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Do network deals like Redback, Siara make sense?

The gold rush is on in the networking business, and companies in the optical equipment trade, in particular, appear to be at the right place at the right time.

Veteran technology executive Robert Barron was offered a position at optical networking equipment upstart Cerent and turned it down more than a year before Cisco Systems paid $7 billion for the company this past summer.

"I wasn't about to make the same mistake," Barron said this week, a month after joining optical start-up Chromatis Networks as president and chief operating officer.

The gold rush is on in the networking business. Companies in the optical equipment trade, in particular, appear to be at the right place at the right time.

Optical technology essentially takes a strand of fiber-optic "glass" and allows the microscopic link to deliver large chunks of voice and data. Optical equipment is hot because of the insatiable thirst for bandwidth from telecommunications carriers. The technology has extended from its roots as a network "backbone" mainstay to other parts of the network, spawning new niches for network gear providers.

A seemingly never-ending flow of cash is going into the niche, as evidenced by the $38 million Chromatis received this week in a second round of venture funding, the $4.5 billion Redback Networks paid for Siara Systems Monday, and the price Cisco paid in August for a company with $10 million in revenue.

The mind-boggling details of the deals don't stop there: Redback has never been profitable, yet it has a market capitalization of more than $6 billion, which allowed it to purchase a company--Siara--that has thus far produced no finished products, has not collected any revenue, and signed its first contract with a customer only yesterday. Upstart Sycamore Networks went public recently with $10 million in revenue from one customer and has since seen its offering explode on the market, resulting in a capitalization of more than $18 billion.

Cisco, which may be remembered as one of the companies that started the gold rush with Cerent, may now be gun shy about further acquisition opportunities in the optical sector, based on comments from executives this week.

Some say that no matter how outrageous the environment seems, the simple fact is that telecommunications is transforming itself. A new breed of optical-based equipment will be necessary to handle the explosion of voice and data traffic that can't be dealt with using current switches, often called "Class 4" or "Class 5" devices. That shift away from these switches will result in anywhere from a $50 billion to a $100 billion opportunity for various firms, according to most estimates.

Companies like Qwest Communications International are among a plethora of potential customers for these upstarts, as evidenced by the communications carriers' recently stated intention to upgrade its sprawling fiber-optic network with the latest technology.

This "Wild West"-like atmosphere in optical-based networking gear has spawned new competition for the likes of entrenched giants like Cisco, Nortel Networks and Lucent Technologies.

"These new companies are definitely breaking the mold and they're definitely outpacing incumbents," said Roland Van der Meer, partner with venture firm ComVentures, one of the investors in Chromatis. "The old way doesn't work."

Redback justified its stock-based merger by pointing out that it increases its market opportunity 10-fold, to about $20 billion, based on the need for optical-based equipment to transport Internet traffic. "This whole Internet age allows you to do certain maneuvers," said Larry Blair, vice president of marketing for Redback.

Many believe Redback is in a unique position to address one of the largest bottlenecks facing the future of the Internet--a lack of access to a high-speed pipe to carry Internet traffic, or "packets," for residential communities and small and medium-sized businesses.

"The changing nature of traffic flows and the emergence of packet-based traffic on carrier networks is changing the competitive environment for all carriers," wrote Paul Johnson, an equities analyst for Robertson Stephens, in a recent research note. "As such, to survive these competitive carriers need a new class of equipment."

Optical technology used to be very expensive and highly technical, left to veteran equipment firms with large research and development budgets. But the explosion of Internet traffic and its implications on current network construction have resulted in a visceral need for more capacity in portions of networks where optics might previously have been thought of as unnecessary.

Coupled with an explosion of fiber-optic line deployment and technology cost reductions, it now makes sense for telecommunications companies to implement optical equipment for long-haul networks, congested metropolitan areas, and in some cases particular business parks and residential communities.

"Optics is the largest capacity pipe you can supply for the Internet," noted Chromatis' Barron. "The issue has been cost and deployment."

Many believe the jury is still out on which firms will survive, but it seems clear that only a massive downturn in the fortunes of the stock market and its accompanying effect on the Internet can stop dreams of a pot of gold at the end of an optical rainbow.

"I don't think you can stop this change," said ComVentures' Van der Meer. "Who wins? I don't think the market's quite discerned that yet."