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Nortel's Xros Buy Propels It in Race for All-Optical Network

The deal nicely positions Nortel against Cisco and Lucent, but it's no guarantee of success.

Mama, let your babies grow up to be optical engineers.

Raising the stakes in the red-hot networking-equipment sector,

Nortel

(NT)

Tuesday agreed to buy closely held optical-device maker

Xros

for $3.25 billion in stock. The acquisition potentially puts Nortel ahead of rivals

Lucent

(LU)

and

Cisco

(CSCO) - Get Report

in the high-stakes race to provide gear for an all-optical Internet and eliminate the gridlocks that plague the medium.

The deal for Xros, which has all of 90 employees, sets a new premium on talent in a notoriously deep-pocketed industry: $36 million a worker. It also demonstrates how, with investor money flooding to Internet infrastructure outfits and carriers waiting with cash in hand, demand-swamped equipment makers are willing to pay up for speed to market. Yet Xros' mirror-based optical switching, while exciting, may not be a surefire success and faces challenges from rival technologies.

Where the Future Is

The Sunnyvale, Calif.-based company, whose name is pronounced

KY-ros

, has no revenue and only one notable product in trials. But Nortel's deal demonstrates that this is where it believes the future of new networks lies. Investors, noting recent months' sharp rally in network-equipment stocks, voiced their approval Tuesday, as shares of Nortel rose 2 1/16, or 1.7%, to close at 123 3/4.

Long viewed as the holy grail of networking, optical switching is to today's electrical switching what integrated circuits were to the transistor, experts say.

To put the Xros purchase in perspective, recall that in August Cisco shocked the tech sector when it paid an eye-popping $25 million per employee for optical networker

Cerent

.

TSC's

Adam Lashinsky

diagrammed Cisco's exploding per-head pay scale. But Nortel's overture to the bright minds at Xros is way off even that chart.

Nortel emphasizes that this deal is worth every last one of the 27.5 million shares it will issue for Xros, because it brings the No. 2 telecommunications-equipment provider another step closer to an all-optical product offering.

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Race for the Optics

Lucent, the No. 1 equipment maker, says it expects to have its

LambdaRouter

optical switch commercially available later this year. Siemens is working with a San Diego firm,

Optical Micro-Machines

, in field tests.

Hewlett-Packard

(HWP)

spinoff

Agilent

(A) - Get Report

is also developing its own optical device.

"This is real, but the jury is still out on whether it's going to be widely deployable," says Lynn Hutcheson, optical analyst for San Francisco-based research firm

Ryan Hankin Kent

. (Kent consults for all of the major network-equipment makers.) Reliability and cost are two of the significant challenges to optical switching, he says.

Using tiny mirrors on tiny hinges, these microelectromechanical systems, or MEMS, reroute light waves from one fiber to another. Conventional switches have to convert the optical traffic into electronic traffic, thereby creating a bottleneck in the network. Micromirrors are the leading edge of the emerging optical-switching industry, but analysts say other methods of directing optical traffic, such as liquid crystals, light bending and phase manipulation, may prove superior.

But at this point, MEMS's the word.

No Smoke, Plenty of Mirrors

"This is orders of magnitude more efficient than electronic switching," says Robert Rosenberg, president of

Insight Research, who has consulted with many telecommunications firms, including Nortel. Last week, Rosenberg was one of those dazzled by the Xros demonstration at the

Optical Fiber Communications

conference in Baltimore. "The X-1000 product won 'best in show,' which suggests to me that while there are a lot of mirrors, nobody saw any smoke," says Rosenberg.

At a

Thomas Weisel Partners

emerging-networks conference this month, Xros CEO Greg Reznick says he found demand so high for optical gear that he's had to limit his customer list.

"We knew we were on to something when large carriers were returning our calls, and in a matter of days signing

nondisclosure agreements and coming in to talk to us," says Reznick.

Looks like the carriers weren't the only ones knocking.