The same news that cheered fans of Cisco ( CSCO) in the wake of its earnings report has unnerved investors in the chipmakers that supply it, such as Vitesse Semiconductor ( VTSS) and PMC-Sierra ( PMCS).

In midafternoon trading Wednesday, communications chips were losing ground on worries that the telecom equipment maker has managed to boost its own gross margins at the expense of its suppliers, bullying them into holding down prices.

In recent trading, Vitesse was down 13%, or 30 cents, to $2. PMC-Sierra, which drew over 10% of sales from Cisco last year, had surrendered 8.3%, or 71 cents, to $7.80. Applied Micro ( AMCC) was off 1.9%, or 9 cents, to $4.61, and Broadcom ( BRCM) was down 3.2%, or 55 cents, to $16.57.

Meanwhile, Cisco had risen 5.6%, or 68 cents, to $12.75.

The equipment maker revealed Tuesday that it seized market share from its competitors in the most recent quarter. Meanwhile, its gross margins continued to rise despite flat product sales, jumping from 57.6% to 67.7% over the past three quarters.

But while those trends are welcome news for Cisco investors, they bode ill for communications chipmakers. Cisco now accounts for over 70% of the market volume for some components, noted analyst Michael Masdea, an analyst at Credit Suisse First Boston.

"As Cisco becomes an even more dominant portion of the total datacom component market, its fragmented supplier base cedes even more pricing power to Cisco," he wrote in a research note.

CSFB has done investment banking for Vitesse and Broadcom in the past year.


Inverse Relationship
As Cisco's margins have steadily increased, margins of the chipmakers that supply it have sagged
Company March 01 June 01 Sept 01 Dec 01 March 02 June 02
Cisco 54.5% 52.3% 54.0% 57.6% 63.1% 67.7%
Applied Micro 73.0 54.0 57.9 58.4 51.1 51.5
PMC-Sierra 70.1 60.9 60.4 58.4 60.1 61.9
Vitesse 62.2 49.4 40.0 44.1 46.2 46.5
Agere 37.0 25.4 7.5 3.0 9.6 11.3
Source: Credit Suisse First Boston estimates, company data.

Masdea estimates that over half the increase in Cisco's gross margins came about through forcing price concessions out of suppliers (with the remainder due to better inventory management and a shift to higher-margin products). "While we do not necessarily believe pricing pressure will escalate, we certainly view the current level as sustainable," he wrote. "It also suggests that if business does accelerate, component vendors may see less of the benefit than in past cycles."

In another worrisome development, Cisco's management said bookings from service providers were likely to decline for the next several quarters. With capital expenditure budgets getting squeezed even tighter, chip purchases will likely shift more towards products with lower margins and prices.

The outlook for IC vendors has shifted dramatically away from 1999 and 2000, when chipmakers each focused on different parts of the communications network and therefore enjoyed more pricing power, explains Aalok Shah, an analyst at Pacific Crest Securities.

"Along the way they made acquisitions; each tried to get into the same space. But now the end market pie is really shrinking. They don't have a healthy Sycamore ( SCMR) or Tellabs ( TLAB) or Ciena ( CIEN) anymore. Now, they're really catering to only one or two players."

"To get in, they will do what it takes just so they can sell. So there will be a lot more pricing pressure on these guys," he predicts.