Impact of Cisco-StratumOne on Comm IC Biz

Electronic News, August 16, 1999 by Arun Veerappan

San Francisco

On June 29, Cisco announced its plans to acquire StratumOne, a developer of high-performance silicon products for high-bandwidth connectivity applications. On the face of it, such a description of an acquisition by Cisco surely can sound normal and even perhaps mundane. After all, Cisco has done 36 acquisitions in total and is on its seventh one (including StratumOne) thus far into the year. But, with the operative word being 'silicon' products, curiosity levels have heightened.

Is the outsourcing trend still intact? Does the traditional "semiconductor story" still hold good? These questions are on investors' minds.

In our view, nothing has changed. The outsourcing trend continues to be strong. In fact, the StratumOne acquisition by Cisco only serves to enhance the value of silicon companies at the forefront of the communications industry.

Let's look at StratumOne. Founded in 1997, StratumOne has focused on developing high-speed processing products for the communications industry. The company has 78 employees (mostly engineers) and is located in Silicon Valley. Vijay Parikh, who serves as the company's president and chief executive officer, joined the company last year after spending several years at Conexant.

While StratumOne has been extremely reserved with respect to communicating its product development efforts to the general public (the company does not have a Web site), it had embarked on bringing to market a slew of products over the coming two years. The first of these products could be an OC-192 (10Gbit/sec.) framer. Beyond this, the company could be focused on developing dedicated network processors that potentially cater to functions such as packet processing and forwarding at OC-48 (2.5Gbit/sec.) and OC-192 rates.

Reportedly, the first of StratumOne's products had seen first silicon and was sampling at Cisco and perhaps another customer at the time of the acquisition. The acquisition is expected to close in August. Cisco is exchanging 6.31 to 7.72 million of its shares for all of StratumOne's outstanding shares, valuing the deal at approximately $435 million at the midpoint.

It's useful to refer to some of the dynamics in the communications systems marketplace, which represents Cisco's core business. The differentiating factors that determine success in the communications systems business, as in any other business, come from the value a company provides to its customers. Value creation by OEMs in this arena comes primarily from the following key areas of competence:

1. System Architecture and Design

2. Silicon Expertise

3. Software Expertise

4. Customer and Channel Relationships

5. Brand Loyalty

Traditionally, communications OEMs have delivered value to their customers through all five of the above-mentioned areas, like the PC OEMs did several decades ago. The fundamental difference between the communications OEMs and the PC OEMs is that the former sell most of their product to corporations while the latter have a far more significant consumer orientation. Such an orientation has forced the PC OEMs to become relatively more price sensitive and product-cycle oriented, leading to a rapid move on their part to outsource both silicon and software requirements.

This move, combined with the massive consumer orientation of the PC, has caused computing OEMs to see their margin structure diminish over time. But unlike the computing sector, communications OEMs do not sell a majority of their product (other than products like cell phones and stand-alone analog modems) to the end user or the consumer. Products like desktop switches, routers and add/drop multiplexers, just to name a few, are not sold to the consumer (people like you and me).

This fundamental distinction, combined with the fact that communications OEMs continue to deliver value through proprietary system design, software capability, etc., is a critical differentiating factor for the communications sector vis-a-vis the computing sector. Thus on the silicon front, over time, we firmly believe that much like the computing arena, the silicon portion of the value will continue to migrate from the communication system OEMs to merchant suppliers.

The reason for this migration is that there is tremendous IP involved in silicon design. A communications OEM seeking to deliver a best of class system to its customers almost has to have two substantial projects ongoing simultaneously -- that of system design and that of silicon design -- in order to come out ahead.

As a result of this complication and given the emergence of dedicated communications merchant silicon providers who understand the semiconductor industry but breathe and live in the communications marketplace, the outsourcing of silicon competence from the OEMs to the merchant players is a natural evolutionary process. The exception to this rule -- and this is where the Cisco acquisition of StratumOne comes in -- is at the ultra high end of the marketplace, where there is a strategic value and need on part of the OEMs to remain completely in control of the entire product.