Why It's the Right Time for EZchip

by: Shlomi Cohen

Israeli router chip company EZchip Semiconductor Ltd. (EZCH) supplies, via its Yokne’am neighbor Marvell (NASDAQ:MRVL), the chips for Cisco’s new routers. These are advanced routers currently undergoing checks and trials at many Cisco (NASDAQ:CSCO) customers, particularly the giant telecommunications companies. For EZchip, this probably means that it is on the eve of a strong boost to sales and profits. The growth will come all at once in one of the coming quarters.

This being the case, I am exploiting EZchip’s low share price, and tripling my investment in it. I added EZchip to my portfolio exactly three years ago, when I wrote that the train was leaving the station, and that after many years of development, the company was on a strong growth track. This indeed is what happened, mainly because of Juniper Networks (NYSE:JNPR), which built its MX family of routers around the second generation of EZchip chips. Along the way, I took advantage of the steep rise in the share price, and sold half my holding at a large profit.

The same Juniper, which has only 17% of the CESR (carrier Ethernet switch/routers) market, has caused a lot of negative noise about the EZchip share in recent months. Because of the economic crisis, it reduced inventory, and so temporarily stopped orders in the second quarter, but the main damage was done by the rumor that it was abandoning EZchip in favor of independent processor development. This noise has opened up a rare opportunity for me to triple my holding in EZchip shares at a price lower than they were at three years ago, in anticipation of the launch by Cisco, which has three times Juniper’s market share of the CESR market, about 50%, and at a time when EZchip itself is already a profitable company, with $60 million cash.

I don’t know of many companies like EZchip, that for the third quarter, when the crisis was still at its height, reported all-time record sales, stemming from internal growth and not from acquisitions. Sales were $10.7 million, and proforma profit was also a record, at $3.9 million, 36% of sales. What’s more, the company generated another $4.9 million cash from business activity, and today about a fifth of its market cap is represented by cash, with no debt.

No one fell off their chair when Juniper unveiled its new processors on Thursday, and objective professionals estimate that they have no advantages over those of EZchip, so Cisco needn’t worry about them. It will take time for sales of Cisco’s new routers to take off because of lengthy checks and trials at customers. So too will Juniper’s new family of routers, with the new processors, only really take off in another year. Until then, and even beyond, it will still be buying processors from EZchip. In the third quarter, Juniper accounted for 62% of EZchip’s sales.

Sales to Cisco via Marvell fell to half a million dollars in the quarter, but these are sales that go straight to the profit line, because the gross sales are recorded by Marvell, and it transfers only the net profit to EZchip. So the greater the proportion of EZchip’s sales that are to Marvell in the near future, the higher will be the growth in EZchip’s gross profit. I was surprised that, despite Marvell’s low share in the quarter, the gross profit margin was above 72%, which is higher than the 69% recorded in the corresponding quarter of 2008.

All those who follow EZchip talk a lot about Cisco and Juniper, but they forget the other customers, which accounted for a third of sales in the third quarter. I estimate that there is a chance that, in the fourth quarter, there will a third customer accounting for more than 10% of sales. According to the table EZchip published in its quarterly presentation, ”Nine of the fourteen leading CE vendors are EZchip’s customers.” My guess is that, besides the customers mentioned in the table, Ciena (NASDAQ:CIEN), China’s ZTE (OTCPK:ZTCOF), ECI of Israel (ECIL), Ericsson (NASDAQ:ERIC), Tellabs (NASDAQ:TLAB), Motorola (MOT), and Nokia (NYSE:NOK), are also among its customers.

EZchip today is very different from the company it was three years ago, among other things because it recently entered an additional market, NPA network processors, which doubles its target market. Initial sales of these products are expected at the beginning of 2010. The markets for them are very large, and include cellular networks’ microwave systems, in which Ceragon Networks Ltd. (NASDAQ:CRNT) is a player, and GPON optical networks, in which ECI is a world leader, and in which Orckit Communications (NASDAQ:ORCT) also had an important win recently with India’s BSNL.

Next week, in the U.S., EZchip founder and CEO Eli Fruchter will present the great potential for EZchip with the burgeoning of video transmission on the networks at the annual Telecosm Conference hosted by George Gilder and Steve Forbes. At the conference, which will be attended by other Israeli entrepreneurs as well, Prime Minister Benjamin Netanyahu will be a speaker via video link. Perhaps his speech will be relayed by EZchip processors.