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.

Low power multicore architectures are going mainstream in general computing applications and are no longer solely the exotic domain of server computing.

With Sun and Intel broadening their relationship, I expect Sun to move completely away from internally developed silicon. I outlined why this would take place over a year ago (see Sun wants to Change the Planet), and the arguments are more valid today given the progress and commitment Intel made towards multicore architectures.

Schwartz’s blog all but indicates this move is underway:

Perhaps the most interesting part of the relationship (at least for enterprises) is this: we’re pairing up to do some collaborative engineering around larger systems (where larger implies greater than 4 socket…). Optimized for Solaris and Java, of course, and leveraging one another’s virtualization and performance technologies.

This is exactly the application their in-house Niagara is targeted. Schwartz is essentially saying Sun will work with Intel to utilize their silicon in high end systems

Apple Computer (AAPL) moved their entire hardware base over to x86. Remember how hard Apple pushed the RISC architecture and it’s technical supremacy? It appears that Sun, the last real holdout in non-x86 computing, is poised to capitulate as well.

Full Disclosure: I own none of the stocks mentioned.

Storewidth is analogous to Bandwidth. Storage capacity is not the problem, it is the bandwidth to the storage, between the storage, and onto the storage that is the problem.

I was pleased and surprised by the depth of the technical debate.

It is clear that opportunities exist for companies to optimize hardware components for new distributed computing architectures. My prediction: Google (GOOG) will fund startup Memory and Disk companies to supply what they need.

(Italics are my comments. Plain Text is my transcription) If folks have changes/corrections by all means add them into the comments.

Panelists:

• Luiz Barroso, Distinguished Engineer, Google 
• Josh Coates, President, Founder, Mozy.com, Berkeley Data Systems, Inc.
• Apostolos Gerasoulis, Co-Inventor of Ask Search Technology, Ask.com
• Lane Patterson, Chief Technologist, Equinix (EQIX)
• Dayne Sampson, Vice President, Information Technology, Ask.com
• Mark Stahlman, (Financial guy involved with this area, I missed his employer/title)

Stahlman: Google is a digital services company. Put $2000 price target on Google earlier this year. Feels that centralizing computing on the network is the future.

Luiz Barroso: Responds to question if his company is worth $2000 a share. “I am very passionate and knowledgeable about some things but the stock market is not one of them.” Good for him… not an appropriate question.

Patterson: Things started to shift to this massively distributed model around 2001 when Google illustrated what could be done with racks and rack of cheap PCs. Google builds their own PCs from scratch and optimizes the hardware design for reliability cost and low power.

Gilder: This approach has worked for search applications, will it work going forward? Good Question… how do you know new apps won’t break this model?

…

Gerasoulis: Power is now the barrier cost to data centers, not computing bandwidth.

Patterson: Future is 380V DC power straight into the PC. Get rid of AC power requirements.

Stahlman: Google will eventually open up their platform to other businesses. Salesforce.com allows third parties to write plugins to their application. Google will do the same thing for consumer applications. (Isn’t Yahoo already doing this? I think this is already happening? What would you call a Google Maps mashup?)

Innovation in drives is not in the right direction for use in data centers. Density keeps going up but speed does not, so in high speed applications, full utilization cannot be achieved. Seek times are a big problem, so big datacenters focus by distributing utilization. Failure rates and mechanisms are not well understood, and it is possible we could be using less backups (Google backs up in triplicate in some situations) if the mechanism of failure is better understood. NAND flash could start bridging the gap. (Intel announced some new Flash technology that would hit this market head on here.)

Audience Question: RAM Disks based on flash would only accelerate by a factor of 2 because the OS is so poorly optimized for accessing fast storage. This problem needs to be solved.

Coates: Problem exists in server interconnect. Attempts have been made (Infiniband) but the issue is always that not enough volume exists to drive the cost down low enough to be better than a big distributed architecture using off the shelf components. There just are not that many customers for this type of equipment.

Gilder: Is it possible that these massive data centers being built next to hydroelectric dams are going to be obsolete in the near future? Good Question…. will this capex yield out.

Unknown Panelist: One solution that would be disruptive is to put portion of Google search index on every device and distribute 80% of the requests. Send out updates via FedEx (Or peer to peer internetworking)

Question for Stahlman: Is Sun (SUNW) going to be acquired by Google? Answer: Anything is possible. Dell (DELL) can no longer continue as the company they are. Without R&D they are hopeless. They will merge with an EMC (EMC) or Sun. (I totally disagree with this. Dell is the ultimate platform company.)

This post is one of a series as I blog the Gilder Telecosm 2006 conference. All posts can be found by searching for ‘Telecosm 2006′.

McAfee (MFE), the manufacturer of anti-virus software, was alleged to have overstated revenues by $611M from 1998 to 2000 by shipping excess inventory into their distribution channel. McAfee settled with the SEC and paid a $50M fine. The details of what took place are documented in an extensive SEC filing (EDGAR link - read this). The filing highlights not only the activities undertaken by McAfee to enhance revenues, but also the exceptional profit opportunities this created for McAfee distributors.

From McAfee vs. Security and Exchange Commission

McAfee offered its distributors lucrative sales incentives that included deep price discounts and rebates in an effort to persuade the distributors to continue to buy and stockpile McAfee products. McAfee also secretly paid distributors millions of dollars to hold the excess inventory, rather than return it to McAfee for a refund and consequent reduction in McAfee’s revenues. In other instances, McAfee used an undisclosed, wholly-owned subsidiary, Net Tools, Inc., to repurchase inventory that McAfee had oversold to its distributors.

A search of the EDGAR database with the terms “Channel Stuffing” will uncover many more companies that engaged in this behavior, such as Sunbeam and Bristol Meyers.

During a conference call on July 27^th (EDGAR transcript here, my summary here), Vitesse Semiconductor (VTSS.pk) announced it was investigating practices that allowed it to recognize revenue beyond actual customer consumption.

From the conference call transcript:

The cash management techniques employed immediately prior to the quarter end include: the factoring of receivables, shipping large amounts of goods to distributors and negotiating incentives for distributors to remit cash on those shipments prior to quarter end… these activities have stopped.

While the Vitesse situation is much smaller in magnitude when compared with McAfee, it is probable that its distribution partners received incentives like those extended by McAfee. Now that these practices have stopped, consider the following questions:

1. Which Vitesse distributor received these shipments and potentially profited from these transactions?
2. How much operating income did the distributor gain from such transactions? What impact will the elimination of incentives have on earnings?
3. What future risks to this distributor exist if other companies engaging in this practice decide to stop?

If the distributor is small enough, and the supplier large enough, these incentives can be a significant share of operating income and drive increases in operating results.

Which Distributor Benefited?

Vitesse lists only one distributor on it’s website for the US and Asia ex-Japan. That distributor is Nu Horizons Electronics (NUHC). Vitesse also lists a distributor in the United Kingdom – DT Electronics Ltd – which was recently purchased by Nu Horizons.

Email feedback from Nu Horizons confirms that Vitesse is their 2nd largest supplier and accounted for $78.6M (16.6% of FY06 COGS) of total inventory purchases for FY06 (YE Feb. 28 06). Vitesse revenue for roughly the same the period was $199M, therefore 40% of Vitesse revenue was sold through Nu Horizons in the year prior to Feb 28, 2006.

Given that Nu Horizons accounts for the majority of Vitesse distribution, it is a reasonable assumption that they received most of the material Vitesse accelerated.

Vitesse increased FQ106 revenue by $6.4M and FQ206 revenue by $10.5M by shipping additional inventory to distributors. In FQ306, Vitesse burned off $3.1M in distribution inventory by shipping $3.1M less than end customers consumed through distribution. (Note these numbers are un-audited and are Vitesse estimates from the July conference call).

Assuming Nu Horizons was the recipient, this activity would require them to cache $6.4M of unnecessary inventory in their FQ406 (quarter ended Feb. 28 06), and $16.9M (6.4M+10.5M as the deficit was accumulating) in FQ107 (quarter ended May 31 06). The overall inventory level should be reduced by $3.1M to a balance of $13.8M in the current Q207 (Aug 31, 2006).

Vitesse was engaging in deficit financing by shipping more product than needed while still collecting cash. Their distribution partners provided the cash flow and in exchange carried excess inventory.

What was this Transaction Worth?

Insufficient information exists to reach a quantitative conclusion about what financial gains Nu Horizons could have derived from this transaction. The franchise agreements with suppliers that spell out contact terms are not available to investors. However, just as McAfee distributors realized lucrative incentives from accelerated shipments, it is likely Nu Horizons realized some short term benefits from Vitesse shipment acceleration.

Suppliers typically ship inventory to distributors at the end of the quarter, therefore Vitesse shipments made during their FQ106 (December 31, 2005) would be received during Nu Horizons FQ306 (Feb 28, 2006). Vitesse Q206 shipments would be received in Nu Horizons Q406.

Distributors demand additional compensation to stock inventory beyond a given time frame, usually 90 days. It appears that Nu Horizons carried a large quantity of material for Vitesse, and it is unclear what compensation was received in return. However, any compensation that was received was revenue with radically higher operating margins than Nu Horizon’s component distribution business.

Component distribution is a business with razor thin margins. Nu Horizons has 15% gross margins and SG&A costs that are 12-14% of revenue, and stated in their FQ107 conference call that a large portion of SG&A costs are based on sales incentives. These costs are incurred only when material is shipped to an end customer. Based on the latest 10Q, 81% of SG&A costs are associated with bonuses, commissions, and salaries – but these costs shouldn’t be incurred when receiving compensation for inventory that isn’t sold.

If this took place, operating margins for Q306, Q406, and Q107 would be significantly enhanced. The P&L statements show this is exactly what has happened.

Vitesse disclosed that $23M of its cash burn since January was due to expanding inventories. Investors that I spoke with assume this was excess inventory built at suppliers – but what if this was inventory bought back from their distribution chain?

Distributors who sold back this material, certainly sold back at a premium in order to cover carrying costs, would realize an excellent one-time gain with no associated SG&A. It would also indicate that the distributor is no longer carrying (and therefore profiting from) excess inventory.

I tried to get Nu Horizon’s perspective on my speculation. As part of a continuing conversation with Paul Durando, Nu Horizons CFO, I sent the following email to the company.

Have you listened to the Vitesse conference call?

They discussed excess shipments to distributors and incentives provided for doing so. They also discussed accelerated cash payments from distributors.

Can you answer the following questions?

1. What percentage of Vitesse resale revenue was made under the 'sell-through' model vs. the 'sell-in' or Point-of-sale model?

2. Can you provide some details on how this activity affected your Q306, Q406, and Q107 operating results and inventories?

3. Are there any risks associated with obsolete inventory as a result of this activity?

I am making the assumption that such activity is very profitable for Nu Horizons.