Sycamore Selling Switches to Vodafone

The deal marks a major victory for the precariously valued networking start-up.
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Sycamore Networks

(SCMR)

Thursday scored a notable victory, selling some optical-networking gear to British wireless titan

Vodafone

(VOD) - Get Report

.

The $40 million multiyear contract includes optical switches and transport equipment, marking Sycamore's third sale of its core switch and the second sale of its metro, or edge-of-network, Sirocco SN 3000 access switch. Vodafone is also buying Sycamore's SILVX network-management software to help operate an undetermined portion of Vodafone's U.K. network. Sycamore shares were off $3.06, or 4.5%, at $65.38, while Vodafone was up 12 cents at $37.62.

In gaining a big-name customer that happens to be expanding its wireless network in Europe, Sycamore bolsters its outlook at a time when investors have been scouring the networking start-up's every utterance for signs of weakness. Questions ranging from the stability of Sycamore's software to the depth of its customer list have pressured the stock as fears of a spending slowdown have rocked the sector.

Moral Victory?

Though it's small as equipment deals go, the Vodafone contract is notable in that it advances Sycamore's optical network management business. One of the more optimistic investment assumptions is that customers will adopt this software as an operating system to run their networks, which could drive future equipment sales.

But it is still too early in the evolution of optical switching to determine a leader.

Ciena

(CIEN) - Get Report

and

Tellium

have had

early wins, and big players such as

Nortel

(NT)

,

Lucent

(LU)

and

Cisco

(CSCO) - Get Report

have been close behind with their competing optical switches.

"Sycamore still needs to show more in order to prove themselves," says one New York hedge fund manager who has no position in Sycamore but has previously been short the stock. While Vodafone is a big name, Sycamore could use a huge contract from a mega player like

Williams

(WCG) - Get Report

or

Worldcom

(WCOM)

to vanquish all doubt, says the fund manager, who asked not to be identified.

Sycamore has three main customers: Williams,

360Networks

(TSIX)

and

Enron

(ENE)

, and the remaining eight customers haven't amounted to much in terms of revenue. Even with its stock some 70% off its peak, slightly profitable Sycamore still enjoys an $18.5 billion valuation, even though its annual revenue is in the $300 million range. So investors obviously believe there is a whole lot of upside to the optical Internet construction project, a case that goes like this:

Surging Internet traffic demands have caused many service providers to move more swiftly to higher capacity networks. Fiber optics provide the most significant shift toward bigger, faster communications pathways. Far more bits of information can travel terrifically faster when carried over lightwaves rather than as electronic signals. The move away from electronic switching to optical switching extends those efficiencies.

Brass in Pocket

Another positive for the deal is that Sycamore didn't have to lend Vodafone money to buy the equipment, which suggests Vodafone made its choice based on product merits rather than financing incentives. As the stocks of telecommunications companies drop and as the debt market turns hostile,

vendor financing has become a key issue in the industry, as it can both prop up equipment companies' results and expose them to risky debt as cash-strapped network builders run aground.

Sycamore has recently jumped into the vendor-financing business. The company has extended loans to two unannounced customers and says it plans to stay under a $250 million loan commitment annually. But it isn't clear whether Sycamore will be able to afford to stick to its guns as deep-pocketed competitors such as Cisco, Nortel and Lucent use their heft to win big deals.

"It is a slippery slope, especially as it starts to fuel top-line growth," one industry observer says of vendor financing. "Once they get involved in it, it's going to be pretty hard to stop."