Author: Gehman Capital
Covestor model: Undervalued Growth Companies
Disclosure: Long EZCH
EZchip Semiconductor Ltd (EZCH) has established an extremely profitable business in its high growth market, and I believe it should generate higher stock prices over time. EZCH stock can currently be purchased at attractive prices because inventory contractions are causing the company to guide revenue down 25 to 30% in 4 Qtr. 2011.
Since 1989, the fabless EZCH (formerly LanOptics, Inc.) has designed and sold unique chips for use in telecom networks, data centers and enterprise backbones. Their chips accelerate the transmission of the “triple play” (data, voice and video). They use Carrier Ethernet technology that offers the cheapest and most efficient method of increasing the capacity of stressed legacy networks.
EZCH offers programmable merchant NPUs (Net Processing Units) with a full range, from the slowest to the fastest chips. The fastest chips are used for 6 to 8 years and the slower chips (less expensive and higher volume) are used for 2 to 3 years. At this time, EZchip’s major competition comes from in-house designed ASIC chips that are extremely expensive to design and test. EZCH competes by introducing new, interchangeable chips with additional features on a three year cycle. New chips can replace existing EZCH NPUs without expensive system upgrades.
EZCH has generated most of its income from chips in the CESR (Carrier Ethernet Switches and Routers) market, where five of the largest six Tier-1 carrier networking equipment vendors are their customers.
Cisco has about 45% of the CESR market and is increasing their purchases of EZCH chips through a royalty arrangement with Marvell. Juniper, with about 20% of the market, used to be EZCH’s largest customer. Orders are now declining because their new products use in-house chips. Ericsson, Huawei, Tellabs and ZTE are becoming larger EZCH customers.
In 2010, EZCH initiated sales of lower speed processors (NPAs). These chips are cheaper and less sophisticated but sell in higher volume. Fourteen vendors operate in this space, of which eleven are historically EZCH customers.
Two positive selling points are (1) that EZCH now offers a full component of programmable and interchangeable chips and (2) that customers are incorporating faster NPUs in slower chip applications.
Market Size
Internet traffic is growing at a tremendous pace because of the dramatic increase of video traffic. Infonetics Research projects that the Carrier Ethernet Equipment market will grow from approximately $32 Billion in 2011 to $40.2 Billion in 2015. The existing legacy networks can only keep pace with the traffic growth by utilizing Carrier Ethernet Technology.
From 2010 to 2015, EZCH estimates that their Merchant NPU and NPA market (as opposed to the ASIC market) will grow from $397 Million to $800 Million and the NPU market (high speed) alone will grow from $116 Million to $450 Million.
In 2010, EZCH sold over 53% ($62MM) of the Merchant High Speed NPUs. EZCH is in position to increase sales significantly because (1) they now sell both NPA and NPU chips (2) the NPU market, where EZCH is stronger, is growing faster than the NPA market, and (3) Cisco, a much larger company than Juniper, should become EZCH’s largest customer.
Product Detail (source)
Note: Marvell pays royalties to EZCH for chips they provide to Cisco. Revenue to EZCH is delayed for 30 days.
In 2011, EZCH generated most of its revenue from NP-2 and NP-3 sales. NP-4 will go into production this month and Tier I customers will install the chips starting in 1st Qtr. 2012.
The NP-4 is a big deal. The NP-4 has won twice the NP-2 and NP-3 platforms and is twice the speed. Five of the seven major CESR vendors have tested and will use the NP-4. EZCH “expects the NP-4 revenues to be four times NP-2 and NP-3 …”
The NPAs are not as profitable as NPUs. EZCH offered their first NPAs in December, 2010. They are used mostly in the Access Market. The NPAs sell in higher volume but are less sophisticated. Infonetics estimates that the merchant NPA market will grow from $281 Million in 2010 to $350MM in 2015.
To EZCH’s advantage, NPUs are transitioning to the traditional NPA areas. In addition, EZCH’s participation with NPAs is starting to offer new opportunities. One EZCH partner is using technology from the NPA-0 to develop a chip that could eventually generate royalties of a few million dollars.
The NP-5 is a bigger deal. The NP-5 should sample in 2012-13 and be produced in 2014. Customers, however, want the NP-5 as soon as possible because it integrates additional functions and will be much faster. EZCH said: “It’s highly likely that all of our NP-4 customers will move to NP-5 with us.”
EZCH is developing a top secret product in Kiryat Gat, in conjunction with specific customers. They hope to announce details in 2012. All the company will say is: “We are making a lot of progress. The customers like it a lot. We believe it’s going to be a paradigm shift in how products of that nature are being built. I think that we will be very successful.”
Both the NP-5 and Kiryat Gat products “are expected to become our growth generators when the NP-4 reaches its peak revenues.”
2011: A Transition Year (source)
EXCH said that 2011 is a transition year because:
1. Cisco, with over 50% of the CESR market , is becoming their largest customer and Juniper, with about 20% of the market, is incorporating in-house chips. All other customers except Juniper will grow significantly in 2011 (and 2012) over 2010.
2. Most revenue in 2011 was earned from NP-2 and NP-3 chips. NP-4 will be in production in 2012 and is “expected to generate very significant production revenues …”
3. EZCH customer inventories are being reduced significantly. When demand picks up, EZCH business will likely pick up stronger.
EZCH expects total revenues in 2011 to approximate the $62 million that was generated in 2010. Operating expenses are expected to be lowered to $20MM from $22MM in 2010 because of the lower US dollar.
Research Expenses (NRE) paid to the Israeli Government were lower in the 3rd quarter, but are expected to grow with the increase in NP-4 sales.
Annual Gross Margin is expected to be about 78%. 4th Qtr. Gross Margins are expected to be in the 75% range because of the product mix and because fixed expenses must be spread over lower total revenue.
EZCH reported $1.14 Non-GAAP net income per share (Diluted) for 2010.
EZCH estimates gross revenue for 2011 at about $62 Million.
I estimate 2011 net income per share (Diluted) of $1.10 to $1.15.
Outlook for 2012 (source)
EZCH says they have limited visibility because NP-4 is just starting production in 4th Qtr. 2011. Revenues in 2012 are dependent on the spending of Tier I carriers. Hopefully, economic conditions will encourage those carriers to spend more by the 1st Qtr. of 2012.
Therefore, EZCH can hope, but cannot project a recovery by the 1st Qtr. They do see accelerated growth in the coming years.
EZCH expects Operating Expenses to increase to from $20 million in 2011 to $25 – 27 Million in 2012 because of higher expenses for research and new employees.
Also EZCH said that revenue in 2012 should be higher than in 2011 because the NP-4 has won “twice the number of platforms” … and the margins are higher “so we expect the NP-4 revenues to be four times NP-2 and NP-3 combined…. The NP-4 will be very significant in our revenues.”
What can go wrong? Among other issues:
1. EZCH is an Israeli company. Even though EZCH has back up administrative and research facilities in the US, the stock is vulnerable to any Mideast conflict.
2. The NP-4 is just going into production. The chips have been tested and approved through a long arduous process. However, production problems can always develop
3. The US and world economy can remain under stress and cause EZCH’s order flow to remain uncertain.
4. New technology could be developed that will compete with EZCH products.
Why buy EZCH now? (source)
1. Trades at about 27 times 2010 and 2011 earnings. The multiple can be much higher with higher earnings.
2. Sells in a rapid growth industry.
3. Has an accepted product quality – with a strong order flow.
4. Released a roadmap of products until the year 2015.
5. Demonstrated revenue and earnings growth
6. Earns a high Gross Margin – estimated 75% for 2011. EZCH projects a Gross Margin of 78% for 2012. Net Income has been running at about 53% of Revenue.
7. Has cash of $127.6MM with no debt.
8. Outsources all production with royalty payments from Marvell
I believe that the inventory adjustment in the fourth quarter of 2011 is giving investors an opportunity to buy EZCH at prices that will be extremely attractive within the next year.
When the earnings from MP-4 start to build, I believe EZCH has a high probability of trading at much higher multiples.
