Following up a stellar year on the stock market, chip firm NetLogic Microsystems Inc. (Nasdaq: NETL) is off to a roaring start in 2006 with two major announcements this week -- not including the company's earnings report.

First, NetLogic announced the NETL7 line of Layer 7 processing chips. Much of NetLogic's work is related to Layers 2 and 3 -- routing tables in particular -- with Cisco Systems Inc. (Nasdaq: CSCO) representing most of the company's revenues. "One reason we're doing this is to expand our market beyond Cisco," says Mike Ichiriu, NetLogic's senior director of applications engineering.

But NetLogic also shored up some more sales to Cisco by agreeing to acquire a competitor, the search engine business of Cypress Semiconductor Corp. (NYSE: CY). That deal, announced yesterday, would have NetLogic paying $50 million in stock plus another $20 million in cash and stock if certain revenue targets are met. If that deal closes, it will be NetLogic's first acquisition. (See NetLogic Buys Cypress Div.)

Cisco is the key to all of this, because it represented 70 percent of NetLogic's revenues as of September, according to a Securities and Exchange Commission (SEC) filing. Cisco's attention helped NetLogic go public in 2004 and boosted the stock to a 179 percent gain in 2005, putting the company's market capitalization near $600 million. (See NetLogic Files for IPO, NetLogic Sags on Debut, and 2005 Top Ten: Stock Gains and Pains.)

[Note that this NetLogic is different from the U.S. service provider NetLogic Inc. ]

NetLogic makes what it calls "knowledge-based processors," which combine a microprocessor with a ternary content addressable memory (TCAM), a type of memory chip. The chips help a router make its forwarding decisions and are understandably important to Cisco.

Cypress and Integrated Device Technology Inc. (IDT) (Nasdaq: IDTI) made similar chips, dubbing them "search engines," and those two companies held the lion's share of the market in 2002 and 2003, with Cypress picking up Cisco as a customer. (See Search Engine Chips Heat Up.) But as NetLogic's latest processors began shipping, Cisco shifted some its business that way, says Tim Kellis, an analyst with Stanford Financial Group .

Kellis believes this led Cypress to consider selling its TCAM business to a private equity group, spinning it off much the way Agilent Technologies Inc. (NYSE: A) sold its semiconductor division to Kohlberg Kravis Roberts & Co. and Silver Lake Partners last year. (See Agilent Launches Extreme Makeover and Avago Springs From Agilent.) He'd heard rumors that the deal might be scuttled because Cisco didn't like it. Whether that was the reason or not, Cypress's chips ended up in NetLogic's hands instead.

Layer 7 processing is a dramatic move for NetLogic, because the technology could let the company branch out to areas like routing, QOS, and security. NETL7 could give NetLogic an early place at the high end of this market -- targeting 10 Gbit/s, versus 1 Gbit/s or 2 Gbit/s for most available Layer 7 appliances -- but more important, it could widen the company's customer base.

"If you look at NetLogic's current market, it is Ethernet switches and routers. What this does is expand that market potential to include a whole host of hardware," Kellis says. Possibilities he mentions range from security appliances to large-volume systems such as laptop computers.

Cisco and Juniper Networks Inc. (NYSE: JNPR) seem likely customers for NETL7, considering they have ambitions on this kind of Layer 7 processing. Juniper in particular puts traffic engineering at the hub of its long-term plans. (See Juniper's Kriens Stuck On Traffic.) And both are acquiring their way into this space with purchases such as P-Cube, Peribit Networks, and Redline Networks. (See Cisco Plucks P-Cube for $200M and Juniper Takes Two: Peribit & Redline.)

This doesn't mean NetLogic is competing with the router giants. It's more accurate to say NetLogic is doing "a small contained piece" of what P-Cube does, Ichiriu says.

NetLogic faces potential Layer 7 competition from Cavium Inc. (Nasdaq: CAVM), Hifn Inc. (Nasdaq: HIFN), and Raza Microelectronics Inc. , which have taken the approach of pacing multiple microprocessors together to attack packet examination at Layers 4 through 7. NetLogic officials say their devices, by contrast, won't need as much programming. (See Niche Chip Players Move Up the Stack, Hifn Debuts 'Antero' Security Processor, and Raza's Triple-Threat Revealed.)

The Layer 7 approach is also related to the wave of chips that process XML or other traffic in native form. Tarari Inc. ships XML-processing chips, and stealthy startup Xambala Inc. is working on a "semantic processor" that seems to target the same kinds of applications. And don't forget Intel Corp. (Nasdaq: INTC), which got a foot in the door with last year's acquisition of Sarvega Inc. (See Telecom Startups Play in XML and Intel Absorbs XML Startup.)

NETL7 is available in sample quantities and is due to ship in volume in the second half of this year.

Separate from all this, NetLogic announced earnings yesterday for its fourth quarter, ended Dec. 31. (See NetLogic Reports Q4.) NetLogic reported net income of $5 million, or 26 cents per share, on revenues of $21.2 million, compared with net income of $3.6 million, or 19 cents per share, on revenues of $20 million in the previous quarter.

For its fourth quarter a year ago, NetLogic reported losses of $75,000, zero cents per share, on revenues of $15.2 million.

NetLogic's fourth-quarter net income exceeded analysts' forecast of 22 cents per share, according to Thomson Reuters . But revenues fell short of the consensus estimate of $21.85 million.

NetLogic's stock was up $0.97 (2.94%) to $34.00 in late morning trading on Thursday.

— Craig Matsumoto, Senior Editor, Light Reading