Software Defined Networking: The Next Cloud Revolution

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Did you miss out on the cloud computing boom? Maybe you thought it was hype in the beginning, then dismissed it. Well, technology is cyclical, and there's an emerging movement for enterprises to adopt something called software defined networking (SDN). Like cloud computing did, it's going to get a lot of attention over the next few years. 

What is software defined networking? Well, it's being able to control hardware -- like routers and switches -- with software. Instead of using an array of dashboards and proprietary firmware options on networking equipment, software developers are able to control the flow of data with their code. Interesting, right?

Software Defined Networking vs. Cloud Computing

The first signs that SDN would become big came when VMware (NYSE: VMW) purchased Nicira for $1.05 billion. This puts SDN right in VMware's wheelhouse since Nicira was the first company to implement a full-on SDN environment. They did this by virtualizing network hardware, making it fully controlled by software. Being able to control a network with software is a developer's dream. 

Enterprise customers don't like paying for pricey licenses. Like any business, they prefer paying for performance. VMware offers them value because they know about how to build complex cloud infrastructures, "private clouds" inside of a company. They now also have Nicira to guide the next evolutionary step into SDN. 

This puts VMware squarely in control of SDN's destiny. The company's Services division is quickly outgrowing its Licenses division. Services grew 30% in 2012, to $2.5 billion while licenses only grew 13%.This is an important step towards a service-based approach for VMware. 

Services vs. licenses

Enterprise providers are starting to shy away from just offering licenses. This is ultimately going to change the industry. We're already seeing it with Microsoft (NASDAQ: MSFT) and the cloud, and we'll continue to see it with SDN. Investment tip: when you're looking at the health of a company, seek out its services revenue. Is that number growing faster than licenses? Then you are on to something. 

With Microsoft, it derives a lot of licensing revenue from its Server and Tools division. From 2011 to 2012, revenue was up 17% there. In its Business Division, where it offers the majority of its services, the increase was only 8%.

Microsoft has a harder time pursuing growth because of its size, bringing in $73 billion in revenue last year. One would expect it to be pushing services, not licenses as the future. It appears to be betting on licensing. This is in order to help it prop up struggling units of its business like Online Services (lost $8 billion in 2012) and the Entertainment and Devices Division (71% reduction in income in 2012).

Back to SDN

Microsoft hasn't even begun to touch SDN. That's unfortunate, because there are plenty of smaller upstarts that will be able to come in and take a princely share of this market. Take Insieme Networks, which brings cash and talent to the table. How? Because they are a "spin-in" of Cisco Systems (NASDAQ: CSCO), an independent entity with $100 million in cash and a depth of experience from the networking experts at Cisco. 

Cisco has faced heavy enterprise competition in recent years from the likes of Juniper. Its growth in emerging markets has been dampened by fierce competition from Huawei. But, it has been able to manage exceptional operational control, turning in 23% profit growth from very similar operating expense numbers in the realm of $35 billion the past two years. 

Look for SDN to help it boost that profit even more. Cisco already has the knowledge it needs to build software-based networks; it just needs to hire the software development. This will effectively put it ahead of the Junipers and Huaweis of the world and allow it to control their destiny in a constantly expanding world of digital network. Insieme is its way of controlling the cannibalism that will come to their traditional networking business before the competition even knows what hit them. 

In the end

Software defined networking is an exciting next step for enterprise technology. Companies like Google and Amazon are already using it to control their incredibly complex networks. The work that they are doing will eventually trickle down to other organizations. 

Companies like Cisco and VMware will be at the cutting edge of this innovation. They are already making moves, showing that they are not afraid of the software defined networking revolution. Rather, they are embracing it.

Eventually, Microsoft will need to as well, either through an acquisition or a "spin-in" of their own, although those are generally pretty rare to see. But with technology moving so fast, you have to cannibalize old tech before you are old tech. Cisco knows this. And so does VMware. 

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Daniel Cawrey has no position in any stocks mentioned. The Motley Fool recommends Cisco Systems and VMware. The Motley Fool owns shares of Microsoft and VMware. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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