The $4 billion acquisition that LSI Logic ( LSI) announced Monday did not come out of the blue.

The chipmaker had frequently hinted in the past months that it was looking to bulk up in order to better compete in its target markets.

But LSI's decision to pair up with Agere Systems ( AGR) in an all-stock merger still came as a surprise to many on the Street.

Rather than bolster its undersized consumer electronics business, which management had indicated was a priority, LSI took a different tack, effectively signaling a shift in its recently unveiled plan.

Shares of LSI fell more than 13%, or $1.46, to $9.10 on the news. Agere investors, on the other hand, applauded the deal, sending the stock up about 8%, or $1.48, to $19.27.

By joining forces with Agere, LSI fleshes out its storage chip business -- an area in which LSI is already strong. The deal also positions LSI to play a larger role in networking and appears to reroute its consumer electronics plan to the cell-phone market: Agere makes baseband chips for cell phones and boasts No. 3 handset maker Samsung as a key customer.

In a conference call with analysts after the merger announcement, executives of the two companies spoke of creating a storage, networking and consumer powerhouse, with combined annual revenue of $3.5 billion, more than 9,000 employees and an impressive patent portfolio and R&D capability.

"Our combined financial profile will be greatly strengthened," said LSI CEO Abhi Talwalkar. "The combined company will be well positioned to drive sustainable long-term revenue growth."

What that revenue growth will be, however, remains unclear. Executives declined to provide specific growth targets for the new company.

Cost Benefits

Neither LSI or Agere has posted a dazzling top line on its own. LSI's sales growth in its most recently completed quarter was 2%; Agere saw revenue decline 6.7% year over year.

The more immediate benefit of the deal involves costs. The companies projected $125 million in cost savings in 2008, as a result of manufacturing savings and operational efficiencies.

LSI CFO Bryon Look said the company would likely provide new profit margin targets -- LSI is currently a few percentage points shy of its 45% gross margin goal -- although he said it was too early to do so at this time.

Wedbush Morgan analyst Craig Berger called the deal a "good strategic combination" that strengthens the combined company's storage-chip offerings and engineering resources, and creates a formidable intellectual property arsenal that can be leveraged across various end markets to battle companies such as Marvell ( MRVL) and Broadcom ( BRCM).

Still, Berger, whose firm makes a market in shares of LSI and rates the stock a hold, said the purchase price was not cheap and was likely pressuring the stock.

Under the terms of the deal, Agere shareholders will receive 2.16 shares of LSI common stock, equal to $22.81 a share at Friday's closing price -- a 28% premium.

LSI will issue approximately 379 million shares to complete the transaction. LSI shareholders will own 52% of the new company, while Agere shareholders will have 48%.

LSI also announced that it had approved up to $500 million in share repurchases.

Agere will get three seats on the board of the new company, compared with six for LSI, and Talwalkar will remain CEO of the newly merged company.

The deal links two chipmakers that were in the middle of carrying out turnaround plans, with each adding new leadership teams and refocusing their respective business models over the past year.

In October, Agere reported its first profitable year in its five-year history as a public company.

LSI, meanwhile, sold its chip fabrication facility earlier this year, exited certain businesses and refocused the company around two target markets : storage and consumer electronics.

While LSI's storage business, which includes storage chips and storage systems, has posted double-digit revenue growth, the consumer electronics business has not fared as well. Consumer chip revenue plunged 28% in the third quarter, hurt primarily by the fact that chip company PortalPlayer ( PLAY), an LSI customer, lost its slot in the Apple Computer ( AAPL) iPod nano.

In a recent interview with TheStreet.com, Talwalkar said LSI was actively looking for ways to increase its scale in the consumer market, pointing to set-top boxes and digital TVs as key areas of interest.

Because the Agere deal does nothing on that end, some analysts predicted that the merger will mark the end of LSI's efforts to build a business around living room-based electronics and could prompt LSI to sell its DVD-recorder business.

On Monday, LSI's Talwalkar said the company was still committed to the consumer electronics market, but he spent more time talking about LSI's new consumer play: cell-phone handsets.

LSI also will get a presence in consumer notebook and desktop PCs as a result of Agere's hard-disk drive chips, rounding out LSI's existing catalog of storage products aimed at corporate data centers.

"We now have the opportunity to grow our footprint with existing customers and expand our customer base," said Talwalkar.

CIBC World Markets analyst Alan Mishan agreed, saying that Agere's consumer hard drive and LSI's enterprise storage businesses fit together nicely. And networking could generate cost synergies as the companies integrate product lines, Mishan wrote in a note to investors.

But Mishan pointed out that Agere's management has had a tough time generating revenue growth from the business, and the deal simply hands off the challenge to someone else.

As a result, Mishan advised Agere shareholders to sell rather than wait to see what the new company is capable of.