industry surveys: computer networking

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INDUSTRY SURVEYS: Computer Networking Megan Graham-Hackett, Computer Networking Analyst - February 28, 2002

Sections Include: CURRENT ENVIRONMENT INDUSTRY PROFILE Industry Trends How the Industry Operates GLOSSARY CURRENT ENVIRONMENT Two-year boom ends amid recession The networking equipment industry saw a dramatic change in demand for its products in 2001. The shift in industry dynamics is evident in operating results for networking gear leader Cisco Systems Inc. Cisco reported revenue growth of 66% in its October 2000 quarter compared with the year-earlier quarter, followed by a 55% year-to-year gain in the January 2001 quarter. Revenues then slumped 4%, year to year, in the company’s April 2001 quarter, and 25% in the July quarter. By its quarter ended October 2001, Cisco’s revenues were down 32% on a year-to-year basis. The industry slump in 2001 followed a two-year boom in networking equipment in 1999 and 2000, led by strong demand from service providers. Service provider spending on equipment surged 81% to $10.3 billion in 1999, and grew by an estimated 70% in 2000 to some $17 billion, according to Synergy Research Group, a market research firm in Phoenix, Arizona. Meanwhile, sales of corporate (or “enterprise”) networking equipment advanced 15% to $21.5 billion in 1999, and were estimated to rise 12% to about $14 billion in 2000. The service provider market suffered a steep downturn in 2001. As the economy weakened, carriers’ access to capital dried up, and expenditures on networking gear dropped sharply. Although enterprise demand for data networking gear held up through most of 2000, toward the end of that year and into 2001 a weak U.S. economy also dampened demand in that sector. As a result, during 2001 the networking equipment industry faced what has been described as the steepest downturn in the industry’s history, with revenues dropping by an estimated 25%.

Standard & Poor’s Computer Networking

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In response to the new economic realities, networking gear vendors have had to restructure, reorganize, and realign their resources. On the other side of this downturn — and signs that the worst may be over and that business is stabilizing are already being seen — the acumen of vendors’ decisions on streamlining and new investments will prove paramount in determining how well each performs as the industry recovers. Standard & Poor’s believes the industry should witness a recovery within the next two years, with revenue growth returning to a 15% average annual rate. Longer term, most industry pundits currently forecast a recovery to 15%–20% annual growth rates over the next three to five years. Even during difficult economic times, certain areas argue for carrier investment, such as upgrades that can make networks more efficient or less complex and allow them to generate a better return on investment. In addition, the need for networking equipment will continue to be driven by increasing use of the Internet. International Data Corp. (IDC), a market research firm in Framingham, Massachusetts, forecasts that the worldwide number of people using the Internet will rise from approximately 500 million in 2001 to one billion by 2005. Over the long term, the Internet’s evolution and its growing role have key implications for networks. For example, the fact that mobile Internet access is becoming a reality will cause a significant increase in the number of access points on the Internet, and result in additional demands on networks at various times of day. Furthermore, growth of wireless Internet access means that complexity will increase, because the form factor of wireless devices and available data rates require different applications. WAN AND LAN UPDATE In the following section, we examine market dynamics and trends in the markets for wide area network (WAN) and local area network (LAN) equipment.


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WAN equipment: overcapacity hurts demand WAN equipment demand witnessed a dramatic reversal of fortune in 2001 versus 2000. After recording sequential revenue growth in each quarter during 2000, WAN switches and routers posted a decline in revenues in the first quarter of 2001 (down 9.6% versus the preceding quarter) to $2.1 billion, according to data from the Dell’Oro Group, a market research firm based in Redwood City, California. While the segment still achieved year-to-year growth of 43% in the first quarter, the sequential decline signaled the industry’s present downturn was coming. By the third quarter of 2001, WAN switch and router market revenues were down some 37.4% from the sector’s revenues in the fourth quarter of 2000. Comparing the same two periods, all major vendors except for Alcatel posted revenue declines of roughly 35% or more (Alcatel actually posted a revenue increase of 3.4%). Cisco Systems remained the leader by a significant margin, with a 32% share in the third quarter of 2001, down from 35% in the fourth quarter of 2000. In second place was Nortel Networks Corp. with 19% market share (versus 21%), followed by Lucent Technologies Inc., which expanded its market share to 16% from 15%. Juniper Networks Inc. was the fourth-largest vendor with a 12% market share. Alcatel, the fifth largest, grew its market share substantially, to 11% in the third quarter of 2001 from 7% in the fourth quarter of 2000. The initial weakness in the WAN switch and router market in the first quarter of 2001 was blamed on product transitions as well as general economic weakness. As 2001 unfolded, however, carriers began retrenching and scaling back their network buildout plans. Thus, the negative pressure on the sector has broadened because the substantial investments in the core of networks in 1999 and 2000 resulted in overcapacity. On the positive side, this increased capacity in the core of the network has led many to anticipate greater demand to improve the bandwidth in bottlenecks at the edge of the network and within metropolitan area networks (MANs). These trends are still emerging, however, and the outlook is clouded by the significant slowdown in the U.S. economy. The Dell’Oro Group forecasts that WAN switch revenues will fall to $3.5 billion in 2002 from $4.0 billion in 2001, and that the overall router market may decline to $7.5 billion in 2002 from $7.8 billion in 2001. These estimates are preliminary, however, and Standard & Poor’s believes that as global economic trends improve, the status of demand trends for the WAN sector should become clearer. LAN equipment: price weakness restricts growth Worldwide LAN switch end-user revenues were estimated to rise just 0.4% in 2001 to $15.8 billion, from $15.7 million in 2000, and were projected to grow just 1.2% in 2002, according to preliminary data from IDC. For 2001 through 2006, IDC projects average revenue growth of just 2.4% a year. The market research firm predicts that the volume of port shipments during that time should see a compound annual growth rate of 11.2%, while the average sales value of LAN switches may fall from an estimated $135 in 2001 to $89 in 2006. The major inhibitor of revenue growth is expected to be aggressive price competition in fast ethernet and gigabit ethernet.


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The leading vendor of ethernet switches, according to the Dell’Oro Group, is Cisco Systems with 58% of the market (based on end-user revenues). The next closest vendors are Nortel Networks (with market share of 7%), Enterasys Networks Inc. (7%), 3Com Corp. (4%), Extreme Networks Inc. (4%), and Foundry Networks Inc. (4%). Some growth areas within the LAN switch market that are expected to boost gains for the category include an acceleration in the migration to gigabit ethernet, a wider embrace of Layer 4-7 switching, and new 10-gigabit ethernet solutions. Part of the accelerated growth anticipated in gigabit ethernet reflects the fact that these switches are implemented mostly by large corporations, so that as the economic recovery unfolds, the demand for these switches should increase. At the same time, the per-port prices for gigabit LAN switches are coming down. The demand for Layer 4-7 switches is likely to stem from their use in data centers, and thus should benefit from the growth forecast for that market as storage demand grows. Layer 4-7 switches are used to provide server load balancing technology.

Finally, demand for 10-gigabit ethernet is expected to come from the fact that it is a lower-cost alternative to support high-speed transport, compared with OC-192 SONET (9.9G bits/second). As of year-end 2001, OC-192 SONET ports cost between $250,000 and $300,000 per port, and 10-gigabit ethernet is expected to cost a fraction of that, while being as simple to manage as standard ethernet. Many industry watchers suggest that 10-gigabit


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ethernet will be of immediate use to carriers looking to provide low-cost, high-speed ethernet services to businesses with MAN services. According to IDC, the number of 10-gigabit ethernet ports shipped may jump from around 2,700 ports in 2001 to 456,200 in 2006, representing a compound annual growth rate of nearly 180%. Over the same period, the firm expects 10-gigabit prices to drop from $35,378 per port to around $4,577 per port. Several 10-gigabit ethernet switch products have already been announced by Avaya Inc., Cisco, Enterasys, Foundry Networks, and Riverstone Networks Inc. Competitors Cisco, Foundry, and Riverstone are targeting their products mostly at service providers, while Avaya and Enterasys are focused on large enterprises. The current LAN switch market is dominated by sales of 10/100 Mbps (megabits per second) switches (also known as fast ethernet), which accounted for nearly 72% of estimated 2001 LAN switch sales. For the 2001–2006 time period, growth in the LAN switch market will be driven by gigabit ethernet, according to data from IDC. In fact, the gigabit ethernet market is expected to take over as the largest segment within the LAN market by 2005, with a 45.1% share versus a projected share of 44.8% for fast ethernet.

New LAN technologies to watch Wireless LAN has been heralded as one of the few high-growth opportunities, but just as adoption of the wireless LAN standard 802.11b (referred to as Wi-Fi) has begun to gain momentum, two next-generation emerging standards have come on the scene. The standard 802.11a (Wi-Fi5) operates in the five GHz frequency, while 802.11b and 802.11g operate in the more crowded 2.5 GHz spectrum frequency. As far as speed, 802.11a offers speed of up to 54Mbps, while 802.11g offers speeds of more than 20Mbps and 802.11b supports speeds of 11 Mbps. The standard for 802.11g was approved in November 2001. An important difference for 802.11g is that it is backward compatible with the 802.11b standard, while the 802.11a standard is not. This could prove to be pivotal since the installed base of 802.11b users is estimated at 15 million as of early 2002. AN INDUSTRY IN TURMOIL In many ways, 2001 marked a significant change from the preceding year. In 2000, companies made acquisition after acquisition because they couldn’t add capacity or people fast enough through organic growth to meet demand. In contrast, restructuring


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announcements abounded in 2001 as companies raced to announce plans to shed assets that once had generated high returns on white-hot demand. Entering 2002, many companies are assessing how well they are positioned for an eventual turnaround in the market. The following is a discussion of each company’s response to the downturn and the bets it’s making on various industry sectors for the future. Cisco reorganizes Cisco Systems is the leading vendor in the enterprise market. As the company also began to penetrate the market for telecommunications equipment, Cisco enjoyed accelerated growth in 1999 and 2000. In calendar 2000, Cisco witnessed year-to-year revenue growth of an estimated 59%. For 2001, however, tracking the slide of the worldwide economy, Cisco’s sales fell by roughly 25%, according to estimates by Standard & Poor’s. In the spring of 2002, Cisco should begin to post positive year-over-year revenue growth, and for the calendar year, Standard & Poor’s estimates the company should post revenue growth of 15%. In April 2001, Cisco began to restructure its business in response to the dramatic slowdown in the economy and the capital spending environment. The new business plan was designed to align the corporation to focus on its largest market opportunities and profit contributions as well as to improve efficiency. Under this restructuring, the company adjusted its organization to one based on a centralized engineering and organizational structure, with 11 new technology groups. (In April 1997, the company had restructured based on lines of business.) The change reflected Cisco’s belief that the differences among many of its customer segments had blurred and that by focusing on technologies that crossed several customer segments, the company would be more responsive to customer needs. The largest technology area is Internet Switching and Services; the other segments are Access, Aggregation, Core Routing, Ethernet Access, Cisco IOS Technologies Division, Network Management Services, Optical, Storage, Voice, and Wireless. Included as part of Cisco’s six-point plan to realign the company’s resources was the decision to reduce its work force by approximately 8,500 people, including about 2,500 temporary and contract workers. This was also announced in April 2001, and as of October 27, 2001, some 5,300 regular Cisco employees had been terminated. In an analyst meeting in December 2001, Cisco seemed to acknowledge that its forecast of 30%–50% average annual revenue growth over the next three to five years in countries with economies that were doing well was likely optimistic. The company had been criticized during 2001 for predicting that high range of growth while other industry forecasters put the industry’s average growth rate at closer to 15%–20%. 3Com talks about growth again Following a difficult past few years, 3Com has started to discuss growth prospects again. The company posted sequential growth in its March 2001 quarter (the third quarter of its June fiscal year.)


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In January 2001, the company set a goal of saving $1 billion within one year. In December 2001, the company said it had achieved that goal. Under the plan, 3Com closed unprofitable businesses and product lines and streamlined its cost structure, including work force reductions. In June 2001, 3Com announced it would continue to streamline the company and would divest itself of its consumer DSL and cable modem business. In an effort to improve results, 3Com reorganized itself into three businesses: its CommWorks subsidiary (focused on the service provider market), Business Networks Company (focused on enterprise networks), and Business Connectivity Company (targeting network access). CommWorks builds Internet Protocol (IP) networks for network service providers. The restructuring involved heavy layoffs. In November 2000, 3Com had nearly 12,000 full-time employees, and by the end of November 2001, the company planned to have 7,000. Because of these restructuring efforts, 3Com has become a significantly smaller company. In fiscal 2001, 3Com posted revenues of $2.8 billion, down 44% from fiscal 2000. Despite Cisco’s discussions of growth, Standard & Poor’s projects the company will shrink by another 45% to $1.6 billion in its 2002 fiscal year. Enterasys and Riverstone emerge unscathed Enterasys Networks Inc. and Riverstone Networks Inc. were spun off from Cable-tron Systems Inc. in the midst of the industry’s turmoil of 2001. The spinoff of Enterasys from Cabletron Systems was completed in August 2001, with demand supported by the fact that Enterasys sold its networking gear solely to the enterprise market, which was holding up better than the service provider market. In addition, Enterasys had opportunities to access new markets: unlike Cabletron, which focused on direct sales, Enterasys had focused on expanding its channel sales program. The company is a leading supplier of high-end LAN switches, but it is also focusing on new high-growth markets like security and wireless LANs. In the early part of 2001, Enterasys’s revenues grew at a 25%–30% rate. More recent comparisons have been obscured by the company’s accounting change regarding revenue recognition (as well as its adjustment from a fiscal year to a calendar year basis). Instead of recognizing revenues when its equipment is sold to channel partners or other distributors, Enterasys now recognizes revenues when sales are completed to the final end-users of the equipment. This accounting policy, which is considered more conservative, is also followed by Cisco Systems. Like Enterasys, Riverstone Networks has emerged from the current downturn without reducing its headcount. Riverstone was spun off from Cabletron in 2001, and during its fiscal year 2001 (ended March 3, 2002), the company posted a 326% rise in revenues. Riverstone has benefited from its position as a leading provider of edge routers for the MAN market and (in contrast to Enterasys) focuses exclusively on the service provider market. Riverstone essentially represents the Cabletron acquisition of Yago Systems (in 1998). The company’s competitive advantage lies in its support of a broad number of interfaces (legacy as well as newer, faster technologies). The company emphasizes that its products can help metro service providers to differentiate themselves from their peers by adding new services, including provisioning. In 2002, revenues are expected to more than double. That estimate is at risk, however, given that the company focuses on one product, and recent growth has come more from international markets as companies abroad continue


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to build out their networks. If the capital spending downturn suffered by the United States spreads abroad, the company could face a slowdown in its business. ISSUES FOR 2002 AND BEYOND The question remaining for the networking equipment industry, in Standard & Poor’s view, is this: once the U.S. economy recovers, will the expectations regarding the pace of adoption of new networking technology deployments prove too optimistic? Industry watchers may be anticipating a strong embrace of new technology similar to that witnessed in 1999 and 2000. However, that period may have been a unique environment. One reason is that many customers bought and deployed new technologies because they were start-up companies (alternative carriers and service providers), and technology was one way to provide them with a competitive advantage versus entrenched players. This was also enabled by the second unique factor, and that was easy access to capital from the investment community. These factors have not entirely gone away. Technology can still generate productivity benefits that should support continued investment in information technology (IT), and recent interest rate cuts by the Federal Reserve have reduced the cost of borrowing. However, we believe these supporting factors will not provide as powerful a catalyst to overall IT investments, or more specifically to networking equipment demand, as did the boom conditions seen in the 1999–2000 period. INDUSTRY PROFILE Long-term prospects buoyed by communications demand The worldwide market for data networking products was valued at approximately $50 billion in 2000, up from $37 billion in 1999, according to estimates by Cahners In-Stat Group, a market research firm based in Scottsdale, Arizona. Following a slowdown in 2001 that will likely persist through the first half of 2002, the market is expected to return to annual growth rates of 15%–20% in the ensuing three to five years. Data networking will likely be aided first by a recovery to healthy growth rates in the enterprise market and then, in the late 2002–2003 timeframe, by a resurgence in demand from telecom providers. The shift in product mix over the past several years — from traditional shared media hubs to faster-performing switches — appears to be largely completed, though there is some debate about whether a material portion of this transition remains. Now, as the dominant kind of traffic carried on telecommunications networks shifts toward data, the technology for telecommunications equipment is also expected to change: away from circuit-switch technology to packet-based networks. Consequently, data networking equipment vendors are poised to benefit from participation in the market for worldwide telecommunications equipment, which is expected to grow to $340 billion by 2002, according to Gartner Dataquest Inc., a market research firm in San Jose, California. Based on estimates by Synergy Research Group, the worldwide communications equipment market exceeded $180 billion in 2000 (latest available).


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While this shift in market demand has buoyed long-term prospects for networking hardware sales, some countervailing pressures exist. Although sales to service providers grew explosively for most of 2000 (up by about 70% for the year), the market contracted in 2001 because of the weak U.S. economy and tight capital markets for telecom firms. These recent problems notwithstanding, service providers’ demand for new networking technologies is projected to return to relatively robust levels as these companies position themselves for the broadband era. The push for carriers to provide high-speed Internet access and to differentiate their services is heightening demand for the industry’s key equipment areas. After heavy spending in 1999 and 2000, the pace of investment decelerated, but following this pause, it’s likely to return to growth as early as late 2002.

GROWTH RATES VARY AS INDUSTRY SLOWS Growth rates within the three main product segments of the industry vary significantly. Our discussion of these markets is based on the segmentation of the networking equipment industry as presented by the Dell’Oro Group: Ethernet switches. Ethernet switches accounted for 24% of the industry’s revenues as of the third quarter of 2001, based on industry data from the Dell’Oro Group. Routers and access equipment. Included are data routers, as well as voice and data routers, access concentrators (supporting ISDN, cable, and digital subscriber line access multiplexers, or DSLAMs), and customer premises equipment (cable and DSL modems). This category made up 29% of the industry’s revenues in the third quarter of 2001. Wide area network (WAN) gear. Along with WAN switches and WAN routers, this category includes optical transport gear (dense wavelength division multiplexing, or DWDM), long-haul equipment, and equipment for the SONET/SDH (synchronous optical network/synchronous digital hierarchy) multiplexer market. (A detailed description of


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DWDM and SONET/SDH technologies follows in the “Industry Trends” section of this survey.) Aggregate WAN gear revenues comprised 47% of industry revenues in the third quarter of 2001.

Ethernet switches change gears The market for ethernet switches has been one of the strongest areas over the past several years. Growth was first fueled by the migration from shared media networks to switched networks, but more recently it has reflected the shift within switched networks, from traditional ethernet to higher-speed fast ethernet and gigabit ethernet. Reflecting the difficult industry conditions, however, demand for ethernet switches slumped in 2001. According to the Dell’Oro Group, the ethernet switch market totaled $2.5 billion in the third quarter of 2001, down 8% from the second quarter. That was a smaller sequential (quarter-to-quarter) decline than seen in the prior two quarters, and the market research firm estimated a sequential increase of 5% for the fourth quarter of 2001. Still, this estimate would indicate that full-year 2001 revenues fell 9%. The outlook for 2002 is dim: Dell’Oro forecasts growth of just 2% for the year. The long-term outlook for growth in switches remains relatively healthy, fueled by demand for high-speed networks, which can be facilitated through fast ethernet and gigabit ethernet, and the expansion of the ethernet switch market from the LAN (local area network), into the MAN/WAN. (MAN is an acronym for metropolitan area network.) Ethernet switches can be divided into categories reflecting their functionality. The Layer 2 market remains the largest segment within the ethernet switch market. Layer 2 refers to the data link layer of the OSI reference model (the OSI reference model is explained in the “Glossary” of this Survey). Within this segment, which rebounded in the third quarter of 2000, growth has been dominated by Layer 2 fast ethernet products, which have benefited from better affordability and performance versus shared media networks. Growth in Layer 2 switches accelerated in the second half of 2000 but eased consistently during the third


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quarter of 2001, according to the Dell’Oro Group. Much of the decrease in Layer 2 modular switch revenues has to do with sharp price declines. By comparison, Layer 3 switches, which exhibited strong growth in 2000, are still relatively new and represent a much smaller market base. In the third quarter of 2001, Layer 3 switch revenues fell by 4% from the preceding quarter, but outperformed both Layer 2 and Layer 4-7. Switches that feature Layer 3 capabilities have a higher level of functionality than Layer 2 switches. They are similar to routers, and thus are called routing switches. In the OSI model, Layer 3 refers to the network layer. The market for “layer four through seven” switches (L4-7 switches, which address the application layer in the OSI reference model) was estimated by the Dell’Oro Group to have doubled to more than $500 million in 2000. L4-7 server switches or Server Load Balancing (SLB) switches and appliances help to switch network or Internet traffic optimally among servers in a group. These smaller switches are typically used in front-end Web sites, server farms, or cache clusters (which are deployed to locate frequently used data close to the end-user). They help to increase the availability, scalability, and security of the Web site or server farm, and to improve latency (access time). In 2001, however, this market witnessed a decline due to the slowdown in the service provider market and increased pricing pressure. In the third quarter of 2001, Layer 4-7 switch revenues declined 11% sequentially. Within the ethernet switch market, Cisco Systems Inc. clearly dominates with a 58% share of third-quarter 2001 revenues, according to the Dell’Oro Group, followed by Nortel Networks Corp. (7%), Enterasys Networks Inc., formerly Cabletron Systems (7%), and 3Com Corp. (4%). Cisco’s revenues for this sector had been growing at a healthy rate, posting a high-teens sequential growth rate in each quarter of 2000. In each of the first three quarters of 2001, however, these revenues declined sequentially in the double digits for Cisco, to nearly $1.5 billion, from $2.3 billion in the fourth quarter of 2000, according to data from the Dell’Oro Group. Nortel’s third-quarter ethernet switch sales rose 6% on a sequential basis, to nearly $172 million, after witnessing a steep 43% sequential decline in the prior quarter. Enterasys’ third-quarter revenues fell 9.6% sequentially, while 3Com’s sales fell 5.8%. Routers see small recovery Router revenues in the third quarter of 2001 rose 5.2% versus the preceding quarter, to roughly $1.25 billion, according to the Dell’Oro Group. This performance followed sequential declines of 6.8% in the second quarter and a sharp 32.1% in the first. However, these results followed strong growth in 2000, particularly in the third quarter of that year. In the third quarter of 2000, router revenues grew sequentially by 13.3% to nearly $2 billion, with the majority of the gain coming from mid- and high-end router lines. The Dell’Oro group noted that this was the strongest third-quarter growth since 1996. For the first two quarters of 2001, Dell’Oro cited the U.S. economic slowdown and product transitions as reasons for the fall-off in router sales. Third-quarter 2001 router revenues benefited from strength in enterprise class routers, which rose some 10%–15% sequentially.


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Performances were varied: the top three vendors posted sequential revenue growth, but the next three recorded sequential revenue declines. Cisco, the leader with some 91% of the market, posted a sequential revenue increase of 5%, in line with the overall market, according to the Dell’Oro Group. Unisphere Networks Inc. (a subsidiary of Siemens AG) rose to the number two spot with 4.0% market share, as its revenues jumped 18% sequentially in the third quarter. As of the fourth quarter of 2000, Unisphere’s market share was just 1.0%. Meanwhile, Juniper Networks Inc., which had slipped to No. 4 in the group in the second quarter of 2001, recorded sequential revenue growth of 21% in the third quarter of 2001 and claimed the No. 3 spot, aided by the success of its Internet backbone routers. Nortel slipped to No. 4 as its third-quarter 2001 sales slumped 36% from those of the preceding quarter; Motorola Inc.’s revenues fell 10% sequentially and Lucent Technologies Inc.’s sales slid 13%. The outlook for routers for 2002, according to Dell’Oro, is for revenues to fall to $7.5 billion from an estimated $7.8 billion in 2001. However, the research firm does expect sequential revenue growth to begin in the second quarter and continue through at least the fourth quarter of 2002.


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Access gear slips further Access equipment revenues fell 21% sequentially in the third quarter of 2001 to $1.7 billion. This followed sequential declines of 10% in the second quarter of 2001 and an estimated 13% in the first quarter of 2001. A number of segments in this market were weak in the third quarter. Dial modem sales witnessed a continual decline during the first three quarters of 2001, and Dell’Oro projects a revenue decline from $1.0 billion in 2001 to $0.7 billion in 2002. While cable access concentrator sales were roughly flat in 2001, compared with 2000, Dell’Oro forecasts an uptick in 2002 to $0.5 billion from an estimated $0.3 billion in 2001. Finally, DSL access concentrators have witnessed a steep decline since the beginning of 2001, and Dell’Oro forecasts revenue of $3.0 billion in 2002, down from $3.6 billion in 2001. The declines in 2001 represent a stark contrast to the accelerated pace of growth during the majority of 2000, aided by the buildout of the Internet. In 2000, market revenues grew 18% sequentially in the first quarter, 17% in the second quarter, and approximately 20% in the third quarter, before sales slipped 3.6% in the fourth quarter from the third-quarter level. With the dramatic change in market momentum for access gear, the ranks of the top vendors also changed substantially over the past year. Lucent Technologies (which entered the market through its acquisition of Ascend Communications in 1999) surrendered its lead in access equipment to Alcatel in the first quarter of 2001. Lucent’s market share dropped to 13% in that quarter from nearly 21% in the third quarter of 2000. By the third quarter of 2001, Lucent’s market share had dropped to just 7.2% (putting the vendor in the No. 4 spot) from 12.8% in the first quarter of 2001, and 22.6% in the first quarter of 2000. Meanwhile, Alcatel steadily gained share throughout 2000 and remained the leading vendor with 18.6% market share as of the third quarter of 2001. Alcatel’s market share was nearly 14% in the third quarter of 2000, and just 7.1% in the first quarter of 2000. Cisco moved up to the No. 2 spot in the second quarter of 2001, and remained there in the third quarter of 2001 with 11.0% of the market. This still represents a dramatic drop from Cisco’s 17.4% market share for the third quarter of 2000.


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Siemens moved up the ranks during 2001, to land the No. 3 spot in the third quarter, just behind Cisco, with 10.8% share of the market, compared with 9.4% as of the first quarter of 2001. In the aggregate, remote access products should post healthy growth over the long term, although this market may see periodic declines. In 1998, for example, the sector witnessed such a slowdown. Reasons for the reduced growth rate in that year included the delay in 56K modem standard (now firmly in place), severe price competition, and disruptions caused by mergers at industry leaders 3Com and Ascend Communications. Long-term demand is expected to be buoyed by the growing base of end users seeking to gain high-speed access to the Internet, reflecting the growing number of telecommuters, mobile computer users, and remote offices that require faster access to corporate networks. Increasingly, recreational users are also seeking high-bandwidth speed and applications. WAN: revenues slump after 2000’s torrid growth In 2000, WAN gear experienced healthy demand as carriers scrambled to build high-speed cores in their networks. For example, in the third quarter of 2000, WAN equipment revenues surged 47%, year to year, according to data from the Dell’Oro Group. In the first quarter of 2001, despite challenging market conditions, sales still grew 43% on a year-to-year basis.

However, sequential trends during 2000 reveal the deteriorating conditions of the market. The category of WAN switches and WAN routers grew 26.6% sequentially in the second quarter, then 16.0% sequentially in the third quarter, according to the Dell’Oro Group. By the fourth quarter of 2000, sequential growth was pared to 8%, and in the first quarter of 2001, sales for the group fell 9.6% sequentially to $2.12 billion. In the third quarter of 2001, the market commanded just $1.4 billion in revenues, down 32% on a year-over-year basis. Dell’Oro does not expect a recovery in demand for WAN switches until the second quarter of 2002, and predicts that revenue for full-year 2002 will decline to $3.5 billion. During this steady downturn, Cisco has remained the leader in WAN switches and routers. In the third quarter of 2001, the company finally witnessed a sequential rise in revenues (albeit less than 1%). According to the Dell’Oro Group, Cisco claimed 32.0% of the market


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in the third quarter of 2001, up from 29.4% in the prior quarter, although down from its 34.7% share in the fourth quarter of 2000. Nortel remained in the No. 2 spot during 2001, and garnered 19.0% of the market in the third quarter, down slightly from 19.3% in the second quarter, and up from its 17.5% share in the first quarter of 2001. Finally, Lucent held its rank as the third largest in the segment, garnering 16.1% of the market in the third quarter, versus 17.8% in the second quarter and 17.2% in the first quarter. Juniper Networks and Alcatel, which had witnessed strong market share gains during 2000, during 2001, remained in the No. 3 and the No. 4 spot, respectively, in 2001. In the optical transport market, third-quarter 2001 revenues fell 11.4% from the second quarter. This followed sequential declines of 18.3% in the second quarter and 22.0% in the first quarter. Indeed, third-quarter revenues were $3.4 billion, down sharply from the $6.1 billion recorded in the fourth quarter of 2000, based on data from the Dell’Oro Group. Within the optical transport market, during the third quarter of 2001 the SONET/SDH market declined, the long-haul DWDM market dropped 28%, and for the first time, the Metro DWDM market declined sequentially, in terms of market revenues. The metro market, while still relatively small, gained momentum during 2000, and the Dell’Oro Group had predicted it would post growth of 116% in 2001 to $871 million. For 2002, Dell’Oro forecasts only minimal growth in the metro market. (The metro market refers to metropolitan area networks.) Nortel witnessed the steepest decline during 2001. Nortel’s third-quarter 2001 revenues in the optical transport market were $519 million, down more than $2 billion from the $2.86 billion the company registered in the fourth quarter of 2000. Indeed, excluding Nortel, the optical transport market held roughly steady through the second quarter of 2001 at about $3.2 billion. Meanwhile, Lucent posted steady revenue gains in the first half of 2001, but saw this trend end in the third quarter of 2001, when its revenues fell 17.3% sequentially. These difficulties notwithstanding, Lucent remained in the No. 1 spot in the third quarter of 2001, garnering 20.3% of the market. Lucent claimed the top spot from Nortel in the second quarter of 2001. As a result of Nortel’s dramatic revenue decline during 2001, it dropped from the No. 1 spot in the fourth quarter of 2000, to the No. 3 spot with 15.1% of the market as of the third quarter of 2001, according to the Dell’Oro Group. Alcatel claimed the No. 2 spot with 19.8% of the market, and it was the only vendor among the top five to record sequential revenue growth in the third quarter.


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Industry Trends The healthy demand for networking equipment reflects several factors, but the surge in recent years prior to 2001 came mostly from rapid growth of the Internet and of private intranets. Contributing factors include the proliferation of PC users connected to local area networks (LANs), a significant change in the role of networking in businesses, and new bandwidth-hungry client/server applications and attractive new technologies to support the demand for bandwidth. Other trends that will affect the industry are the convergence of voice, data, and video technology, and continued industry consolidation. INTERNET/INTRANET POPULARITY BOOSTS GROWTH As their popularity has grown, the Internet and intranets (private internal networks based on Internet programming standards) have fueled dramatic growth in demand for networking equipment. Demand for Internet access now comes from homes and corporations alike, and Internet service providers (ISPs) are spending millions of dollars to meet it. They must make investments in new networking equipment — routers, high-speed switches, and remote access products — to upgrade their networks to meet the explosive growth in customers and the demand for high-speed connectivity. Despite the setback in 2001, reflecting the global economic slump and the fall-out from a two-year investment boom, the investments in networking gear are likely to continue for the next several years, as the Internet continues to grow in popularity. International Data Corp. (IDC), a market research firm based in Framingham, Massachusetts, estimates that Internet users worldwide should grow from an estimated 500 million in 2001 to one billion by 2005. The proliferation of networked PCs The explosive growth of personal computers (PCs) over the past decade and the trend toward linking them into local and wide area networks (LANs and WANs) have fostered strong demand for networking products. Since the late 1980s, corporate America has steadily abandoned earlier systems in which users were connected to a single centralized mainframe


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or other large host computer. The architecture replacing this environment is referred to as client/server computing. In this model, PCs (known as clients) communicate with servers via a network; the servers distribute such services as printing and database access. Networks facilitate transfers of electronic mail or files between computers. Meanwhile, advances in PC hardware and software technology have resulted in demand for greater network capacity (bandwidth). As networks grow in size and as users place greater demands on them, performance degrades. This is fueling strong demand for new network interface cards (NICs) and higher-speed switches and routers. Corporate networks promise better returns Local area networks have proliferated in the past 15 years, emerging as a critical business tool. Providing a high-speed communications link between computers and other data processing devices (typically in a small geographic area such as a department), a LAN allows users to share vital resources like printers and, even more important, the information needed to do their jobs. Wide area networks link users over a larger geographic area and typically tie two or more LANs together. For large corporations, networked PCs have helped to streamline operations, improve profitability, and increase customer satisfaction. Before the proliferation of LANs and WANs, it was more difficult for companies to gauge supply and demand. In today’s fiercely competitive global marketplace, it is now virtually mandatory to be electronically connected to key suppliers and customers, whether through a linked intranet or an Internet connection. Furthermore, 24-hour service and support, the norm in many industries, is now increasingly enabled through these networks. Indeed, with the recent momentum in Web-based supply chain management and the deployment of customer relationship management software, the value of these networks is increasing. TODAY’S NETWORKS NEED A BOOST The world is being “wired,” or networked, but the rule of thumb in networking is that performance degrades as networks grow in size and as users employ networks for a greater number of tasks. The networking equipment industry has had to respond with a steady stream of new technologies to meet the need for high-speed performance. Switched networks are the most popular way of internetworking LANs, and have replaced many networks based on shared bandwidth. In a shared environment, users share the total capacity available on the network; as more users are added to a network, competition for bandwidth grows and network performance suffers. Ethernet, which is the protocol (the format for transmitting data between two devices) of choice in approximately 80% of all existing networks, tops out at speeds of up to 10 Mbps (megabits, or million bits, per second). Although it’s sufficient for relatively simple network services like printing, it is unsuitable for today’s high-bandwidth tasks such as real-time video. (See this survey’s “How the Industry Operates” for an explanation of this and other protocols.)


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To provide the same quality of service for bandwidth-hungry applications, network vendors are offering multimedia-focused solutions (like asynchronous transfer mode, or ATM) and other new high-speed switching technologies (like gigabit ethernet). Many networking analysts believe that, because of its similarity to the ubiquitous ethernet protocol, gigabit ethernet should eventually become the dominant desktop protocol. Meanwhile, ATM is expected to continue to be used primarily as a backbone technology. ATM is relatively high-cost and complex, but it offers the advantages of multiprotocol networking (voice, data, and video), quality of service, and high reliability. Another trend in networking equipment, aimed at helping to alleviate congestion, has been the segmentation of networks into smaller and smaller groups. The rationale for segmentation is that if fewer users compete for transmission time, bandwidth availability will remain high. Routers, devices typically used to segment networks, are expensive. The high price of routers reflects the inclusion of software to provide more “intelligence,” or functionality, such as the ability to filter messages and forward them to different places based on various criteria. These features are necessary for the efficient use of the network and for prioritizing different types of traffic on the network. Routers have long dominated in the backbones of networks. Recently, however, switches have been used in some instances to replace routers in this crucial part of the network. The reasons for this shift include improvements in the intelligence of switches and declining prices. With the emergence of Layer 3 and Layer 4 switching, network managers can achieve the intelligence of routers, at the cost of switches. We believe the debate will continue, but that the industry adage — “switch where you can, route where you must” — will remain true. Optical networking explodes on the scene Optical networks use optical fiber as the primary medium for transporting data and photons (units of light). In contrast, the traditional voice network is based on a circuit-switch architecture in which signals are transmitted electrically through a network of interconnected switches and copper wires. With the shift in traffic over telecom networks to data and bandwidth-hungry applications, traditional systems are being replaced by fiber-optic cables, as carriers like WorldCom and AT&T, as well as new service providers, race to capitalize on Internet demand. These new systems offer greater bandwidth and flexibility in service. In addition, their scalability enables a more cost-efficient network. The deployment of fiber has gone on for more than a decade. The synchronous optical network (SONET), used primarily in North America (and established in 1985), and synchronous digital hierarchy (SDH), used throughout the rest of the world, are standards established for fiber-optic equipment to translate electrical to optical signals. However, SONET/SDH architectures have limits: although optical fiber is used as the transmission medium, most of the signaling, processing, and switching is performed electronically. Specifically, the electronic signal enters the network and is converted to an optical signal, which travels across the network to a SONET terminal, and is then converted back to an electronic signal. Now SONET/SDH architectures are converting to support DWDM (as evidenced by the growth rates for these markets, discussed in the “Industry Profile” section of this


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survey). Dense wavelength division multiplexing is an optical technology used to increase bandwidth over existing fiber-optic backbones. DWDM was largely enabled by the introduction of an optical amplifier (the erbium-doped fiber amplifier, or EDFA), which amplifies a signal purely in the optical domain; that is, without conversion to an electronic signal. DWDM enables the use of different wavelengths on the same fiber: by creating multiple virtual fibers over the same fiber-optic line, it adds capacity without laying down additional fiber. Other advantages of DWDM are that it’s protocol independent (that is, it’s able to transmit data in IP, ATM, SONET/SDH) and bit-rate independent. This enables carriers to offer different services over their existing DWDM-based networks. The market for DWDM systems had been projected to grow to $21 billion by 2004, according to Cahners In-Stat Group, but given recent weakness in the market brought on by capital spending restraints on telecom service providers, these figures may be revised downward. CONVERGENCE: THE INTERNET USHERS IN NEW TECHNOLOGIES, NEW PLAYERS Converged networks — networks that can transmit voice, data, and video traffic over a single system — have recently become an area of focus for the major data networking equipment providers. By carrying different types of traffic on a single network, companies can substantially decrease the cost of communicating. For example, voice-over-IP (VoIP, where IP stands for Internet Protocol), is emerging as a popular technology: it basically allows people to use the Internet as the transmission medium for phone calls. IP-based technologies are attractive not only because of the cost savings they generate, but also because of their inherent flexibility, which benefits carriers as they seek to offer new services. In fact, many industry pundits have forecast that some 90% of all traffic over carrier networks will eventually use IP technology. In anticipation of this phenomenon, traditional data networking companies are competing with traditional voice network equipment players like Lucent Technologies. As both data and telecom equipment suppliers rush to serve this emerging market, there will likely be more combinations like the 1998 merger between Bay Networks and Northern Telecom Ltd. (the company has since changed its name to Nortel Networks Corp.), and the 1999 combination of Lucent and Ascend Communications. (Details of each are provided in the section below.) Acquisitions define competitive landscape, confirm technology shifts Standard & Poor’s expects acquisitions to continue to define the competitive landscape over the next several years, based on a number of industry trends. First, the industry’s largest players have found that purchasing small start-up firms that specialize in emerging technologies is often more effective than developing their own products internally. In addition, exploding demand for optical networks spawned intense investment in this area — and an acquisition binge during 2000. Among data networking companies, Cisco Systems has been the most aggressive acquirer. Cisco consummated 48 acquisitions from late 1993 through December 1999. In 2000, Cisco announced a total of 23 acquisitions. Nortel, meanwhile, completed five in 1999, and nine major acquisitions in 2000. Reflecting the difficult industry environment, in 2001, Cisco made just two acquisitions — Allegro Systems Inc. and AuroraNetics Inc. — while Nortel


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made just one. For 2002, Cisco has projected that it could make eight to 12 acquisitions, likely in the voice, storage, and optical markets. Much of the consolidation between traditional data networking equipment vendors and telecom equipment suppliers has already occurred. Among these mergers, bellwethers include the $9.1 billion acquisition of Bay Networks by Northern Telecom (now Nortel Networks, as mentioned above) in August 1998 and Lucent Technologies’s acquisition of Ascend Communications, a leader in data networking equipment, for $16 billion in June 1999. Both deals combined leaders in the data networking and telecommunications equipment markets. During 2000, the industry shifted into overdrive to tap into the burgeoning opportunities in fiber-optic gear. Over the seven-month period between October 1999 and May 2000, $11 billion in stock and cash was used to grab optical network/component companies. Some noteworthy deals of the recent past include some significant acquisitions by Cisco and Nortel. Cisco acquired Cerent Corp. for $6.9 billion and Monterey Networks for approximately $500 million (both announced in August 1999), as well as Pirelli Optical Systems for $2.15 billion (December 1999), and Qeyton Systems (May 2000); the last is a play on the high-growth opportunity for metro DWDM. Nortel’s acquisitions include Photonic Technologies for US$35.5 million (announced in May 2000), CoreTek Inc. for $1.43 billion (June 2000), Xros Inc. for $3.25 billion (June 2000), and Qtera Corp. for $3.25 billion (January 2000). While industry M&A activity slowed in 2001, reflecting the overall market slowdown and low visibility on market demand for networking gear, this environment could change during 2002. Companies are likely to be attracted to the more reasonable valuation levels in the current market, and may be ready to take on the task of integrating a new company to gain market share or enter a new market as the overall economy is anticipated to improve. Nortel/Bay Networks merger changes landscape Perhaps no merger in this industry was more criticized than the October 1994 combination of SynOptics Communications and Wellfleet Communications to form Bay Networks. Opponents argued that the two networking pioneers — SynOptics in hubs and Wellfleet in routers — would be unable to blend these disparate technologies successfully within a single company. The integration was indeed problematic and was made more difficult by distance: the companies were on opposite coasts. After the merger that created it, Bay acquired companies and technologies that filled gaps in its product line and let the firm compete in networking’s emerging growth areas. Nonetheless, poor execution in bringing out new products limited Bay’s effectiveness. Specifically, the firm was late to grasp the trend favoring switching products. This lapse hurt it financially and tarnished its reputation as a technology leader in the industry. Consequently, it became an attractive takeover candidate. The August 1998 Nortel/Bay merger speaks directly to the changing landscape of the data networking industry. It combined Northern Telecom, the No. 2 supplier of telecommunications equipment worldwide, with Bay, a leading supplier of enterprise


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networking equipment. The marriage was designed to allow the two companies to take advantage of convergence in voice and data communications. But it remains to be seen whether Nortel can overcome Bay’s decelerating hub and router product revenues and take advantage of its historically well-received switching products (recent data shows spotty success in this area). Cabletron joins the acquisition party, only to split itself up After vowing to expand its product offerings exclusively through internal development, Cabletron began making small acquisitions in 1996, and subsequently accelerated the pace and made some substantial acquisitions. Those that occurred in 1998 were the most definitive. Specifically, Cabletron acquired switch routing company Yago Systems in that year, a deal that further rounded out Cabletron’s product line and gave it the successful SmartSwitch router. As of August 2001, Cabletron completed a restructuring plan designed to leverage the strength of its momentum from the successful SmartSwitch router family by dividing itself into four separate entities. Following the spin-off of two units, Enterasys Networks Inc. and Riverstone Networks Inc., to form new publicly traded companies, Cabletron ceased to exist. Cisco’s acquisition strategy builds networking powerhouse Since Cisco became a public company in the early 1990s, most of its revenues have come from its successful router business. But Cisco was not blinded by its success in routers. Instead, it has followed the shift away from shared-media LANs (in which routers play a prominent role) toward networks based on switching technology. In the new switched-networking model, the router plays a valuable but less prominent role. With an aggressive acquisition strategy that shows no signs of abating, Cisco quickly shifted its focus to this new networking model. From 1993 through December 1998, Cisco made about 30 acquisitions, with most of its early efforts directed at gaining market share in LAN switching. Because of these acquisitions, Cisco is now a leader in the LAN switching market. During 2000 and early 2001, Cisco’s strategy shifted to focus on optical networking and transport technologies, as mentioned above. The company announced 19 acquisitions in 1999 and 23 acquisitions in 2000, most of which were concentrated on boosting the company’s capabilities in IP+Optical networks, which combine the speed of optical-based technologies with the intelligence of IP-based networks. As noted above, the company made just two acquisitions in 2001, but it plans to accelerate the pace by making eight to 12 acquisitions in 2002, with targets likely in the voice, storage, and optical markets. 3Com’s acquisitions and divestitures In an acquisition spree that began in 1992, 3Com Corp.’s largest purchase by far was its June 1997 acquisition of U.S. Robotics Corp., a modem and remote access vendor. For 3Com, this purchase marked a defining moment: it filled technology gaps in its hub and remote access product lines, and gave 3Com access to large institutional accounts and complementary geographic markets. More important, the merger with U.S. Robotics


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catapulted 3Com into Cisco’s league, making it the only other networking firm with revenues of more than $5 billion. After the acquisition, 3Com had a rocky ride, with inventory problems, merger integration costs, and margin pressures. 3Com has since reinvented itself, jettisoning traditional data networking equipment in favor of fast-growth, emerging market opportunities in broadband access, wireless access, and IP telephony. How The Industry Operates Although computer networking has attained widespread strategic importance in corporate America only in the past 10 to 15 years, various forms of computer networks have been around for decades. Over the years, the network has increased in complexity, but its underlying principles are still simple. At its most basic, a network consists of two or more computers connected together by a cable that allows them to exchange information. Today’s networks are typically far more complex, involving a collection of computers, printers, and other devices that communicate with each other over some transmission medium. Data networking equipment is the hardware that constitutes the infrastructure of a network. The hardware consists of various switches, hubs, routers, network interface cards, and other devices, all of which provide communication between the network’s components at varying levels of speed and service. Computer technicians configure the network components and string these items together to create the network. Networking firms often sell software (e.g., Cisco System’s IOS software) and provide services for monitoring and managing networks. Demand for data networking equipment, fueled in part by the rapid growth of the Internet and intranets (private networks), helped the industry grow from approximately $15 billion in annual sales in 1995 to some $50 billion in 2000, according to estimates by Cahners In-Stat Group. As the role of network computing has expanded in the corporate environment as well as in daily life, the exploding number of users has led to the development of new technologies to boost speed and capacity. THE EVOLUTION OF COMPUTER NETWORKING The first networks were pioneered by IBM Corp. and Digital Equipment Corp. (now owned by Compaq Computer Corp.) in the 1960s and 1970s and were designed to support the computing environment introduced by the mainframe computer. From the 1970s to the 1980s, minicomputers and wide area networks (WANs) characterized networked environments. The personal computer (PC) revolution and local area networks (LANs) ushered in the next major technological shift, which occurred primarily during the 1980s through the early 1990s. Today, the emphasis in the networking equipment industry is on internetworking. Largely involving high-speed switching and routing, the networking of today is expected to continue


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to fuel the industry’s growth through at least the next several years. Meanwhile, momentum is building for converged networks, which combine voice, video, and data on a single network, and would be based on IP, or Internet Protocol. This emerging growth area appears poised to fuel healthy demand for networking equipment for the future. The mainframe and the minicomputer In the 1960s, the mainframe was the major computing platform in most businesses, and it was the first to dominate network architecture. Developed by IBM, the proprietary mainframe-centered network provided simple and stable connections. Under this environment, IBM’s System Network Architecture (SNA) applications ran on the mainframe, groups of terminals were attached to controllers, and controllers in turn were connected to the front-end processor by point-to-point cables (for local terminals) or telephone lines (for remote users). Many of these simple but effective networks are believed to still be in use. In the mid-1970s, with the rising popularity of minicomputers, a slightly different version of computer networking emerged. Compared with large, expensive mainframes, minicomputers provided a more flexible and cost-effective form of computing. Consequently, many users began to move key applications and data to these new platforms. This “changing of the guard” in corporate computing created a need for new networking solutions. Instead of using controllers and front-end processors to provide access to corporate information, terminals were attached directly to ports on the minicomputers. Digital Equipment, the driving force behind the minicomputer revolution, introduced the terminal server to act as an intermediary between terminals and the host computer. Terminal servers were connected to minicomputers through a 10 Mbps (megabit, or million bits, per second) ethernet LAN. While these changes in networking architectures were subtle, their effects were significant in that they lessened IBM’s dominance as a networking provider. The new technology created room for competitors to enter the field, and several upstart networking vendors began to offer alternatives to IBM’s version of networked computing. Even IBM shifted from its mainframe-centered networks, replacing the point-to-point cables attaching clusters of terminals to mainframes with Token Ring local area networks. The PC and the shared bandwidth era In the 1980s, the dramatic inroads made by the PC meant that more users needed to share resources and peripheral devices. The answer was the network, which allowed users to share not only files but also disk drives and printers. Fundamental to this shift was the growing popularity of LANs, which joined users in a small geographic area. WANs, in turn, interconnect LANs across normal telephone lines (and other media). The Open Systems Interconnection (OSI) reference model (see the “Glossary” section of this Industry Survey for further explanation) provides the conceptual framework for one computer to communicate with another; communication protocols make the communication possible.


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Communication protocols describe how information from a software application in one computer moves through a network medium to a software application in another computer. They are largely categorized into LAN protocols, WAN protocols, network protocols, and routing protocols. Networking protocols include Xerox’s Ethernet or IBM’s Token Ring. These are based on the concept of shared bandwidth — that is, a configuration in which end users compete for the right to send and retrieve information over the network. The shared-bandwidth era spawned a host of new products that remain critical components in today’s mainstream networks. Intelligent hubs (the central wiring device for LANs) were introduced to replace the thick and expensive cables to each individual terminal. In the PC’s early years, bandwidth availability was not a major issue, but as more users were added to each network, the systems became bogged down. Corporations tried to alleviate congestion by segmenting their networks into smaller and smaller groups. The rationale for segmentation is that if fewer users compete for transmission time, bandwidth availability will remain high. Bridges and routers, described below, are two common hardware devices used to segment a network. Bridges. These box-like devices provide a basic connection between two similar but physically separate LANs — between two ethernet networks, for example. Unlike routers, bridges are protocol-independent, and they forward packets (a “packet” is a unit of data sent across a network) without analyzing and re-routing messages. Compared to routers, bridges are less costly and somewhat faster, but they are also less intelligent than routers. Bridges are usually deployed in small, relatively simple network environments, since they “scale” well — that is, they enable the scope of a network to broaden. Routers. Routers are advanced interconnection devices that provide links between LANs that use different protocols. For example, they may be used to connect a Token Ring network and an ethernet network. After evaluating and compensating for such factors as network congestion and the distance between a transmission’s source and destination, they pick the best path for moving a packet of information closer to its destination. Although routers are more reliable and secure than bridges, they’re also more expensive and often slower. Consequently, routers are generally used in larger multiprotocol networks. Switching technology boosts bandwidth Although bridges and routers have been used to alleviate network congestion, neither device increases network bandwidth. To use a highway metaphor, a bridge or router can connect two “roads” (individual networks) to even out traffic along each. They cannot, however, widen either road. Widening the road — that is, increasing the bandwidth — has become critical as the Internet and a growing number of intranets place greater demands on networks. Switches have emerged as the fastest-growing solution to meet this need. Switches offer dedicated bandwidth to each user, and thus each device has access to the network’s full transmission speed. For example, an ethernet switch would dedicate 10 Mbps of bandwidth to each of 10 users, for a total capacity of 100 Mbps. In contrast, in a nonswitched ethernet network, the 10 users would share a total of 10 Mbps.


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The deployment of switches is also extremely cost-effective compared with traditional router solutions; switches cost several hundred dollars less per port, due mainly to their limited software make-up and lower support costs. Switches that include routing technology have become more popular as a way to meld the intelligence of routers with the speed of switches. In the following section, we briefly discuss the different types of switching available to end-users. Ethernet switching. Having turned 25 years old in May 1998, ethernet now accounts for roughly 80% to 85% of all networking connections worldwide. In a traditional ethernet environment, a packet of data is sent out, or broadcast, over the entire network. Each ethernet-equipped computer, also known as a station, operates independently of all other stations on the network. To send data, a station first listens to the channel, and when the channel is idle, the station transmits its data in the form of an ethernet packet. However, since ethernet interfaces are equal in their ability to send frames onto the network, two interfaces can sense that the network is idle, and transmit simultaneously. When this happens, the ethernet system has a way to sense the “collision” of signals, stops the transmission, and resends, which can result in network congestion. Ethernet switching, introduced in the late 1980s, provided an immediate bandwidth boost. This is because in a switched environment, an information packet is sent directly to its destination. This allows the network to be divided into multiple smaller segments and provides the full available bandwidth to each port. Because ethernet switches are relatively low in cost, they have become widely used devices in networks. Fast ethernet. Gaining popularity in the 1990s, fast ethernet offered a tenfold improvement over ethernet, providing a maximum of 100 Mbps of shared bandwidth. Although two fast ethernet implementations (100BaseT and 100VG-AnyLAN) are available, 100VG-AnyLAN is not widely deployed, and 100BaseT has become the fast ethernet standard. The popular 100BaseT owes its success to widespread support from the vendor community, including 3Com, Cisco Systems, and others. Another key advantage is that it can be implemented on unshielded twisted pair (UTP) cable, that is, ordinary telephone wire. In addition, the conversion from ethernet to 100BaseT does not require installing new adapter cards or switching hub modules. On the other hand, 100BaseT has a number of drawbacks. One disadvantage is that although 100BaseT is fine for small groups, performance degrades when the network must support more than 10 users. Second, the protocol awards transmission to users on a first-come, first-served basis. Finally, 100BaseT supports a network diameter of only 250 meters, about one-tenth of the maximum length of a segment in 10 Mbps ethernet. For connections beyond this distance, additional routers are required. Gigabit ethernet. Gigabit ethernet is the latest high-speed switching technology to be introduced to the networking industry. Gigabit ethernet’s advantages are that it is fast,


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relatively inexpensive, fault tolerant, and can work with equipment made by different manufacturers. It is also able to leverage existing ethernet technologies, enabling management ease of use and competitive cost. Offering network speeds of up to one gigabit (one billion bits) per second, gigabit ethernet compares impressively with fast ethernet’s 100 Mbps speed. The gigabit ethernet standard was reached in June 1998, and the technology has been gaining momentum ever since. The standard for 10 gigabit ethernet (10 gigabits per second) was not ratified as of December 10, 2001. (For more about the 10 gigabit ethernet market, see the “Current Environment” section of this report.) Token Ring switching. The rise of ethernet switching has come at the expense of Token Ring networks. Token Ring networks transmit data (or a “token”) around a defined circular path from computer to computer. Each node (a node is a client in the ring) is polled to see if it has information to send. Only the node that chooses the token is allowed to transmit data. The Token Ring switching process is simpler, faster, and less costly than traditional LAN internetworking devices; however, ethernet switches are even simpler and cheaper. Fiber distributed data interface (FDDI). FDDI describes a network that is a dual ring architecture offering 100 Mbps token-based transmission over fiber-optic cable. The advantages of fiber distributed data interface, or FDDI, include transmission rates of up to 100 Mbps over a distance of up to two kilometers, built-in network management, and fault tolerance. While finding acceptance for use in highly intensive corporate applications, FDDI has not won greater acceptance in the mainstream networking community because of its premium price. Asynchronous transfer mode (ATM). ATM supports speeds of 25 Mbps to 622 Mbps. As ethernet prices have gone down and speeds have gone up, the future of ATM remains hotly debated. A key advantage of ATM technology is the protocol’s ability to transmit voice and video signals as well as data. The convergence of voice, data, and video technology, a trend long forecast by experts, is finally gaining momentum. With telecommunications companies entering the networking arena and traditional network companies acquiring companies with voice and video technology, voice and data are rapidly converging. Indeed, many telephone networks have used ATM in their networks in the past, attracted by its QoS (Quality of Service) characteristics. COMPETITIVE LANDSCAPE: NEW TECHNOLOGIES, NEW PLAYERS As with any high-growth segment of the technology industry, competitive conditions can change quickly and dramatically. In the mid-1990s, four vendors dominated the networking industry: Cisco Systems, 3Com Corp., Bay Networks (acquired by Northern Telecom in August 1998), and Cabletron Systems Inc. (which in August 2001 essentially split itself up to create two new companies: Enterasys and Riverstone). The ability of these networking companies to identify the market opportunities presented by the various technologies and devices mentioned in the section above, and exploit those opportunities, has been a key factor in determining their competitive positions today. For


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example, all of these companies were early beneficiaries of the shared-media revolution during the 1980s, and each dominated in one product area. Bay and Cabletron were leaders in high-end hubs, Cisco in routers, and 3Com in network interface cards. However, the competitive landscape began to shift in 1996 because Bay and Cabletron were late to embrace new switching technologies. In the following section, we take a closer look at the industry’s competitive structure and the roles that acquisitions and spin-offs have played in shaping the landscape. (Acquisitions are also discussed in the “Industry Trends” section of this issue.) Consolidation begets spin-offs The networking equipment industry witnessed significant consolidation over the 1997–98 timeframe. Among major moves, Nortel acquired Bay Networks in 1998, and Lucent Technologies acquired Ascend Communications. But now some of the large players are looking to spin off their enterprise data networking divisions as they pursue the high growth opportunities in supplying equipment to service providers envisioned for the long-term. As part of this new trend, Cabletron Systems, whose fortunes had dramatically lagged those of its peers in the mid- to late 1990s, essentially divided itself into two separate publicly traded companies. 3Com has sold its LAN and WAN chassis-based networking gear units as well as its analog modem business. Meanwhile, Lucent spun off its enterprise network division. (Called Avaya Inc., this spin-off was completed in September 2000). Start-ups and other incumbents, while certainly a concern to the traditional vendors, have gained only a small share of the overall networking industry equipment market. Fiercely competitive market dynamics, combined with rapid technological change and growing customer demand for a single vendor to provide all networking requirements, have made it difficult for new entrants to make major inroads, and are mainly viewed at point-product alternatives. In the world of technology, however, nothing is ever static. The push for faster networks powered by new high-speed switching technologies, and the convergence of data and voice networks, have fostered competition and accelerated the role of mergers and acquisitions in the industry. The industry’s participants are thus facing new challenges and challengers, and the competitive landscape could drastically change again over the next several years. Acquisitions and market dynamics are blurring distinctions among the following groups of competitors: Cisco sets the pace. By virtue of its size and its dominance of the industry, Cisco sets the standard by which all competitors are measured. Since 1994, when the original Big Four (Bay, Cisco, 3Com, and Cabletron Systems) were virtually identical in size, based on revenues, Cisco has grown at a multiple of its peers. Cisco’s revenues reached $24 billion in 2000, compared with the less than $4 billion reported for 3Com, the next-biggest player at that time. Indeed, as Cisco penetrated the telecommunications equipment market, its revenue growth also outpaced rivals Nortel and Lucent during 2000. Even in the downturn of 2001, Cisco fared better than its rivals, and its balance sheet remains strong.


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This impressive growth record has come from the company’s aggressive acquisition strategy, effective marketing, and excellent execution. While the company decelerated its pace of acquisitions during 2001, during recent years, the company has steadily targeted fast-growing new markets through its own technology or via acquisitions, pushing its rivals into a constant search for a competitive response. Cisco continues to capitalize on its position as an end-to-end networking vendor. Partly thanks to its higher-end mix, the company appears solidly ahead of its peers. All vendors must react to Cisco’s actions or risk being left further behind. Other large networking vendors. 3Com, before its recent exit of the enterprise market, had been the industry’s second largest player. While Cisco’s consistent execution put that company in the leadership position in data networking gear for large corporate enterprises, 3Com’s execution was less than stellar, and that led to its exit of this business. Some of 3Com’s traditional products are now being reengineered specifically to target the market for equipment for carriers and Internet service providers. In June 1997, 3Com merged with U.S. Robotics Corp., the market leader in modems and remote access technology, in a deal valued at $6.6 billion. The merger catapulted 3Com’s revenues upward, significantly closing the revenue gap between it and Cisco, and pushing it further ahead of the rest of the pack. For some time after the merger, however, 3Com encountered problems with inventory levels and other transition issues, which caused its growth to slow. The industry’s other large vendors regularly compete head-on with Cisco and 3Com for corporate customers. Included in this group are Nortel (reflecting its acquisition of Bay), Enterasys Networks (spun off by Cabletron in August 2001), and Newbridge Networks (which was acquired by Alcatel in May 2000). Niche vendors/start-ups. Niche vendors are companies that specialize in only a few segments or technologies (such as ATM, remote access, and so on), as opposed to providing the end-to-end solutions offered by the major network equipment companies. Over the past year, many have been acquired, as data communications and telecommunications equipment companies are attempting to gain a foothold in the market for converged networks. Among the niche vendors that have been acquired is Ascend Communications, the largest such company, which was purchased by Lucent Technologies in June 1999. (Ascend had acquired Cascade Communications in mid-1997.) Lucent, via its ownership of Ascend, is a major player in remote access. Shiva Corp., also a remote access vendor, was acquired by Intel Corp. in early 1999. ATM leader FORE Systems was acquired by General Electric Co. plc in June 1999. Many niche vendors witnessed sharply reduced revenue growth as larger players broadened their product lines and as major customers increasingly sought entire network solutions, not just components. In addition, recent start-up companies have emerged in the networking industry, focused on competing for the service provider market. These include Juniper Networks Inc. and Sycamore Networks Inc., as well as Foundry Networks Inc., Redback Networks Inc., Riverstone Networks, and Extreme Networks Inc., all of which serve certain high-growth networking equipment product categories, and thus lack the product breadth of major industry players. Juniper has achieved the greatest penetration so far, garnering some 30% of


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the Internet backbone router market, according to the Dell’Oro Group, a leading market research firm based in Portola Valley, California. Telecommunications equipment companies. As signaled by the acquisitions of Bay Networks by Nortel and Ascend by Lucent Technologies, the convergence of voice, data, and video technologies has the potential to transform the networking industry and its competitive landscape. In this period of rapid technological change, the major telecom equipment companies must migrate into data networking or risk falling behind the competition. For Cisco and the other networking equipment leaders, this is good news. Telecom carriers that need networking equipment represent a new market opportunity. However, Cisco and others will now face many new competitors. The ability to stay on the leading edge will be critical as traditional networking companies come up against the competition that has the advantage of older relationships with telecommunications providers. Networking divisions of large computer firms. Large computer vendors like Hewlett-Packard Co. and semiconductor market leader Intel Corp. maintain networking hardware divisions of varying sizes. In 1999, IBM announced the purchase of certain networking intellectual property by Cisco Systems. However, these divisions have yet to pose a serious threat to the networking giants. THE BOTTOM LINE In this fast-paced environment, competitors must understand the dynamics of the customer base to meet the changing needs of the marketplace. New product development is essential, and transitions to new technology present an ongoing challenge. Marketing and distribution are the final critical parts of the equation. In the following section, we discuss these operational keys to success. Major customer groups Networking players are vying for customers in essentially three key market segments. The first consists of enterprise customers, including large corporations, and government and educational organizations. The second is service providers — firms that provide data communication services — including telecommunication carriers, cable companies, wireless communication providers, and Internet service providers. The third category comprises small and midsize businesses, home offices, and residential users. Product transitions key to success For vendors, growth depends on successfully navigating the straits of rapid technological change. Compared with most other industries, networking companies typically invest heavily in research and development (R&D) — often 10% or more of sales. Such outlays are crucial in that they enable network companies to identify new product opportunities and bring products to market in a timely manner. Industry participants must be constantly alert to changes in technology and end-user buying patterns. The rapid transition to switching products in recent years serves as a good example of what can happen when companies successfully navigate (or miss) key product transitions.


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Keenly aware of the marketplace shift to switching, Cisco embarked on a series of acquisitions beginning back in 1994 to boost its exposure to this fast-growing, strategic market. On the other hand, Bay Networks was slow in getting new switching products to market, and as a result, its revenue growth suffered. In another example, the move to higher-speed optical interfaces on fiber optic equipment (OC-192) was missed by Lucent Technologies during 2000, to its financial detriment. Meanwhile, Nortel was able to capitalize on the high demand for the gear, and prospered for most of that year (although it later suffered from the general telecom equipment slowdown). Often, the miss of an important product transition leads customers to question a vendor’s long-term vision and future product roadmap. Product forecasting, manufacturing crucial The ability to forecast demand properly and execute manufacturing initiatives is key to the success of networking hardware vendors. At times when the industry has witnessed unexpectedly strong end-user demand for such items as network interface cards (NICs) and switches, a premium was placed on a vendor’s ability to have the right amount of product available at a moment’s notice. This means making assumptions about the demands of hundreds of thousands of customers across many geographic markets. Failure to meet this challenge can lead to lost sales, as well as an undesirable inventory mix. Recently, many networking equipment vendors have been outsourcing the manufacturing of certain products to contract manufacturers. This trend appears to be in.creasing, as demand for networking hardware accelerates. Most components used by networking companies in the production process are based on industry standards and are available from several suppliers. In some instances, however, there’s only one source, which raises the risk that the supplier will be unable to meet demand for the component in a timely and cost-effective manner. Distribution options grow As revenue opportunities in the networking industry grow rapidly and become more global, vendors have been forced to use a variety of channels to bring products successfully to the market. Many vendors use a two-tiered approach: a direct sales force to service large corporate customers, and distributors and resellers (or “indirect sellers”) to service smaller corporate accounts and international customers. Cabletron, before it spun off Enterasys and Riverstone Networks, had been the only exception, relying primarily on its direct sales force, although its spin-offs have broadened their reach via channel reseller agreements. The two-tiered approach allows for greater market coverage, but also presents some challenges. First, products sold through resellers typically carry lower margins than those sold through direct channels. Vendors must offset these lower profitability levels with increased volumes or lower overhead. Even more important, companies that rely heavily on indirect sales channels face a greater challenge in gauging end-user demand and managing inventories. Failure to monitor indirect distribution channels properly can result in overly optimistic sales forecasts and resultant inventory imbalances. In early 1998, for example, 3Com had unacceptably high inventory


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levels in its distribution channels due to lower-than-expected demand. To combat this, 3Com decided to halt production of certain products for a short time until the clogged channels cleared. Obviously, the impact on sales was dramatic and negative. The Internet is a distribution channel quickly gaining in importance. In fact, Cisco Systems has reported that it books roughly 90% of its orders over the Internet. GLOSSARY Asynchronous transfer mode (ATM) — A high-speed switching technology for transmitting multimedia information across a wide area or local area network. ATM divides information into fixed-length cells and can transmit different types of traffic (voice, video, and data) simultaneously. Backbone — A network’s high-bandwidth, main connection path (lines, cables, and connections) that carries the most traffic. Smaller data paths, connected by routers or bridges, branch off from the backbone. On private networks, backbones often are used to carry messages between different departments of a company. On the Internet, backbones link regional segments of the public network. Bandwidth — A measure of the information-bearing capacity of a communications channel, usually denominated in bits per second. Bandwidth varies according to the type and method of transmission. Bridge — Like a router, a bridge joins two segments of cabling; it performs limited network traffic-control functions, such as segmenting the network into subsets. Local bridges connect physically proximate networks. Remote bridges connect geographically disparate networks by transmitting data over ordinary phone lines or via satellite. Broadcast — The generation and delivery of a packet to all workstations on a network. Cabling — The lines that physically link devices on a computer network and that allow information to flow from one device to another. The two most common types of cable used in networks are coaxial cable and standard telephone wire. Fiber-optic cable is also popular, because it moves large amounts of information at extremely high speeds. Client/server model — A model of computing in which one computer (the server) acts as a central storage area for data and software programs, which can be accessed and manipulated by other computers (the clients — usually PCs or workstations) that are linked to the server via a network. Digital subscriber line (DSL) — A high-speed technology for transmitting high-bandwidth information over ordinary copper telephone lines. Individual connections run at speeds from 512 Kbps to 6.1 Mbps. Several variations of DSL exist; when referring to all forms, the term xDSL is sometimes used.


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Enterprise — Large organizations with complex networking needs, usually spanning multiple locations and types of computer systems. Enterprise customers include corporations, government agencies, utilities, and educational institutions. Ethernet — A 10 Mbps standard for network communications; the most popular standard in LAN networking today. In an Ethernet network, a packet of data is sent out (broadcast) over the entire network, and only one device can send data at a time. Devices on an Ethernet network constantly monitor the network, checking for packets directed to them and ignoring those that are not. Fast ethernet — Also known as 100BaseT, fast ethernet is a high-speed version of Ethernet, transmitting at speeds of 100 Mbps rather than 10 Mbps. Fiber optics — A technology in which light, rather than electrical energy, is used to carry data. Fiber-optic cable, made of thin filaments of glass, can carry up to 30,000 times as much data as copper wires using electrical signals. File server — A computer on which applications, data, or both reside. Most servers are “dedicated,” that is, they are used only to provide data, applications, and processing power to other computers that are connected to them, and to control and monitor the network. Gateway — A device for connecting networks that do not use the same architecture; e.g., a network of PCs and a network of workstations and file servers. A gateway is often a network’s most complex component. Gbps — Gigabits (one billion bits) per second; a data-transfer speed measurement for high-speed networks. Gigabit ethernet — A high-speed version of ethernet, with transmission speeds of one Gbps. Header — Control information added to the beginning of a transmitted message; contains the packet address, destination, and routing instructions. Hub — The site where all the various network cabling intersects. An “enterprise” hub supports multiple networks in a single chassis; such hubs are usually found in corporations. A “stackable” hub is a stand-alone wiring concentrator that supports a small number of users (usually fewer than 25); as more users are added, more hubs can be stacked on top of those already in place. Integrated services digital network (ISDN) — A standard developed in the mid-1980s that provides the fastest way to access voice and data services over public digital networks. ISDN offers bandwidth speeds of 128 Kbps to 1.5 Mbps. While DSL is faster, ISDN is a more mature, standardized technology that is used worldwide. Internet Protocol (IP) — IP specifies the format of packets and the addressing scheme. Most networks combine IP with a higher-level protocol called Transport Control Protocol (TCP), which establishes a virtual connection between a destination and a source. IP is like a


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postal system: a package that is addressed and dropped in a mailbox can be delivered, although there’s no direct link between the sender and the recipient. TCP/IP, in contrast, establishes a connection between two hosts so they can send messages back and forth for a period of time. Internetwork — Two or more networks connected by bridges or routers. Layer 3 switching — An emerging technology in which high-speed routing is built into LAN switches. (Its predecessor, Layer 2, doesn’t perform routing.) Because Layer 3’s routing capabilities are built into the hardware, rather than software, it also costs less than high-end routers. Layer 4 switch — A network device that integrates routing and switching. When packets are inspected at Layer 4, the forwarding decisions are made based on the type of application being serviced. Local area network (LAN) — Two or more computing devices that are connected in order to share data and peripherals. Mbps — Megabits (one million bits) per second. Metropolitan area network (MAN) — This is a data network designed for a town or city. MANs typically cover a larger geographic area than LANs, but are smaller than WANs. In addition, MANs typically feature high-speed fiber optic cable connections or other digital media. Network interface card (NIC) — A small computer component installed in each device on a network (including file servers, workstations, and printers) that allows these devices to transmit and receive network signals. Also known as an adapter card. Open system interconnection (OSI) model — The OSI reference model was developed by the International Standards Organization and first published in 1978. It describes the process of network communication, facilitates communications among computers from different manufacturers, and provides a common basis for coordinating international standards. Its seven layers, from the bottom up, are as follows: • Layer 1, the physical layer, handles bit transmission between one node and the next. It

involves a connection between two machines that allows electrical signals to be exchanged between them.

• Layer 2, the data link layer, maintains a reliable communication link between adjacent nodes by checking for errors.

• Layer 3, the network layer, establishes a path for the data packet traveling along the communication subnet from the source node to the destination node.

• Layer 4, the transport layer, provides reliable data transportation between a sender and a receiver.

• Layer 5, the session layer, establishes, maintains, synchronizes, and manages dialogues or sessions between communicating applications.


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• Layer 6, the presentation layer, is responsible for the presentation of information in a way that is meaningful to users. This layer establishes the syntax in which data are exchanged between the two hosts.

• Layer 7, the application layer, provides a means for application processes to access the system interconnection facilities in order to exchange information. The end user interacts with this layer.

Packet — A unit of data sent across a network; also called a datagram. A packet carries an address header and control information. Protocols — Rules that regulate the transmission of information moving through a computer network. Different systems are employed to deliver signals from one device to another and to prevent packets of information from crashing into one another. The protocol used in a particular network (such as Ethernet or Token Ring) is usually determined by the adapter card or network interface card. Repeater — A device that boosts or amplifies a signal as it travels along the network. Repeaters are used to extend a network’s geographic reach. Router — A device that connects two LANs. Routers are similar to bridges, but provide additional functionality, such as the ability to filter messages and forward them to different places based on various criteria, using address information. The Internet uses routers to forward packets from one host to another. Service providers — These customers provide data communication services, and include telecommunication carriers, Internet service providers, cable companies, and wireless communication providers. Token Ring — A networking architecture that operates at a speed of four or 16 Mbps. Clients in a Token Ring have the ability to transmit data while they are in possession of a token (a predetermined formation of bits) that passes continuously from client to client. Topology — A term that refers to the way devices in a computer network are wired together. The topology is like a string of Christmas tree lights: network devices or nodes are attached at various points along a continuous length of cable (often referred to as the backbone). Ring topology is also based on a continuous length of cable that forms a closed circuit. In star topology, each device on the network is attached to a central hub by individual cables that radiate out from the hub. Virtual private network (VPN) — A network that supports private data traveling over public Internet protocol infrastructure. Wide area network (WAN) — A network that extends across a larger geographic area than a LAN and in which telecommunication links are implemented. Copyright © 2002 by Standard & Poor’s All rights reserved.

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