Cisco's New Processor: Good For Cisco; A Big Concern For EZchip

Sep.16.13 | About: Mellanox Technologies, (MLNX)

EZchip (EZCH) is engaged in the development and marketing of Ethernet network processors for networking equipments that can scale from a few Gigabits per second to hundreds of Gigabits per second according to the end product requirements.

Edge routing (routing that normally process data from multiple LANs) is currently its main market and the company generates over 90% of its revenue from the said routing segment. The company generates bulk of its revenues from few customers viz. Cisco (NASDAQ:CSCO), ZTE (OTCPK:ZTCOF) and Juniper (NYSE:JNPR). Cisco is its largest customer and contributed about 46% of its total revenues during second quarter 2013. So, the company is over depended on Cisco for its current revenues as well as for the future revenues. As stated in company's latest annual report:

"The growth of our revenues will depend in large part on the revenues we generate from Marvell attributable to Cisco. If Cisco purchases significantly lower quantities than expected due to global economic conditions or otherwise, or if the products that incorporate our network processors are not commercially successful, or if Cisco does not elect our future products, our future revenues and the growth of our business will be materially adversely affected."

The company sells its N3 (30-Gigabit network processor) and N4 (100-Gigabit network processor) to Cisco, thereby the company serves the mid to high end network processing requirements of Cisco.

Investment thesis/theme:

Its biggest customers (Cisco) is developing product that can limit the business for the company and even increase the competition for the company in other markets. I will like to avoid the company; Even after the recent fall in share prices, it's a risky investment for the short as well as for the long term.

Cisco's new product:

On Sept 12, 2013, came out the following press release:

"Cisco today unveiled the world's most scalable and programmable network processor, uniquely designed to power the Internet of Everything (IoE), as more people, processes, data and things become interconnected. With trillions of advanced "networked events" predicted to come online over the next decade, the Cisco® nPower™ integrated network processor delivers new levels of performance and bandwidth, as well as programmable control using open APIs and advanced compute capabilities."

The stock market reacted to the news negatively and the stock price of EZchip fell sharply (see the chart below).

EZCH Chart
(Click to enlarge)

EZCH data by YCharts

The reaction of the market is understandable as the largest customer of the company is moving towards self developed technologies/products, and In-fact has already developed the product that can replace the company's products.

Cisco new processor can affect the company negatively, in multiple ways:

  1. Negatively affect the near-term sales.
  2. Bring down the future revenue projections
  3. Can give the competition to EZchip in the other markets.

1. Negatively affect the near-term sales:

It can affect the sales of its current products to Cisco, particularly, the high end products like N4 as the new product is more likely to serve high end segment of Cisco's requirements. Cisco is claiming its product as:

"First true 400 Gigabits-per-second ("GBPS") throughput from a single chip, to enable multi-terabit network performance. All packet processing, traffic management and input/output functions are integrated on a single nPower X1 and operate at high performance and scale." (source: press release)

So the new processor is perfect for the high end requirement of the Cisco's networking needs, from where the company (EZchip) gets significant part of its business and profits.

If Cisco immediately starts to use its product by replacing EZchip's products then it can significantly affect the revenues of EZchip in a negative way.

2. Bring down the future revenue projections:

The company (EZchip) is developing another processor (NP-5, currently in design, is a 240-Gigabit network processor), and hoping to get significant business from this product in future (see the chart below). As stated in the latest transcript:

"substantially all NP-4 customers will select the NP-5 for their next generation platform. We now expect that to sell for approximately eight years. NP-5 was the NP-4 performance and total entity reduces the price for both for our customers and we expected to sell at approximately 50% higher ASP compared to the NP-4."

If Cisco starts to use its own processor that can handle much higher through put than NP-5, the company future revenue projections can fall dramatically.

(Source: company's presentation)Click to enlarge
(Click to enlarge)

3. Not just high data transfer but also for fast response:

As commented by senior management (comments on the new processor):

"Where most bits sent today result from human action-sending an email or calling up a Web page, for instance-many of the future signals traversing the Net will instead reflect "events," as devices notice things happening and respond by communicating with other devices or people,"

"As a result, communications carriers that designed their networks for today's traffic will need not just greater capacity but more flexible switching systems that can be adjusted to handle the growth of "event-driven" traffic, he says. The nPower chip line was designed to handle the variety, Cisco says."

The new processor is not just focused on high data transfer but also is designed for quick response to any event that happens on the connected network. These are the key requirements for a network processor that is used for routing, particularly, for edge routing, which normally handles the multiple LAN network. As such there is high possibility that Cisco may use its own processors for its products, if not immediately, in the future. Further in can give the competition to EZchip in the other markets also.

Conclusion:

I am of the view that the event raised a big concern for the company's future growth possibilities and if Cisco actually starts replacing EZchip's products with self-made products then the future growth prospectus of EZchip will suffer a big blow. The company will not only lose its revenues but also will have to work with reduced margins because the products that company sell to Cisco generate higher margins as compared to other products as the company earns fixed royalty fee and do not incur any production costs on the products that the company sells to Cisco.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: Investments in stock markets carry significant risk, stock prices can rise or fall without any understandable or fundamental reasons. Enter only if one has the appetite to take risk and heart to withstand the volatile nature of the stock markets.

This article reflects the personal views of the author about the company one must consult its financial adviser before making any decision.