Few Prizes Left in Data-Networking Merger Spree

When Liza Draper began organizing a venture capital conference six months ago on budding data-networking companies, she started with a list of 40 firms that produced a host of cutting-edge products from network telephony applications to high-speed Internet routers.

By the time the conference took place in April, six of the companies had been sold for a total of more than $2.3 billion. Two other company presidents had to cancel their speeches because they had entered the so-called “quiet period” before an initial stock offering.

In April, at least seven other networking companies were sold for more than $7.5 billion. “This has been kind of an amazing season,” said Draper, an associate with McQuillan Ventures.

Voracious acquisition has long been a hallmark of the digital revolution, but even by high-tech standards, the buying spree over the last year by telecommunications equipment makers and data-networking companies has been remarkable.

What is taking place is a historic consolidation and convergence that is replaying the bloody battles in the realms of software and hardware--and mirroring the current battles in Internet commerce.

“This is another of those inflection points in history, and this time it’s happening because of the network,” said David House, the head of Bay Networks who became president of Nortel Networks Corp. when the telecommunications equipment maker bought Bay in 1998. “We’re at this incredible point that is going to change our lives. No one wants to miss out on the banquet.”

Where there were once dozens of independent companies vying to provide the esoteric equipment that links computers together, there are now essentially only three of the big, old-line networking companies left: 3Com, Cabletron and Cisco Systems. There would be four companies in the group, but Fore Systems of Warrendale, Pa., agreed April 26 to be bought by Britain’s General Electric Co. for $4.5 billion.

Cabletron and 3Com are the targets of frequent rumors that they too will be sold soon, leaving Cisco as the apparent victor in the consolidation of data networking.

Cisco has been the dominant player for years, but unlike Microsoft and Intel, which became monopolies in software and microprocessor battles, Cisco’s battle is just beginning.

The pressure is coming from a formidable corner populated by the biggest makers of telecommunications equipment in the world: Nortel Networks of Canada, Siemens of Germany, Alcatel of France, Ericsson of Sweden and Lucent of the United States.

The entry of these companies is a seismic event, bringing decades of telephone networking experience, millions of customers and enormously deep pockets into an already frantic battleground.

The once-separate networks for data and voice calls are gradually merging into a single mesh of silicon, optical fiber and wire. The telephone equipment and data-networking companies have realized that neither has the expertise or resources to do it all. Little companies have sprouted in every nook and cranny of the market as it evolves, making them ripe for the picking.

“There’s been a steady stream of acquisitions in this industry, but the change is in who is making the acquisitions,” said Douglas Hill, vice president of marketing for data-networking company Xylan Corp., which was bought by Alcatel in March for $2 billion. “Everyone has got to get in the game. If you don’t get into the game now, it will be too late.”

The current acquisition mania is a reflection of the ferment in the world of networking. Just two decades ago, networks connecting computers and those connecting telephones were largely separate entities, each with their own equipment and vendors.

Computer networks are built in a kind of pyramid out of network adapter cards plugged into personal computers, hubs or switches linking small groups of computers and more intelligent routers handling the flow between groups of hubs or larger networks.

Data networks use a technology known as “packet switching” in which information is broken into tiny digital pieces and sent to a particular destination.

Packet switching is an efficient and flexible means of placing disparate flows of information from different computers on the same line. It can carry video and voice, but there can be quality problems because of occasional delays caused by packet congestion.

Voice networks are based on a different concept, known as circuit switching. In its earliest form, the telephone network would literally make a direct connection between two telephone lines to complete a call. Because the line was carrying only one phone call, there was no interference or delay.

The difficulty in merging the two networks lies in their different methods and mediums of communicating. To join the two requires equipment that seamlessly handles both types of traffic, providing speed for data and uninterrupted quality for voice and video.

The advantages to joining the two networks lie in the simplicity, efficiency and cost-effectiveness of maintaining a single network.

The Internet’s emergence as a mass medium in the early 1990s has made the convergence of data and voice--and video as well--a pressing issue. The demand for faster, larger and more flexible networks has created an opening for scores of tiny companies to slip into the seams.

The seams have opened across the spectrum of network technology, from the modest networked telephone developed by Selsius Systems Inc., which can be plugged into any computer network, to the cutting-edge routers that can move billions of bits of data developed by companies such as Juniper Networks Inc., a private company that is the perennial subject of acquisition rumors.

“No one can keep up with all the changes,” said Draper of McQuillan Ventures. “The field is huge and the specific requirements of any niche market [create] ripe territory for any focused engineering team.”

The consolidation of data-networking companies began years ago. It is perhaps best marked by the 1994 merger of Wellfleet, once the No. 2 maker of routers behind Cisco, and SynOptics, the leading maker of hubs, to create Bay Networks.

But the convergence of data systems and telecommunications equipment really began only last year. The opening shot was a big one: Nortel’s announced purchase of Bay Networks in June for the princely sum of $9.1 billion.

That purchase was quickly followed in January with Lucent’s $20-billion deal to acquire Ascend Communications, a leading rival to Cisco, 3Com, Cabletron, Bay Networks and Fore Systems.

While makers of telecom equipment have been buying computer networkers, the networkers have been trying to acquire voice technology. Cisco has been the primary player, pursuing a strategy of buying lots of smaller companies, in part because they are easily absorbed into Cisco’s culture.

“We are a 15-year-old company,” said Ammar Hanafi, the company’s director of mergers and acquisitions. “We know what it is like to get your first product out the door. We know the DNA of start-ups quite well, and we like their DNA.”

Cisco, the leading data networker, has made 34 acquisitions of both data and telecommunications companies since 1993, nine of them just last year. Last month, Cisco struck a $170-million deal for a company called Amteva, which produces software that allows users to receive voicemail, e-mail and fax messages over computer networks.

Cisco chief John Chambers says the company intends to make nine to 15 acquisitions a year for the foreseeable future.

Farrokh Billimoria, a former equities analyst and now a partner in the venture capital firm Sprout Group, said the complexion of the buying spree is likely to change by the end of this year as fewer multibillion-dollar deals are struck because there are simply few large companies left to buy.

In the data-networking realm, essentially only two big acquisition targets are left: Cabletron and 3Com. Cabletron could be sold by the end of the year, Billimoria said. 3Com is a more difficult call, because a large part of the company’s business is in modems and network adapter cards, which are quickly becoming cheap commodities, he said.

Billimoria added that there is still life left in the acquisition frenzy, which could continue for 18 to 24 more months.

There are too many large telecommunications equipment makers in Europe and Japan that have yet to make big acquisitions, including Siemens, Ericsson, Nokia, Fujitsu and NEC.

House, of Nortel Networks, agreed that the big purchases will probably trail off soon, but he expects an increase in takeovers of start-ups, which have traditionally been the fastest movers in this fast-moving industry.

“We’re about to run out of big pieces so we’re going to have to buy lots and lots of little ones,” he said. “We kind of ate up all the seed corn--all the companies that were created over the past decade--and now we’re going to be chewing at the nubs.”

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Ashley Dunn can be reached at ashley.dunn@latimes.com.