Why Smaller Is Better: RRsat, EZchip

by: Shlomi Cohen

Last week saw history in the making with the U.S. election of the first black president, but it was also a week in which Wall Street made a bit of history of its own. In the two days following Barack Obama's victory last Tuesday, the Dow Jones saw its sharpest ever two-day drop. It is not clear whether the fall was a result of the fact the markets rose on election day itself in anticipation of a shock result that wasn't to be, or that it was the grim reality of the state the economy is now in which brought about a swift awakening from the euphoria over the Obama win.

The four leading indices ended the week with a cumulative negative return of 33-38% since the beginning of the year, and if we go back one year, the fall has now reached more than 40%. A fall as heavy as this means that the markets have now priced in the onset of a severe recession, but historical figures show that since 1929, the total fall from high to low on markets in times of recession has averaged 36.5% - which means that the potential for further falls from the current levels is limited.

With the recession now taking hold worldwide, giants such as General Electric Co. (NYSE:GE), and Cisco Systems Inc. (NASDAQ:CSCO) are facing an uphill battle to maintain their growth as the slowdown in the U.S. spreads to other countries. One would do well to focus instead on small niche companies, currently enjoying a business momentum in their own specific field, and which, because of their size, will continue to grow, even vigorously. As opposed to what would be considered in normal times the advantage of 'economies of scale' of large firms like GE, Cisco, and others, one would be better off opting for an 'advantage in smallness' when recession sets in.

Among the recommended small caps in my portfolio, tracked by "Globes", are a number of niche companies in different fields. RRsat Global Communications Network Ltd. (RRST) is one to watch in TV content distribution, while in healthcare, Omrix Biopharmaceuticals Ltd. (OMRI) is growing, recording profit, and is also up for sale to one of the giants.

Representing the telecommunications hardware sector is Ceragon Networks Ltd. (NASDAQ:CRNT), whose CEO, Ira Palti told "Globes" just Monday that he remains optimistic, despite the current situation. Another member of this sector, Orckit Communications (NASDAQ:ORCT) will be giving us some indication of how it feels when it unveils its third quarter results today, while over in the telecommunications chip industry, EZchip Semiconductor Ltd. (EZCH) also had reason to be cheerful when it unveiled its own results last Thursday.

EZchip - waiting for Cisco

EZchip - formerly LanOptics - which was floated exactly 16 years ago this week, will go down in history as one of the chip companies that took the longest to reach business success, and when I say success I mean it in the proper sense of the word - annual sales of more than $100 million by 2010.

I know of another company like this, and also have it in my portfolio - Sigma Designs Inc. (NASDAQ:SIGM), which floated in 1990, and whose sales, earnings and share price didn't go anywhere until 2007. As a rule in this sector, if you haven't made a go of it within three to four years from the time you put your first design concept on the drawing boards, your chances of survival are extremely slim.

Anyone who has ever sat with EZchip founder and CEO Eli Fruchter will have immediately realized that he is a man with endless patience and that it is no surprise that he didn't give up during the long and winding road the company has taken in the 20 years since it was founded. If the rocket attacks on Yokneam in the summer of 2006 didn't rattle him, he is hardly likely to be unsettled by a delay of a year or two in the commercialization of a processor developed over almost an entire decade. Fruchter has been exceptionally lucky to have reached 2008 - which has seen the onset of the most monumental credit crunch in decades - with $44 million in cash, strong sales growth, and an impressive profit margin, which is set to receive a tremendous boost next year.

Like Orckit, EZchip too has timed its arrival perfectly, with the right products for the right market - the burgeoning demand for video-over IP transmission, including on advanced handsets. Another connection between the two companies can be found in the fact that some of Orckit's components are used in EZchip's processors. Cisco is launching a new series of broadband infrastructure products for leading service providers which are having difficulty accommodating video over IP traffic, and it is rumored that these will also include router and/or advanced switching platforms, at least some of which have been built around EZchip's network processors, on the basis of its collaboration with Marvell Technology Group (NASDAQ:MRVL).

Cisco is now a customer of EZchip through Marvell, albeit on a small scale only, in terms of pilots and pre-commercial production trial runs. EZchip earns the bulk of its revenue from Juniper Networks (NYSE:JNPR) and from smaller players in the telecommunications hardware sector. It ended the third quarter with an operating profit of $2 million on $9 million in sales, and will probably improve on this substantially in 2009, in step with the rate of sales of Cisco's new platforms, an improvement that will, in economic terms, justify the $20-24 high its share price reached a year ago, and which looked insane at the time.

There were quite a few analysts in attendance on EZchip's conference call last Thursday, and as no one is currently covering the company, I expect the first analyst review to be forthcoming in the near future, probably once the progress of Cisco's latest launches becomes clear. This could also have been the cause of the 18% jump in share price on Friday on large turnover totaling 400,000 shares. As of the end of June, EZchip's largest shareholder is Goldman Sachs Group Inc. (NYSE:GS), with 2.7 million shares - nearly 12.7% of the company.

RRsat - poised for rapid growth

I have included RRsat, an Israeli company that is largely unknown, because its niche is quite unique - the relay of television content via satellite uplinks to subscribers worldwide. The slump on equities markets has sent its market cap down to a very attractive $160 million, with sales for 2009 likely to top $100 million, and net profit of more than $16 million. To add to all this, the company had $60 million in cash at the end of September. In contrast to other Nasdaq companies, RRsat has a policy of distributing dividends from current profit, and its current share price reflects a dividend yield of more than 6%.

The market gives RRsat a 2009 earnings multiple of just 10, but this is a company enjoying rapid growth - 30% year-on-year over the last five years, and it is expected to repeat this in 2009. I believe it is also one of those niche companies that will be affected to a lesser extent by recession, since it actually enables cable and television companies to save on operating costs and source content distribution to an outside provider such as itself. Furthermore, during times of recession people spend more time at home consuming television programming, especially the HD-quality broadcasts that have been driving RRsat's market share upward.

Part of RRsat's growth has been achieved by acquisitions. It started the year with the acquisition of the Hawley Teleport in Pike County, Pennsylvania, and a few days ago, it closed the acquisition of the Bezeq (TASE: BZEQ) satellite ground station in the Elah Valley, which will contribute $4-6 million of its projected sales for 2009. The Bezeq ground station comes with extensive tracts of surrounding land, which will give RRsat room for further expansion in the area, which already has all the requisite regulatory approvals for the stationing of large satellite dishes.

Disclosure: None

Published originally by Globes [online], Israel business news - www.globes.co.il

© Copyright of Globes Publisher Itonut (1983) Ltd. 2006. Republished on Seeking Alpha with full permission.