Ready-to-Wear Chips Could Give Applied Micro a Huge Boost

As the market changes, the company appears better positioned than its larger rivals to cash in.
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SAN FRANCISCO -- Selling communications chips off the shelf may sound unorthodox, but it's a strategy that could transform a small communications chipmaker,

Applied Micro Circuits

(AMCC)

, into a giant supplier of optical-networking chips.

AMC makes $400 chips essential for running million-dollar fiber-optic networks. Its stock has climbed 553% this year amid a widespread demand for those chips. AMC estimates that next year, some $2.8 billion worth of synchronous optical-networking chips will be sold -- chips that, among other things, convert fiber-optic signals for transmission across networks.

Many believe AMC has what it takes to add to those gains. "Clearly the stocks that are the leaders will move up from where they are now, and those that aren't will fall by the wayside," says Michael Prouting, senior equity analyst at

Insight Capital

, which holds Applied Micro shares.

Even so, Applied Micro plays fourth tenor to

Lucent

(LU)

,

Fujitsu

and

Vitesse

(VTSS)

.

But AMC's market faces a big change, and the company is better positioned than its rivals to cash in. Customers such as

Cisco

(CSCO) - Get Report

are facing increasing competition from start-ups

Juniper

(JNPR) - Get Report

and

Extreme Networks

(EXTR) - Get Report

, so they're shooting products out faster. They can't afford to spend a year or more waiting for chip companies to design new chips. So AMC is building off-the-shelf chips to meet its customers' needs.

"Off-the-shelf silicon is becoming a great way for equipment companies to speed their time to market," says Clark Westmont, an analyst at

Salomon Smith Barney

, which has a strong buy rating on Applied Micro and which has no underwriting relationship with the company.

The beauty of this market is that -- unlike many PC chips -- off the shelf doesn't mean easy to copy, says Brent Little, vice president of marketing at Applied Micro. The chips are so complex that there are no clones, and once an equipment vendor chooses a particular chip design, it can't go shopping around to competing chipmakers for better prices.

So for companies like Cisco, buying chips from Applied Micro will be like buying an

Oscar de la Renta

dress in

Bergdorf's

. It might be ready to wear, but no one else makes it. And you have to shell out bucks if you want to wear it.

The transformation Applied Micro is undertaking has a precedent in the wireless market, where

Texas Instruments'

(TXN) - Get Report

focus on standard cell-phone chips turned the sluggish maker of memory and hard drives into a fast-growing, communications-chip leader. Shares of Texas Instruments have risen some 336% since the market for cell phones took off in October 1998.

Rivals

PMC-Sierra

(PMCS)

and Vitesse are also trying to standardize communications chips. But analysts and investors say AMC has the edge because PMC doesn't produce chips at the highest speeds and for the latest products. And Vitesse works primarily in gallium arsenide, a more expensive material than Applied's silicon products.

As competition among the equipment makers intensifies, price performance of chips will become more important. Vitesse is already losing ground to Applied, says one analyst who asked not to be named. And Applied has made inroads with Juniper,

Sycamore

(SCMR)

and Lucent during the last year -- all potentially key customers for Vitesse. "Vitesse was very skeptical of AMC's capabilities," the analyst says. "As a result, Vitesse's growth this year has been slower."

Applied Micro has been beating its competitors on the Street as well. Until recently, all three stocks have followed smooth uphill paths. But this fall, AMC began to break out. Since Sept. 20, Vitesse has risen 2% and PMC-Sierra 1%, while AMC has shot up 56%. After hitting a high of 103 1/2 Thursday, AMC fell 3 7/16 points to close at 97.

Clearly, Wall Street thinks Applied has room to move even higher. The company's rated one of the top four semiconductor stocks among analysts surveyed by

First Call/Thompson Financial

despite a stock price valued at 117 times 12-month forward earnings. By comparison, the other three --

International Rectifier

(IRF)

,

ATMI

(ATMI)

,

Amkor

(AMKR) - Get Report

-- trade at less than 30 times forward earnings.

Now, AMC is entering an area of business that likely won't produce revenue for several years but that will ensure a steady stream far into the future. It's what gives Insight's Prouting the confidence to hold on to AMC stock even as it climbs to stratospheric levels. "I only wish I owned more of it," he says.