As expected, telecom equipment manufacturer Lucent(NYSE: LU) stepped up and bought privately held Chromatis Networks, a Herndon, Virginia company that makes switching systems designed to manage network traffic in metropolitan areas.
Lucent gained nearly 4% yesterday on speculation it would close the deal, though it slipped a bit in early trading today. It wasn't surprising to see the stock trading up yesterday. With the market for optical bandwidth management equipment expected to jump to $15 billion in 2004 from $543 million this year, investors have decided you can't pay too much for optical expertise. This will prove too generous an assumption, and some companies will suffer mightily from bad moves. Investors shouldn't jump headlong at any company with the words "optical networking" in its business description. It's a growing field with many different segments and players.
Nevertheless, Lucent and optical networking equipment rivals Nortel(NYSE: NT) and Cisco(Nasdaq: CSCO) are locked in a technology arms race that will cost billions. So far, they have been smart buyers, with Nortel grabbing the long-haul market lead, Cisco nabbing fast-growing Cerent, and Lucent picking up a stake in well-regarded Tellium and now Chromatis.
The Chromatis deal is Lucent's biggest move in the optical space so far. It ponied up $4.5 billion in stock, or about 78 million shares, to reel in the start-up. If it lives up to expectations, certain employees will receive an additional 2.5 million Lucent shares, adding $145 million to the purchase price. With 155 employees, that means Lucent paid on the order of $29 million per employee for the company. That's just about what you have to spend to scoop up an optical equipment start-up these days. Nortel paid about $36 million per employee for Xros in March.
When you stop to consider that Chromatis has essentially one product, two customers, and had virtually nothing in sales last year, $4.5 billion is a staggering amount of money, even though 78 million shares represents just 2% of Lucent's outstanding stock. I don't know how to value Chromatis -- probably no one does.
That said, it looks like a solid company, well positioned in perhaps the fastest-growing part of the optical networking sector -- metropolitan markets.
Industry experts divide the fiber optic market into two segments: the core and the edge. The core is the long-haul networks carriers use to ship data from city to city; the edge is the metropolitan networks that channel data from the core to the customer. The challenges are very different at the core and the edge.
To understand the strategy Chromatis has chosen, it helps to know a few things about fiber optic networks. Everyone knows the advantages: higher carrying capacity, less interference, and less fade. But fiber networks come with their own set of challenges. The signals have to be boosted for traveling long distances -- a difficult, costly process that involves converting the pulses of light to electrical signals, boosting the signal, then reconverting it to light. The signals also must be reconverted when switched -- sent along on the right path.
This is why the Holy Gail of fiber optics, in a sense, is the all-optical network. In this kind of network, carriers wouldn't have to convert and reconvert signals, just ship unlimited bandwidth to everyone. Problem is, it's very expensive to convert existing edge networks to optical technology, and not every user out there requires that much bandwidth. Companies that recognize the business need to assimilate legacy systems should do very well. Chromatis has developed a platform that integrates existing technologies in metro markets and allows carriers to deliver the right amount of bandwidth for each customer. It's a business-centric rather than a technology-centric approach, and it makes good sense. In addition, the platform is scalable, meaning it can offer more bandwidth as its customers grow.
Chromatis faces plenty of competition in this market from companies such as Redback Networks(Nasdaq: RBAK) and start-ups Alidian Networks and Astral Point Communications, but it picked a smart way to attack the field and is attracting attention from the Baby Bells and competitive local exchange carriers like Qwest(NYSE: Q) . With Lucent's deep pockets and distribution strength, Chromatis should have an edge at the edge.
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