However, the last-mile assets are unique infrastructure, and if the telcos/cable companies remain price disciplined will see very strong volume growth from this convergence and good returns on invested capital for scarce infrastructure. The highest returns for infrastructure are generally recognized through scale from horizontal structure in a more consolidated environment. We believe players at the wholesale layer are in a very strong position (EQIX, AMT, AKAM), but in the enterprise and consumer layer, the industry is more fragmented, with a battle for the end user being waged. The wireline carriers are likely in a strong position in the enterprise market, but we believe they need to figure out a way to integrate networks with cloud more efficiently.

Exhibit 3: Horizontal Segmentation

Wholesale (I.E. AMT, CCOI, EQIX,

Dish?)

Source: Oppenheimer

Enterprise (I.E. T, VZ, CRM, MSFT,

RAX)

Consumer (I.E. GOOG, AAPL, FB,

AMZN)

Wireless Technology Driving Technological Convergence

LTE is driving massive improvements in mobile broadband speeds, coverage and capacity, and this will be improved with small cells (in many forms) and unlicensed spectrum. Consumers will get used to and demand mobility for all their applications. As we're beginning to see across the industry, Comcast and Cablevision are gradually taking steps to enter the wireless industry, as is GOOG, while the wireless carriers are 8

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