Cisco Paid $6.9 Billion for
Cerent but Can Still
Manage to Smile
By Andy Kessler
Special to TheStreet.com
9/1/99 12:39 PM ET
We happened to be in Petaluma, Calif., last week
visiting one of our portfolio companies, Advanced
Fibre Communications (AFCI:Nasdaq). Petaluma is
not what you'd call cosmopolitan: There are lots of
cows and the stench of manure is everywhere. But
the area is quickly becoming the telecom equipment
annex to Silicon Valley.
Advanced Fibre owns 5.5% of Cerent, the company
Cisco (CSCO:Nasdaq) just paid $6.9 billion to buy.
That 5.5% means they will soon have $350 million
plus of Cisco stock on their balance sheet. I
reminded Advanced Fibre's chief financial officer that
only in bear markets do investors pay a multiple of
book value or cash value -- in bull markets, it is
always multiples of earnings.
Of course, everyone is wondering: What was Cisco
thinking? They paid $6.9 billion for Cerent, which did
just $10 million in revenue the last six months. Can
anything be worth that much? But the answer, if you
study the chessboard thoughtfully enough, is that
Cerent probably is.
The word in the valley was that Cisco's opening offer
to the company was only $600 million. But then
Cerent had a series of quota-beating months in a row.
And they used the oldest trick in the M&A book:
When you can't agree on price, file an S-1 to signal
your willingness to go public (which they did on July
22) and get the acquirer to pay up.
So, you may be asking -- what is the strategic fit? It's
much more than adding waveform-division
multiplexing equipment to Cisco's product line. Cisco
is not so quietly amassing everything they need to be
the telecom equipment supplier going forward. Ciena
(CIEN:Nasdaq) is also in the multiplexing business,
but while Ciena provides equipment for the long-haul
market, Cerent's gear is both short haul and provides
the add/drop directly to/from the big intercity
fiber-optic backbones. And their products fit under a
huge pricing umbrella established by offerings from
Lucent (LU:NYSE), Nortel (NT:NYSE) and
Siemens.
What Cisco bought was more than an interesting
product line. It was some very smart people -- with
quite a different expertise than that of the
data-communications world. These guys are more
akin to physicists than programmers.
But to really understand what Cisco's doing, walk
with me through the underlying technology and where
it is headed. There is too much to explain, and not
enough room, so please excuse the lack of detail.
Today's Data Networks
Today's current data networks are overkill, as they
are built on top of existing voice-telephone networks.
A Cisco router looks at the headers of incoming
message packets and decides where they should be
routed. A router may have 24 outputs, and it decides
to which one of them it should zip the packet.
This router usually sits on the edge of a big backbone
network composed of fiber-optic lines, many of which
are high-speed asynchronous transfer mode, or ATM
switching networks. The two makers of ATM switches
are Cascade -- which is inside of Lucent by way of
Ascend -- and Stratacom, which is inside of Cisco.
So this is a business for the big boys.
These ATM switches also decide where to move
message packets, but at really high rates of speed,
and perhaps fewer port options than a router. One of
these frequently is a very high-speed SONET port --
i.e. a synchronous optical network port -- that sends
the packets down a fiber line between two cities.
SONET is a protocol for splitting data carried over
fiber lines by using time-division multiplexing. It is
used by phone companies to handle thousands of
phone calls on a fiber line, with very high reliability.
SONET does this through redundancy: It is
implemented in a ring composed of two strands of
fiber, where information is duplicated and goes
simultaneously in both directions around the ring. If
one fiber gets cut (construction backhoes are a
constant source of problems), SONET senses it and
uses the backup information going in the other
direction.
One fiber optic line can handle 16 or 64 SONET lines
by using a more complex splitting technology: Wave
division multiplexing, which uses the different colors
of light on the fiber. This equipment is what Ciena and
others offer.
This may all be very exciting, but what is usually left
out of the discussion is the absolutely disgusting
cost of implementing all of this equipment -- from
router to ATM to SONET to WDM to SONET to ATM
to router. That's a lot of equipment, and much of it
provides a complete overkill on redundancy and
reliability. For example, the beauty of a router is that
if the network is congested in one direction, it will
route packets in another direction. So it can learn of a
fiber cut and reroute packets without the overhead
and expense of SONET (SONET interface cards can
run $90,000 a piece).
Same with ATM. ATM was invented to offer both
speed and quality of service guarantees for message
packets. ATM switches and cards are more
expensive on a per-port basis than fast Ethernet. But
if you have enough bandwidth, you can get higher
speed and virtually guaranteed performance without
ATM.
An engineer at Qwest (QWST:Nasdaq) once told me
that it would cost several billion dollars to upgrade
even 10% of its capacity because of the cost of the
SONET cards and equipment. Together, Lucent and
Nortel own the SONET market, and they are minting
money selling the stuff. (My guess is they get 90% to
97% gross margins on that equipment vs. 40% to
55% on normal competitive equipment.)
Meanwhile, Cisco and others have figured out that if
they can go directly from the router to WDM
equipment and then back to a router, much of that
overhead and expense disappears. What has been
missing is the ability to do this with short-haul
equipment -- existing WDM gear is meant for
long-distance fiber hauls between, say, Chicago and
St. Louis, not from the east side to the west side of
New York, or from Sunnyvale, Calif., to Cupertino,
Calif. To do that with the existing gear, you would
have to splice the optical fiber, and go from an optical
to an electrical signal, thus slowing things down.
Cerent was one of the leaders in add/drop optical
multiplexers, which can tie into the fiber backbones
anywhere, and so with their acquisition Cisco nails
several key strategic goals:
1.Be able to offer simplified data networks
composed solely of router-to-WDM-to-router
gear.
2.Establish leadership in optical -- i.e. fiber --
networking technology.
3.Offer end-to-end next-generation data networks
that can do phone connections in their spare
time.
4.Get one up on both Lucent and Nortel by
making obsolete what is probably a huge
portion of their reported profit stream.
Now I ask you: Is that worth $6.9 billion? Sure is. The
telecom equipment business will soon be a
trillion-dollar -- yes, a trillion-dollar -- business. And if
they can weaken Lucent and Nortel in the process,
and keep Cerent out of their hands, Cisco protects
their own $220 billion market cap, simply by
threatening someone else's.
Andy Kessler is a partner at Velocity Capital and runs
a technology and communications fund out of Palo
Alto, Calif. This column is not meant as a solicitation
for transactions; it is instead meant to provide insight
into the methods of venture capital, technology and
investing. At the time of publication, Kessler's firm
was long Advanced Fibre Communications, although
holdings can change at any time. http://www.thestreet.com/comment/kessler/779228.html |
