Author: Gehman Capital
Covestor model: Undervalued Growth Companies
Disclosure: Long EZCH
This year has been extremely difficult for small cap stocks. Every time I think that we are going get a reprieve, the market provides another kick in the pants.
ExChip Semiconductor (EZCH) is my largest holding and the stock that I think has the greatest possibility of providing extremely significant profits within a reasonable time frame. Unfortunately, the company disclosed a downbeat earnings outlook that hit the stock hard.
EZCH reported Q2, 2012 earnings before the New York stock market opened on August 8th. Gross earnings of $15.8 million and non-GAAP margins of 82.2% were at the top of EZCH’s guidance. Unfortunately, investors were shocked with the slowdown in orders for EZCH’s new NP-4 in Q3, 2012.
This devastated the stock price. The company, a wide range of analysts and investors, believed that Q3, 2012 would be the beginning of a significant “earnings ramp up.”
EZCH’s chairman has always said that “earnings will be lumpy,” but this was totally unexpected. I have read and studied all the information that I can get my hands on.
I believe Eli Fruchter, Chairman, EZCH, when he said in the conference call (Q2, 2012) that “it is a very disappointing short term guidance that delays our expected revenue ramp but we believe it is just a delay that does not change our long term view.”
Two factors caused this delay:
(1) The slowdown in the global economy has slowed up the capital expenditure spending of carriers that buy the routers (that use EZCH NPU’s).
(2) It is taking new EZCH customers more time to go into production than was expected. The technology is new so they need more time for software development.
Eli was questioned in the conference call if the carriers, that drive 90% of EZCH’s sales, will continue to delay spending on wire line products (Note: carriers are spending on wireless products).
He said, “I believe that the carriers cannot halt investments in wire line products for too long because then it creates a bottleneck and the networks will not function well. So I think those investments will resume, and right now, I think that they will resume at the end of the year.”
Eli also said they have not lost any “designs” in edge routers, where EZCH does 90% of their business.
Eli stated that they are not seeing any “pressure on pricing,” even though EZCH makes 82% gross profit margin.
He also said he doesn’t think their customers are having difficulties beyond what would be normally expected. “It’s a new platform … in the new platform there are many other chips and a lot of software development – it’s not just EZCH related.”
Cisco (CSCO) and ZTE (SHE:000063), which used EZCH’s NP-3, easily transitioned to the NP-4. It’s the new customers that were delayed. However, Eli said “… we believe that NP-4 based systems at Huawei, Ericsson and Tellabs as well as many other customers will enter production at the end of the year.”
Where does this leave EZCH going forward?
Eli said that Q4, 2012 will be higher than Q3, 2012 for sure. He will not be able to give reliable guidance until the Q3, 2012 conference call. He did say “the real growth will come next year.” There is a possibility that Q4, 2012 revenues will be much higher.
EZCH is now scheduled to sample their next chip, the NP-5, in Q1 2013 (one quarter later than earlier projected). The NP-5 will have significantly higher profits than the NP-4 that is just starting production shipments now.
Also, EZCH is developing a top secret, evolutionary product that will double their addressable market. The product will be announced next month and should go into production in 2015.
EZCH does not fill in the 2016 NPU revenues, but since most of their business is the High Speed NPU’s, we can estimate $220 million of sales (55% of 400 million) of High Speed NPU sales alone.
The $63.5 million revenue generated $31.0 (49%) Non-GAAP Net Income in 2011.
EZCH has been projecting that on their NPU business alone, they will generate four times the revenue of 2011 ($63 million) in 2015. That may roll out a few months because of this delay, and that represents $250+ million dollars that would result in $122+ million (49%) in Non-GAAP Net Income.
theflyonthewall.com reports: On August 9, RBC Capital lowered their EZCH price target to $36 from $44. However, “the firm is still upbeat about the outlook for EZchip growth, and it maintains an Outperform rating on the stock.”
On August 9, Benchmark Co. lowered their EZCH price target to $40 from $45. However, “Benchmark calls EZchip’s revenue outlook for the second half of 2012 ‘somewhat disappointing,’ but reiterates a Buy rating on the stock with a lowered price target.”
The peaks and valleys of EZCH are difficult to endure, but I believe the rewards will be well worth the trouble.
