Manufacturers: despite a dip amid the recession, demand is destined to grow over the long term to keep up with an explosion of Internet traffic

[investors bus. daily] To understand the networking gear market, you need to learn three basic things.

First, despite a dip amid the current recession, demand is destined to grow over the long term to keep up with an explosion of Internet traffic, online data, videos, games and text messages.

Second, Cisco Systems is the industry's undisputed gorilla. The company has a foothold in nearly every aspect of networking, though a strong cast of rivals competes against Cisco for certain subsets of this market.

Third, forget everything else you know about the business -- this lucrative market is about to enter a state of flux.

Worldwide sales of networking gear are expected to top $117 billion this year, according to market research firm Dell'Oro Group. Vendors are merging or partnering to bulk up and grab more market share. And technological change is a constant.

For instance, cloud computing and virtualization are becoming big trends for data centers, and both require reliable, high-capacity networks. At the same time, mobile phone carriers must continually roll out new services to please consumers.

This spring, Cisco alienated its longtime sales partners Hewlett-Packard and IBM by launching its own competing line of servers. Cisco envisions an integrated system that bundles networking, processing power and storage into a unified package.

Meanwhile, computer giant HP has elbowed into the networking market with its own ProCurve line of products. Such shifting dynamics are creating new alliances for vendors such as Juniper Networks, Brocade Communication Systems and possibly Netgear and Extreme Networks.

1. Business

Computer networks are critical for any information-based economy. Networking equipment is essential for connecting digital devices to each other and moving data from point A to point B. Networks transmit packets of electronic data so users can talk or share information. Cell phone calls, Internet searches and Web transactions would all be impossible without a solid foundation of networks.

As the Internet proliferates and analog media goes digital, corporations, governments and universities will depend more and more on networking gear.

Networking equipment makers have a range of business models. Some build their own gear. Others contract for most supplies and simply assemble the systems.

Riverbed Technology focuses much of its research-and-development budget to build complex software that runs on cheap commodity hardware. The approach leads to large gross margins -- anywhere from 60% to 80% -- according to Eric Wolford, Riverbed's senior vice president.

"Building your own custom hardware is expensive, often involving the design of (computer) chips and boards," he said. "This gets you into a high capital-expense business and a much different model than we use."

While the barriers to entry are low in any given niche of networking gear, building a broad portfolio of products and earning the trust of buyers is tough.

The old saying "Nobody ever got fired for buying IBM," could easily apply today with Cisco. The more dependent a customer is on their network infrastructure, the less they're willing to risk on a newcomer.

But that hasn't stopped a slew of small firms from entering the market to cash in on a flood of bandwidth-hungry digital music, on-demand movies, videoconferencing and YouTube video. And the amount of data moving through corporate networks is growing at 60% to 100% per year, according to Brocade CEO Mike Klayko.

"We provide technology and services to a marketplace with an appetite that can't be satisfied," Klayko said. "When I look out at this market and see our growth opportunity from my standpoint, I'm kind of giddy."

Brocade got its start in storage-area networks used to archive data. Last year, Brocade paid $3 billion for Foundry Networks, which makes network switches for Internet traffic. As a result, Brocade is partnering with HP and it appears to be taking market share from Cisco, says Ryan Hutchinson of Lazard Capital Markets.

Brocade's integration of Foundry is "proceeding very well," according to a research note from Hutchinson on May 13.

"Our checks indicate that Brocade and HP will likely announce a formal relationship to sell Foundry products," he wrote. "We believe this is an effort to counterbalance Cisco's recent entry the server market."

Cisco CEO John Chambers recently cited the wild popularity of online videos as the next killer app for networks. Toward that end, Cisco in March bought Pure Digital Technologies, makers of the Flip mini camcorder. Analysts expect more market maneuvers from Cisco and its rivals.

Name Of The Game: Provide reliable equipment to telecom and enterprise customers at the right price. And continually innovate with new features and services.

2. Market

Networking gear customers buy a broad range of equipment. Most networks involve routers to direct the flow of traffic and switches to branch data off into different certain nodes and devices.

Local area networks, or LANs, connect computers across a company or campus. Metro area networks move data around a city. Wide area networks, or WANs, transmit data across states and continents.

The industry serves three main customer groups. One is gear for telecom service providers, or carriers, to build wired public networks. This segment includes underground cables made of copper and optical fibers. Sales of such wireline products for service providers are expected to decline 8% this year over last year to $35.7 billion, according to Dell'Oro Group.

A second subset involves the equipment that carriers use to build wireless networks for cell phones and other mobile devices. This market is set to fall 3% this year to $42.1 billion.

The last subset involves products to build private networks for enterprise clients. This group includes ethernet switches to link up computers as well as storage-area networks, which pool storage devices. Sales of such enterprise networking gear should fall 9% this year to $39.5 billion.

Cisco is the market's dominant leader. But buyers have other options depending on which products they need from each category, notes Shin Umeda, an analyst with Dell'Oro Group.

"This is a technology-based industry, so products tend to change rapidly," he said. "Many competitors don't have the breadth of Cisco, but they can still compete in certain technologies."

3. Climate

The networking market has entered an era of consolidation as vendors seek out an advantage. For instance, 3Com is a former highflier that's working on a comeback through a joint venture with Huawei Technologies of China. 3Com bought Huawei's business for enterprise routers and switches so Huawei could focus on its core carrier gear.

In just five years, 3Com has risen to market parity with Cisco in China, according to Ron Sege, 3Com's chief operating officer. This month, 3Com launched its new H3C switches -- short for Huawei-3Com -- across Asia, Europe and Latin America. The growing market competition in China is "very interesting" because most companies there are only building out their networks now, Sege says.

"Our strategy is to be successful in China and leverage that strength in China to the rest of the world," he said. "I think there's a tremendous opportunity for us."

3Com is trying to emulate Cisco as a "one-stop shop" for its customers, according to Jay Zager, the CFO of 3Com.

"We offer our customers a value proposition with a full set of products and solutions," Zager said. "All the others have to form some partnerships to provide a complete offering."

4. Technology

The most pressing issue for data center managers today is doing more with less, while curbing energy costs and carbon emissions in the process. They're trying to squeeze more out of fewer data centers by centralizing them using technologies such as virtualization and cloud computing.

That means more computing resources will be remote, rather than on-site, transmitting information back and forth over networks, says Eric Wolford, chief executive of Riverbed Technology . Products from Riverbed improve the speed and performance of wide area networks.

"We see a major trend toward data center consolidation and virtualization," Wolford said. "This massive industry trend is wind in our sails because it increases the distance between end users and their data."

5. Outlook

The deluge of digital information will continue to fuel demand for bandwidth. The question is, can network gear buyers afford to keep up.

Upside: The Internet continues to change the world. An increasingly networked planet will put new demands on carrier loads and require ever more reliable networks.

Risks: If the worldwide recession lingers too long, there will be no escaping the downward draft for all tech companies.

Nortel Networks just filed for bankruptcy in January. Other network gear makers could see extended delays of future purchases as clients put off moving to next-generation systems.

"There are no safe houses now," says analyst Umeda. "The global economic problem is very pervasive."

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