Cisco Paid $6.9 Billion for Cerent but Can Still Manage to Smile

Let's just say Cerent is Cisco's Lucent-Nortel killer.
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We happened to be in Petaluma, Calif., last week visiting one of our portfolio companies,

Advanced Fibre Communications

(AFCI)

. Petaluma is not what you'd call cosmopolitan: There are lots of cows and the stench of manure is everywhere. But the area is quickly becoming the telecom equipment annex to Silicon Valley.

Advanced Fibre owns 5.5% of

Cerent

, the company

Cisco

(CSCO) - Get Report

just paid $6.9 billion to buy. That 5.5% means they will soon have $350 million plus of Cisco stock on their balance sheet. I reminded Advanced Fibre's chief financial officer that only in bear markets do investors pay a multiple of book value or cash value -- in bull markets, it is always multiples of earnings.

Of course, everyone is wondering: What was Cisco thinking? They paid $6.9 billion for Cerent, which did just $10 million in revenue the last six months. Can anything be worth that much? But the answer, if you study the chessboard thoughtfully enough, is that Cerent probably is.

The word in the valley was that Cisco's opening offer to the company was only $600 million. But then Cerent had a series of quota-beating months in a row. And they used the oldest trick in the M&A book: When you can't agree on price, file an S-1 to signal your willingness to go public (which they did on July 22) and get the acquirer to pay up.

So, you may be asking -- what is the strategic fit? It's much more than adding waveform-division multiplexing equipment to Cisco's product line. Cisco is not so quietly amassing everything they need to be

the

telecom equipment supplier going forward.

Ciena

(CIEN) - Get Report

is also in the multiplexing business, but while Ciena provides equipment for the long-haul market, Cerent's gear is both short haul and provides the add/drop directly to/from the big intercity fiber-optic backbones. And their products fit under a huge pricing umbrella established by offerings from

Lucent

(LU)

,

Nortel

(NT)

and

Siemens

.

What Cisco bought was more than an interesting product line. It was some very smart people -- with quite a different expertise than that of the data-communications world. These guys are more akin to physicists than programmers.

But to really understand what Cisco's doing, walk with me through the underlying technology and where it is headed. There is too much to explain, and not enough room, so please excuse the lack of detail.

Today's Data Networks

Today's current data networks are overkill, as they are built on top of existing voice-telephone networks. A Cisco router looks at the headers of incoming message packets and decides where they should be routed. A router may have 24 outputs, and it decides to which one of them it should zip the packet.

This router usually sits on the edge of a big backbone network composed of fiber-optic lines, many of which are high-speed asynchronous transfer mode, or

ATM switching networks. The two makers of ATM switches are

Cascade

-- which is inside of Lucent by way of

Ascend

-- and

Stratacom

, which is inside of Cisco. So this is a business for the big boys.

These ATM switches also decide where to move message packets, but at really high rates of speed, and perhaps fewer port options than a router. One of these frequently is a very high-speed

SONET port -- i.e. a synchronous optical network port -- that sends the packets down a fiber line between two cities.

SONET is a protocol for splitting data carried over fiber lines by using time-division multiplexing. It is used by phone companies to handle thousands of phone calls on a fiber line, with very high reliability. SONET does this through redundancy: It is implemented in a ring composed of two strands of fiber, where information is duplicated and goes simultaneously in both directions around the ring. If one fiber gets cut (construction backhoes are a constant source of problems), SONET senses it and uses the backup information going in the other direction.

One fiber optic line can handle 16 or 64 SONET lines by using a more complex splitting technology: Wave division multiplexing, which uses the different colors of light on the fiber. This equipment is what Ciena and others offer.

This may all be very exciting, but what is usually left out of the discussion is the absolutely disgusting cost of implementing all of this equipment -- from router to ATM to SONET to WDM to SONET to ATM to router. That's a lot of equipment, and much of it provides a complete overkill on redundancy and reliability. For example, the beauty of a router is that if the network is congested in one direction, it will route packets in another direction. So it can learn of a fiber cut and reroute packets without the overhead and expense of SONET (SONET interface cards can run $90,000 a piece).

Same with ATM. ATM was invented to offer both speed and quality of service guarantees for message packets. ATM switches and cards are more expensive on a per-port basis than fast Ethernet. But if you have enough bandwidth, you can get higher speed and virtually guaranteed performance without ATM.

An engineer at

Qwest

(QWST)

once told me that it would cost several billion dollars to upgrade even 10% of its capacity because of the cost of the SONET cards and equipment. Together, Lucent and Nortel own the SONET market, and they are minting money selling the stuff. (My guess is they get 90% to 97% gross margins on that equipment vs. 40% to 55% on normal competitive equipment.)

Meanwhile, Cisco and others have figured out that if they can go directly from the router to WDM equipment and then back to a router, much of that overhead and expense disappears. What has been missing is the ability to do this with short-haul equipment -- existing WDM gear is meant for long-distance fiber hauls between, say, Chicago and St. Louis, not from the east side to the west side of New York, or from Sunnyvale, Calif., to Cupertino, Calif. To do that with the existing gear, you would have to splice the optical fiber, and go from an optical to an electrical signal, thus slowing things down.

Cerent was one of the leaders in add/drop optical

multiplexers, which can tie into the fiber backbones anywhere, and so with their acquisition Cisco nails several key strategic goals:

    Be able to offer simplified data networks composed solely of router-to-WDM-to-router gear.

    Establish leadership in optical -- i.e. fiber -- networking technology.

    Offer end-to-end next-generation data networks that can do phone connections in their spare time.

    Get one up on both Lucent and Nortel by making obsolete what is probably a huge portion of their reported profit stream.

    Now I ask you: Is that worth $6.9 billion? Sure is. The telecom equipment business will soon be a trillion-dollar -- yes, a trillion-dollar -- business. And if they can weaken Lucent and Nortel in the process, and keep Cerent

    out

    of their hands, Cisco protects their own $220 billion market cap, simply by threatening someone else's.

    Andy Kessler is a partner at Velocity Capital and runs a technology and communications fund out of Palo Alto, Calif. This column is not meant as a solicitation for transactions; it is instead meant to provide insight into the methods of venture capital, technology and investing. At the time of publication, Kessler's firm was long Advanced Fibre Communications, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, Kessler appreciates your feedback at

    akessler@thestreet.com.