I have always loved the study of complex systems, hence my Masters in Systems Engineering from Boston University. One of the largest complex systems to observe is an economy. I marvel at the terms economists use to define every possible market scenario or behavior in their quest to understand and explain what seems to be the unknowable or incomprehensible. Terms like creative destruction which defines the process of new companies being built over the ruins of others; an “efficient economy?¬¢‚Äö?ᬮ¬¨??, is one that grows without the need for new jobs (a very popular term today); and one of my favorite terms “idiosyncratic volatility” which explains how you can feel so down right miserable about your bad luck in this economy even as the industry indexes increase.

A Deflationary Cycle?

But one term in particular resonates with our industry — deflation. Deflation is an unstoppable drop in prices that lowers corporate profits and economic growth. The down side of deflation, so I’m told, is that consumers continue to wait to buy in hope of a lower priced product right around the corner. Well if economists are interested in studying deflation they need to look no further then the IT industry. Our industry has been living and thriving with deflation for as long as I can remember.

It’s always been hard to buy any IT product since you know that in 6 to 9 months a faster and cheaper one will be available. Computing is the best example. I just purchased a Toshiba Satellite Pro with an Intel Centrino processor for $1,600. It’s about 4 times faster, has 10 times more storage and a bigger screen then my old Dell InspironTM which cost me $3000 in 1999. Networking gear has always been under price pressure and it’s actually expected to continue its unstopped drop in pricing. A 10 Mbs switched Ethernet port cost approximately $545 in 1995 and now costs some $54 according to the Dell’Oro Group. That’s a 90% reduction in price in just 8 years! And during this price slide companies came and went just like creative destruction said they would. Do you remember Xylan, Bay Networks, Cabletron, Chipcom, U&B, et al?

I believe that we could be at a turning point in the networking industry that accelerates a deflationary cycle. A potential flash point could be in the making. And what is the flash point spark? Consider 3Com’s new 7700 Ethernet switch which is priced at approximately 25% below Cisco’s www.cisco.com 4506 and 40%+ below Cisco’s 6506 catalyst switch. Put another way, an IT manager would pay some 66% or 1.66 times more for a Cisco 6506 than a 3Com switch 7700.That’s a huge difference. If the price difference is this large, and the feature set comparable for their application, than an IT manager would be delinquent not to consider it.

The 3Com Switch 7700

The 3Com Switch 7700 modular LAN switch is a high performance, multi-layer, Gigabit and Fast Ethernet layer 3 switch packaged in an integrated platform; layer-3 routing, hot-swap modules and redundant power deliver 24×7 operation. Quality-of-Service and bandwidth management is delivered thanks to packet filtering and 8 queues per port which classifies traffic flows of real-time applications such as voice and video along with best effort IP traffic. Network security is built in to the 7700 to assure unauthorized access is blocked through network login, access control lists and authentication.

The 7700 architecture boasts 96 Gbs backplane capacity and a total of 71 Mpps forwarding rate. In its first version, the 7700 will have a 7-slot configuration, capable of supporting 48 10/100/1000 Mbs and up to 288 100Mbps ports. The 7-slot version will scale to over 100 aggregate 10/100/1000 Mbs ports and support 10G links some time during 2004. To provide high availability, there are N+1 redundant power supplies, hot swappable modules, fans and power supplies plus support for link aggregation, VRRP, and spanning tree. For layer 3 forwarding the 7700 will offer OSPF, RIP V1, V2, PIM DM/SM multicast routing and access control list and filters. The pricing on the 7-slot 7700 starts in the low $20K range and can scale up to over $60K.

Can 3Com Make It?

The 7700 demonstrates that 3Com is serious about the enterprise market. It has engineering centers in Marlborough, MA and Hemel, Hempstead, UK; it has sales nearly everywhere, and has increased its direct touch capabilities to support its VARs. Most importantly, 3Com has formed a Joint Venture (JV) with Chinese powerhouse Huawei www.huawei.com. The 3Com-Huawei JV could be a catalyst for deflation in the networking industry. We hear a lot about the fear of jobs moving outside of the US these days. It’s clearly happening in the networking industry. A fully loaded engineer would cost a corporation some $130K+ in the US versus $28K in China or India.

The JV will be populated with some 500 highly motivated Huawei engineers. It’s clear that certain engineering functions and their associated jobs will eventually move overseas. This is what the economist would say is a by product of deflation, companies searching for major operational efficiencies to lower cost. So the 3Com JV with Huawei should enable 3Com to deliver product on a far lower cost basis than its peers while it continues to innovate. Bruce Claflin, 3Com’s President and CEO, a veteran of the computing industry, has often discussed the success that Amdahl had over IBM in the 1980s and 1990s. Amdahl gained huge market share from IBM in the Front End Processor (FEP) business by offering similar products priced well below IBM. Key to Amdahl’s strategy was that complexity in FEP and SNA networking was reduced thanks to standardization. Standardization and lower pricing based upon low cost operations gave Amdahl an edge to cut into IBM´s profitable FEP business. 3Com’s Claflin
believes the same could be true today. With standardization and a willingness to operate 3Com at much tighter margins (40/50%) than Cisco´s mid 70% range, Claflin believes that he can win in several large enterprise market segments.

This is key. 3Com’s strategy is not to go to market and compete horizontally in the large enterprise market, but rather to focus on its core strengths in education, healthcare, finance, and government. This is extremely important since three out of four of these market segments didn’t experience 3Com’s exit from the high end enterprise market in 1999 to a large degree and therefore, 3Com should receive a warm welcome as it moves upward in these markets. The 7700 after all is positioned to scale up 3Com’s Switch 4050/4060/4900 XRN implementations.

But just having a good product at low price doesn’t mean you win business in this economy. What else is important in vendor selection? Well, financial stability and worldwide service and reach are huge barriers of entry in today’s market. It’s hard to argue that 3Com will not survive this down turn. It has cash less debt of some $1.37 billion. It also has strong working capital management meaning that its cash to cash cycle of negative 4 days is the best in 3Com history and perhaps in the entire industry. In short, it seems like 3Com is managing the company and its cash well. It has the second best net liquidity rate in the entire industry, second only to Cisco with its huge $20 billion. In terms of worldwide support, the JV offers 3Com unprecedented access to Asian markets while 3Com is already in 51 countries with over 86 locations and 41,000 channel partners. 3Com is a serious player.

3Com’s Challenges

Cisco and Huawei are in a legal battle over intellectual property and who knows if 3Com will get dragged into it. On June 6, 2003, the U.S. District Court for the Eastern District of Texas in Marshall, TX did issued a narrow preliminary injunction order against Huawei in the suit filed by Cisco which can be interpreted as opening the door for 3Com´s JV with Huawei. See http://www.3com.com/corpinfo/en_US/pressbox/press_release.jsp?INFO_ID=150726 for more details. I´m no lawyer nor do I have any insight in to this matter, but this is clearly a risk 3Com needs to manage.

Also 3Com has to prove that it can execute this JV between American and Asian firms with the added complexity of SARs to boot. It also has to successfully manage the internal transition and focus on the enterprise market. And who knows if 3Com’s competitive price difference coupled with its innovation in networking will be enough to buy and sustain customer loyalty. It´s a pretty good bet that 3Com will have TCO advantage over Cisco in the markets mentioned above for enterprises with 5,000 employees and less. What 3Com has over other Cisco competitors however is a broad networking solution set, good brand and tier one player status. But Cisco, Extreme www.extremenetworks.com , HP www.hp.com , Avaya www.avaya.com , Nortel www.nortel.com and Foundry www.foundry.com have been busy working on efficiency measures of their own to take cost out of their switches by reducing suppliers, employees and streamlining processes. Will these companies be able to narrow the 3Com price gap enough to reduce 3Com’s overall value proposition? The real question is if 3Com’s JV is successful does it have a sustainable competitive advantage or simply a window of opportunity to grab market share? In either case 3Com may very well succeed at launching a new round of creative destruction sparked by a deflationary cycle in the networking industry. Our industry is about to get very interesting again.

Posted 2 July 2003 at 7:15 pm under Lippis Report. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.