Picking which telecom equipment startups have the best shot at acquisition or IPO over the next 12 to 24 months requires facing a number of hard questions. Who will win the telco vs. cable battle? Can anyone really succeed with yet another core router or 10-Gbit/s Ethernet switch? Are all IP appliances doomed to become blades and feature sets on Cisco routers? Is this FTTP stuff for real? Will WLAN switch vendors make any money from telcos? After a while, the head spins; each one of these questions is a report in itself.

But analysts love matrices, taxonomies, and, most of all, lists. So in Telecom Recovery Investment Opportunities, we applied a bit of science and a lot of subjectivity to picking the top startups for 2004. First we broke the telecom equipment market into 21 categories, grouped public and private vendors into each, and then evaluated the prospects for growth and differentiation for each of those categories. The ones we ended up liking included the obvious Ethernet access, the nebulous high-value IP, the risky cable/MSO advanced services equipment, the slightly out-of-bounds WLAN switch market, and the confusing broadband remote access server (B-RAS) sector.

If there is a thread holding these all together, it is an acknowledgement that access is king in 2004: Operators want to use access equipment as a way to finally add some value to their IP service portfolios.

We created a scoring system for these categories, awarding each segment one to five points for its ability to demonstrate rapid market growth, the presence of weaknesses in incumbent product lines, the quantity of VC investment to date, the opportunity for a new startup to differentiate itself, a low cost to capitalize, and at least some indications of a path to acquisition or IPO. The categories listed below fit the bill.

Table 1: Top Market Segments for M&A and Investment

When it came to picking private companies to single out, a great deal more subjectivity was applied. Many of our picks had in common a record of revenues, a projection for a real "up" year in 2004, partnerships with leading OEMs, and a place in relatively hot market segments. Finally, they demonstrated that major incumbents were not entirely bulletproof.

But along with the obvious selections, we have a few odd choices that are worth explaining in more detail. First there's BigBand Networks Inc., a supplier of an edge router designed to deliver advanced video services, including video on demand, switched digital video broadcast, and rate-shaped HDTV delivery. BigBand's success as a startup in the MSO space is impressive.

VCs have historically shied away from this area. From our interviews with VCs for this report, the note sounded on cable was strikingly uniform, regardless of whom we talked with. Cable companies are notoriously cheap and ruin margins for private companies. The supplier oligopoly of Motorola Inc. (NYSE: MOT), Scientific-Atlanta Inc. (NYSE: SFA), and Arris Group Inc. (Nasdaq: ARRS) make it a real pain to break into the top tier of operators. CableLabs is a negative force in the industry, devising specifications with the singular goal of commoditizing equipment. Add the fact that most VCs don't have the kind of long-cultivated contacts in this segment that they have with North American telcos, and you have a situation in which cable is considered a rather nasty foreign country to invest in, rather than a fertile, innovative market.

But BigBand is succeeding. It can count Time Warner Inc. (NYSE: TWX) and Comcast Corp. (Nasdaq: CMCSA, CMCSK) among its customers, which is absolutely a must if you're going to prevail in this strange land. It is attacking an application space in which traditional suppliers are notoriously weak, namely VOD, IP video, and digital broadcasting services. All of these services require a significant level of media processing and switching, something big suppliers are not used to.

Beyond the cable market, BigBand has set its sights on telcos as they make their own transition into video. This is particularly attractive ground for BigBand, since telcos aim to differentiate from MSOs through more interactive digital services. Telcos understand switched services much better than MSOs do, and must push forward with these from day one to compete. Finally, we like BigBand's VCs, particularly Santo Politi of Charles River Ventures, who knows the cable space well and knows how to get companies into the top tier.

Next, Luminous Networks Inc. needs some explaining. Luminous made the list, easily fulfilling most of the requirements for success (OEMs, diverse customer base, good market segment, increasing revenue), but it certainly has been a tough company to love over the years. For starters, you have to write the name of its marketing VP in pencil. You also have to believe that RPR (resilient packet ring) is for real, that growth in China and Latin America will translate into success in North America, that an OEM relationship with Ciena Corp. (Nasdaq: CIEN) is a positive, and that the level of competition in the MSPP space will allow a private RPR vendor to make it.

The good news is that Luminous has raised plenty of money to make a solid showing in the metro market worldwide, and it was savvy enough to follow the activity in the cable market first, and the telco market second. The question hanging over Luminous is just how it will exit and return some value to investors. An acquisition by Ciena is the obvious choice, but the Scientific-Atlanta OEM deal complicates the picture. IPO is a huge longshot for Luminous, given that Wall Street will need some real convincing to support an MSPP supplier in a market so utterly dominated by the likes of Alcatel SA (NYSE: ALA; Paris: CGEP:PA), Cisco Systems Inc. (Nasdaq: CSCO), Fujitsu Ltd. (OTC: FJTSY; Tokyo: 6702), Lucent Technologies Inc. (NYSE: LU), and Nortel Networks Corp. (NYSE/Toronto: NT).

Just saying that list out loud sort of deflates one's enthusiasm rather quickly. Luminous made the cut, though, and we're sticking with it.

Then there's Force10 Networks Inc. Force10 appeared so perfectly situated in 2002 that its success seemed all but inevitable. Every customer that got its hands on a Force10 switch loved it. It delivered what it preached: line-rate performance at 10 Gbit/s, with all the features turned on. Add to that its status as first to market with a 10-GigE switch, and you'd think an incumbent vendor would have taken Force10 out just for lack of any other quality startup out there and a near-guaranteed market opening as service providers and enterprises migrated GigE infrastructure to 10-GigE.

But sometimes the world doesn't cooperate with pat predictions. The market slows down (or grinds to a near halt, depending on where you look), and the big incumbent vendors scramble to catch up. And catch up they did.

Cisco got 10 GigE out the door and slashed prices, as any good market dominator should. Then Foundry Networks Inc. (Nasdaq: FDRY) followed suit, delivering an edge and core 10-GigE switch and pushed prices down even further. One day you're first, the next you're eating sand off the heels of your rivals, which not so long ago you had said were caught sleeping.

Force10 may no longer be in the pole position, alas, but we still like its prospects. Its boxes remain rock solid, no matter whom you ask, and it keeps winning customers. The big question is not whether Force10 will find an exit (this is the Ethernet switch market, remember), but whether the investors will make out. To date, Force10 has raised over $200 million, rivaling core router startups and other money pits for the title of "most VC capital still at work today."

That said, we're more inclined to believe in an IPO for Force10 than an acquisition. Why not? The Street can see the value of a company that straddles the enterprise and service provider worlds well, and Force10's only real weakness is the fiercely competitive world it inhabits, with its pricing and margin pressures. But Force10 has proven it can compete, so why not set it on the waters of the Nasdaq and see if it floats?

— Scott Clavenna, Chief Analyst, Heavy Reading