This decision by Google, while small in terms of units purchased, is enormous in terms of the disruptive impact it should have on 10GbE switching equipment providers and their component supply chains. It is as if a MACHO just arrived in the Enterprise networking business and the orbits of the existing satellites have begun to shift without observers knowing why – until now.

We were watching shipments of SFP+ components for 10GbE in the market but simply couldn’t account for their end destination – sort of an optical component dark matter problem. After a great deal of investigation we have reached the following opinion:

Through conversations with multiple carrier, equipment, and component industry sources we have confirmed that Google has designed, built, and deployed homebrewed 10GbE switches for providing server interconnect within their data centers. This is very similar to Google’s efforts to build its own server computers (excellent article here). Google realized that because its computing needs were very specific, it could design and build computers that were cheaper and lower power than off the shelf alternatives. The decision to do so had a profound impact on server architecture and influenced the market’s move to lower power density solutions that Sun (JAVA) , Intel (INTC) and AMD (AMD) now embrace.

It now appears that the process Google trail blazed in the server computing market will repeat itself in the enterprise switching market. Given the relative dearth of low-cost 10GbE switching solutions, it isn’t surprising to see Google revisit this approach.

We believe Google based their current switch design on Broadcom’s (BRCM) 20-port 10GE switch silicon (BCM56800) and SFP+ based interconnect. It is likely that Broadcom’s 10GbE PHY is also being employed. This would be a repeat of the same winner-take-all scenario that played out in 1GbE interconnect. Vendors of standalone 10GbE PHY silicon ( AMCC (AMCC), VTSS (VTSS.PK), Netlogic/Aeluros (NETL) ) should take close note. Broadcom’s role in hollowing out equipment is something we previously profiled in depth (see Cisco’s Fear of a Broadcom Planet).

What is interesting about Google’s approach is that it has eschewed traditional 10GBASE optical standards and instead adopted off-standard solutions that better suit its needs for time-to-market, power and port density, and cost. While Google makes use of the SFP+ cage format, it does not use the receive dispersion compensation (EDC) function typically associated with SFP+. Instead Google is looking to employ a combination of twinax cabling for short reach (<10m) intra-rack cabling and a motley 850nm SR-like standard. Off the shelf SR optical modules appear to work well up to 100m over without receive equalization. Ironically, Finisar (FNSR) proposed such a solution several years ago.

This non-standard and very low cost optical format should prove just as attractive to other datacenter customers. Given the delays in deploying production grade EDC solutions it is possible vendors will move forward with an SFP+ SR standard without EDC. This would be a boon to suppliers of SR based SFP+ modules such as Finisar and Avago as adoption of the SFP+ standard will accelerate faster once decoupled from the complexity and cost of EDC. (see Five Misconceptions About the 10G Optical Market)

It is difficult to determine the precise amount of components Google is purchasing. Google is believed to have in excess of 500,000 servers. Based on shipments of 10G SFP+ modules, our best guess puts Google’s current usage at approximately 5k ports of 10GbE a month. This would include both server based SFP interconnect as well as the switches themselves. While the number is low, it is Google’s implementation and motivation for building their own switches that will resonate through the equipment and component industries.

At this time, other purveyors of large data centers like Yahoo, Microsoft, and Equinix do not appear to be following the same aggressive path with SFP+ optics. This is likely to change as new low cost per port 10GbE equipment from Arastra, Woven, Force10, Cisco (CSCO), and Juniper (JNPR) come into production that make use of the new format.

To us, it is Arastra that is the most interesting company in the context of Google’s decision. Arastra is building a system that closely matches what Google appears to be doing in secret. A picture of Arastra’s 7148S system with 48x 10GbE ports is below.

Arastra presents the pseudo-IEEE standard 10GBASE-CR which appears to match the twinax approach Google is taking. Furthermore, Arastra was founded and funded by Andy Bechtolsheim, Chief Architect at Sun Microsystems and who is closely tied to Eric Schmidt, the CEO of Google and an ex-Sun executive. Andy Bechtolsheim was also one of the first investors in Google. With these connections, Arastra may be the commercialization of Google’s technology and the ultimate supplier to Google itself.

Through our investigative research, Nyquist Capital reached the conclusion  that 12 months ago Google took a look at the state of the art in 10GE switching equipment and decided that it could do better. The reasons behind this decision will have a large impact on how the small but rapidly growing 10GbE equipment and component market evolves.

Author holds positions in Broadcom, Vitesse, Finisar and AMCC.

More JP Morgan than Bill Gates

Google is often compared to Microsoft (another enemy, incidentally); but its evolution is actually closer to that of the banking industry. Just as financial institutions grew to become repositories of people’s money, and thus guardians of private information about their finances, Google is now turning into a custodian of a far wider and more intimate range of information about individuals … Google, through the sheer speed with which it accumulates the treasure of information, will be the one to test the limits of what society can tolerate.

The Economist makes a skillful argument that the issue isn’t whether Google is evil today but whether the foundations are laid for a large scale conflict of interest between individual privacy and corporate profit.

Google in effect controls a dial that, as it sells ever more services to you, could move in two directions. Set to one side, Google could voluntarily destroy very quickly any user data that it collects. That would assure privacy, but it would limit Google’s profits from selling to advertisers information about what you are doing, and make those services less useful. If the dial is set to the other side and Google hangs on to the information, the services will be more useful, but some dreadful intrusions into privacy could occur.

And this is the core issue. Google guards it’s internal processes with the utmost secrecy. Legions of consultants live off of reverse engineering the ranking schemes of Google’s engine. Gmail and Google Reader users consume free services without any knowledge of how their actions and content are being used.

When you deposit money at a bank, you have right to know how it is being used. Depositing information at Google should be no different.

This acquisition is exceptionally interesting because it clearly shows Google recognizes the vulnerability of the Telcos bread-and-butter voice and long distance business and intends to capitalize on their failure to deliver incremental value.

Note: ‘Telcos’ in the context of voice services applies to any provider of simple landline voice service, whether Cable (like Comcast (CMCSA) ) or copper based Telco (like AT&T (T ) or Verizon (VZ). I view the ‘war’ between Telco and Cableco as increasingly irrelevant as both are fighting for a rapidly depreciating and irrelevant asset – POTS and long distance voice minutes. (see “Comcast: Party like it’s 1999“)

The greatest voice feature from the Telco establishment in the last 20 years was Caller ID. Your teenage daughter might argue Call Waiting is more important, but then again she probably hasn’t used a landline since she became a teenager, preferring the vastly superior features of a mobile phone or IM client.

In the meantime, the Telcos have completely failed to implement any evolutionary or revolutionary improvements based on VoIP. Upstarts like Vonage (VG) have impaled themselves on the lance of the incumbents while running up huge customer acquisition costs. You would be correct in saying that VoIP has been a consumer success and a commercial failure.

The big guys like Google, Yahoo (YHOO), and yes, even Microsoft (MSFT) don’t have the same problem. They have deep pockets and more relevant marketing platforms than the Telcos themselves – their email and instant messaging platforms. Voice is a natural extension of their business.

Their offerings up until today have focused on computer to computer connectivity and address the most cost sensitive and technically savvy customers of the telephony market. GrandCentral type services are a big step up the value chain and offer much higher value than the home phone I pay $50 a month for. They are also dead simple to use.

I just do not see how this ends well for the Telcos, whose oxygen is derived from overcharging for landline service, a service that is vastly superior and cheaper when provided over VoIP. Telcos are great at innovating the pipes (digital switching, digital voice, SONET, DSL, FiOS) they are awful at innovating with features. Just ask your teenage daughter.

Author owns no positions in companies mentioned. And keep the jokes about Microsoft as Phone company to yourself, as my readers should have sufficient imagination there.

Everyone talks about the explosion in Video traffic. Everyone talks about the explosion in the bandwidth required to carry it. No one talks about who is going to pay for it. There is one likely source: transit bandwidth inflation.

Robert X. Cringely is hit or miss as far as I’m concerned. He’s on a rant lately about how Google (GOOG) is secretly planning to control the universe by purchasing dark fiber. I don’t buy it. However, the benefit of his frequent delusions are the interesting sources he uses to make his arguments. His most recent post cites a paper that investigates the costs of video distribution on the Internet.

Lazy Blog Reader Summary of Paper: P2P distribution of media is radically cheaper than distributing it yourself using your own datacenter or outsourcing it to a CDN like Akamai (AKAM). By a factor of 1000.

Not a huge surprise to folks who understand how the Internet works. Everyone from the datacenter that hosts this blog to Akamai to your ISP pay for the right to transmit and receive bits on the Internet. The big cost contributor to the non-P2P applications, and what makes them more expensive, is transit bandwidth - the cost of transporting bits from the NBC or CBS datacenter to the eyeballs in the household.

This blog sits on a shared server at Mediatemple. Mediatemple pays for connectivity to the Internet cloud that allows these bits to reach your screen, typically a fixed price per Mb/s. The rate companies like Mediatemple pay for transit is highly elastic- the more they buy the better rate they get.

Akamai’s business is technically complex, but fundamentally it is about buying transit bandwidth low and selling high. Big bandwidth users like Akamai pay the least for transit so there is an economy of scale in their business. They couple this with a distributed computing infrastructure that allows content owners to stay out of the datacenter business. But a big source of their advantage in the marketplace is the arbitrage gains of reselling transit bandwidth.

If this is a source of competitive advantage then this is the critical question - who has the lowest transit bandwidth costs?

It’s the Telcos and Cablecos themselves. If Verizon wants to distribute content to subscribers their transit costs are zero. They don’t need to peer with anyone, in fact the Akamai’s of the world pay to send data into Verizon’s network.

Theoretically, this means that the Telcos and Cablecos could all enter the CDN business with a structural cost advantage. I have little faith in the creative business strategy of these companies but I have full faith in their ability to extract a pound of flesh from others. And I think this day is coming.

Therefore it would seem that folks like Verizon (VZ), AT&T (T ), Comcast (CMCSA), Time Warner Cable (TWC), Cablevision (CVC), etc are in a very good position to charge higher transit costs into their network, as the majority of traffic growth (Video) is going into their network.

The amount of bandwidth going into Verizon’s network destined for FiOS customers watching YouTube may explode, but the costs of carrying it will explode too. Verizon has a monopoly on the connectivity to these eyeballs. Theoretically, they could charge whatever they want for transit into their network.

Akamai and others will grimace at this bill but can effectively pass this cost on to their customers. It’s the content providers that will ultimately absorb the increase.

As a result, Network neutrality will never need to happen. Carriers will simply charge more for everything. Cablecos and Telcos can simply keep their transit rates flat while the amount of bandwidth explodes. Since they own all the end customers, maybe they even jack up rates. And surprise surprise, the cost of transit bandwidth no longer is headed to the floor (note log y-axis).

Carrier transit bandwidth cost inflation will pay for the video bandwidth explosion. Prediction: Total fees paid for transit into Cableco and Telco networks are going way, way up. Couple this with the possibility of the Mb/s transit bandwidth rates increasing and you can see the carriers are sitting on a very attractive source of cash flow. This cash will finance whatever new infrastructure they care to purchase, and maybe a little (or a lot) left over to pay shareholders.

That is, of course, if they can keep legitimate content providers from using P2P to eliminate the need to pay transit altogether. That scenario completely destroys the above assumption. I’ve said before P2P isn’t a business, it’s a catalyst to force media companies to distribute digital content. It’s clear to me it’s also the only weapon they have to avoid transit bandwidth inflation.

Full Disclosure: Author is long AT&T and Verizon

• Web 2.0 as an investment theme peaks. Equities like Akamai (AKAM), Google (GOOG), suffer though their businesses continue to do well.
• Google (GOOG) makes a really big move into hardware. This is accomplished by close partnership with Samsung or Sony (SNE) who finally realizes it needs a software partner to sell hardware.
• The Third PC emerges, after the desktop and laptop in many homes, and its in the living room. This drives all sorts of new trends, from a focus on highly integrated chipsets to low power to new software companies.
• Sales of gaming platforms explode though most aren’t used for gaming as the general public recognizes that game machines serve additional purposes, particularly as a Third PC. They become the must-have high def accessory. The major players at the end of 2007 are Microsoft, Sony, Nintendo, and Apple (AAPL).
• AMD (AMD) successfully integrates ATI and positions itself as the leading provider of silicon for The Third PC, using the Nintendo Wii as the flag bearer. Markets agree.
• High Def explodes. A perfect storm of cheap DVD hardware, content, and carriers finally make it accessible to mainstream consumers.  Service providers Verizon (VZ), Comcast (CMCSA), Cablevision (CVC), etc. figure out that High Def subscribers are profit centers and catalyze adoption.
• Muni-Fi loses it’s luster. After a year of really good publicity and some isolated deployments the public forgets about Muni-Fi and it enters the “Trough of Disillusionment“. (Graphic Here)
• Cisco (CSCO) attracts negative publicity. People realize it’s lack of innovation and monopolistic behavior makes it the Microsoft of the communication hardware business. Market share peaks as customers purposely enable competition, and Chinese suppliers like Huawei and 3Com (COMS) benefit.
• The luster comes off US Cable and Telecom stocks as investors realize they have only begun to beat the living shit out of each other. Cable fares worse. Net Neutrality debates in the fall of 2006 turn into infrastructure subsidy debates by spring of 2008.
• Net Neutrality debates move to the wireless domain, which is where they should have started in the first place. Anti-trust rumblings are heard about Verizon and AT&T/Cingular (T ) locking hardware and complicating the use of unlocked phones. One of the Four cellcos offers an ‘almost unlimited’ data plan for $9.99.
• Tivo (TIVO) becomes increasingly irrelevant.
• China becomes the next investment meme as retail investors pour money into the country. Every company rushes to present their China strategy. Any investment with China attached to it get a premium. The 2008 Beijing Olympics become the must-have ticket for the glitterati.
• Medical Tech and Silicon Valley increasingly team up. Silicon medicine is the new buzzword.
• Lots of M&A in the Networking Component and Equipment business (Full disclosure: Key Nyquist investment theme)

And finally, the most useless prediction of all – the markets. I’m going to waffle here and say what they won’t do – The S&P500 and Nasdaq will close +/- 5% from where they are today. Key word- VOLATILITY.

If I missed a particular theme, let me know and I might take a shot at it.

Om Malik has his take on the WSJ article here, filled with lots of good linkage to previous Level3 articles.

The CDN business model is about taking content and storing it close to the consumer. Whether it be Apple’s (AAPL) iTunes, Microsoft (MSFT) software patches, or the latest silly video (my favorite), geographically distributing the data achieves the following:

• Reduces the need for core bandwidth. Rather than everyone downloading iTunes tracks from Cupertino from around the world they download the file from a server 50 km away.
• Improves latency. There’s no getting around the speed of light, and each router hop in the Internet adds latency.
• Improves QoS and reliability. If the closest server is down or overloaded, others a little further away can take over.

Hence, every time your computer fetches data from an Akamai server, it’s essentially robbing a carrier like Level3 of the right to carry that traffic, and reduces the overall demand for carrier transport services.

There are very valid technical arguments for NOT using distributed caching. Some would argue it’s better to centralize the distribution of content for all but the most popular files, and use techniques like SIP to ensure QoS. There are big economies of scale when it comes to building datacenters (example: Google (GOOG)), and others would argue that core bandwidth will be so cheap there is no need for the hassle and expense of caching at the edge.

I’m not trying to say one approach is better than the other. Experience has shown me that Akamai investors are second only to Apple and Google investors in their rabid devotion. I think it’s an excellent technical debate and far too early to call it one way or the other.

However, I don’t think there is any way that companies like Level3 and Akamai will both profit in an outsized way from the distribution of digital content. It is a zero-sum game; either cached at the edge or transmitted from far away. Not both.

This type of market paradox exists in other areas, and leads me to believe we are in a Web 2.0 equity bubble, albeit localized to a handful of stocks I like to call the ‘Web Twenty’.

Full Disclosure: I hold shares in Akamai but am market neutral

The Wall St. Journal editorial yesterday captures the true issue at hand, and why the FCC is now deadlocked on approving the merger.

Meanwhile, Congressmen Ed Markey and John Dingell deserve their place in this story, having bared their teeth at Mr. McDowell in a threatening letter last week that questioned Mr. McDowell’s suitability to vet the merger. Their true interest was in strengthening the hand of Democratic Commissioners Copps and Adelstein, who seem bent on using this merger review to advance “Net neutrality” mandates that neither Congress nor the FCC have seen fit to impose through normal channels.

We’d like to see these two Congressmen demonstrate the same concern for public integrity by calling on the Commission to quickly approve a merger that everyone from shareholders to the relevant unions supports. But that probably makes us “uncurable optimists” too. The duo are eager to do favors for the campaign check-writers at Google and MoveOn.org, which want Net neutrality rules so AT&T and other telecom companies can’t charge market prices for use of their broadband pipes.

Check out the latest video from the “Save the Internet” coalition.

The only thing worse than having Washington involved in free markets is when they are trying to solve a problem that DOES NOT EXIST. My extended opinions can be found here.

1. Dell
2. AT&T
3. HP
4. Verizon
5. Microsoft
6. Cisco
7. Comcast
8. Intel
9. Google
10. Apple

Highlight the area below with your mouse to see the answer.

1. Microsoft – $295BB
2. Cisco – $163BB
3. Google – $154BB
4. Intel – $126BB
5. AT&T – $125BB
6. HP – $109BB
7. Verizon – $103BB
8. Comcast – $85BB
9. Apple – $75BB
10. Dell – $57BB

How many of you had Google ranked in the top 3? How many of you had Comcast and Verizon ranked nearly the same?

Sorry for being so breathless but I think his is really a big deal. Who gives a hoot about stupid pet tricks on YouTube. People want quality content, and it looks like the content providers just found a premium distributor.

I’m writing this post today because I haven’t written anything substantial for a week and a half and readers deserve better. Brightcove, a company I have written about, released their video content distribution platform today (WSJ Link, free article here). It seemed necessary to footnote what I  have written before and summarize why I’ve closed the door on Akamai.

First and foremost: Everyone is talking about Akamai and how great they are (This is a great example, and is what catalyzed me to action).  I rarely read articles or speak with anyone who has anything bad to say about Akamai. This indicates the market has built in perfect expectations to the price.

Of greater concern is whether Akamai is a high margin service provider, or a low margin hosting service.

Today, Akamai exists to outsource hosting for companies using their large, distributed datacenter. Whether it is Salesforce.com, NBC, Apple iTunes, etc. – Akamai sells a distributed hosting infrastructure that ultimately is application agnostic. 

Building and operating large data centers is a depreciating barrier to entry. Google (GOOG) has them. Yahoo (YHOO) has them. Microsoft (MSFT) is building them. This blog is hosted on one. They are not the unique resource they used to be. Therefore, Akamai’s hardware infrastructure is no longer a unique advantage.

They do have a compelling advantage on the sales side, with a large direct Salesforce and great connections into the big media companies. This advantage is eroding as well. The issue is Akamai offers nothing but hosting. Companies like Microsoft, Google, and Yahoo can add value beyond hosting. These companies all have the infrastructure to not just host content, but also pair it with the appropriate advertising to extract revenue.

From ‘The Inevitable Competition of Akamai and Google‘:

Our assumption appears to be breaking down, as Google deftly repositions itself a more of a mediator of video content rather than an author/owner. The WSJ article captures the leading edge of this trend very well. Google appears to be convincing major networks like CBS to allow them to host and monetize high value content. This is very negative for Akamai.

This was before Google bought YouTube. Google bought YouTube because they wanted to monetize the video content. Akamai provides an agnostic solution that requires the content owners to monetize the content. Extracting value from content is inherently a higher margin business than hosting it on a server.

I believe that Google, Yahoo, Microsoft can better pair content and advertising for each individual viewer. NBC, CBS, ABC, etc. evolved in a world where 50mm people all view the same content and advertising (broadcast TV). It is hard to imagine they will evolve better advertising systems than the ones already evolving within the search behemoths.

The cost of hosting quality content that can generate revenue will be zero. Google, Yahoo, Microsoft, and others will line up for the chance to cache content for free in order to pair advertising with it (extracting a success based fee). Akamai has no means and has shown no interest beyond operating a very sophisticated hosting company (see Brightcove vs. Akamai from Feb ’06). This business model does not deserve a triple digit P/E.

Hosting is a commodity. Akamai’s service is no different. The market will eventually price this in; next week, next month, or next year. I don’t want to be a stockholder when it does.

I can calculate the movement of the stars, but not the madness of men. – Isaac Newton