Ikanos Revisited

| About: Ikanos Communications, (IKAN)

Ikanos Communications (NASDAQ:IKAN) is a stock that has disappointed investors over recent years. Since the last major restructuring bomb that decimated the stock in August 2010, the stock has held up better-than-expected in face of weak operating results. Specifically, since my last write-up in August 2010, the stock has only declined from $1.00 at that time to $0.86 currently. I encourage investors to read this article entitled Ikanos: Lessons Learned, as it may be a useful guide before initiating a position in "value-based" technology stocks.

Since August 2010, Ikanos fundamentals have deteriorated further. Losses continue to pile up, another restructuring charge was just announced, another CEO has come and gone, revenues and market share are shrinking.

Management is focusing on VDSL chips with node-scale vectoring to reverse its fortunes, along with upgrading its Fusiv communication processors. The new Fusiv processors are moving along as planned, and should start contributing to revenues starting in the second quarter and building over time. But the larger revenue potential is in node-scale vectoring. Unfortunately, there have been engineering delays in launching this product. Having experienced first-hand the delays and complexities of multiple silicon tape-outs with private semiconductor companies, this can be a long process. Ikanos has a fairly complex four-chip solution with both analog and digital components that will be a wonderful chipset if achieved, but is an engineering challenge today. To make matters worse, competitor Lantiq announced a node-scale vectoring chip solution last month. Lantiq still needs another 9-12 months to pass carrier qualifications before commercial shipments, but still has roughly a 6-to-12 month lead over Ikanos.

At least for 2012, Ikanos will continue to lose market share and revenues. Broadcom's (BRCM) low-cost combo-chip integrating DSL and WiFi capabilities on a single chip continues to take market share, albeit at the low-end of the market. Lantiq has become a more formidable competitor at the high-end of the market. The result is that Ikanos VDSL chip market share has dropped from 82% at the time of the Conexant Broadband Access acquisition in 2009, to under 50% today. Given advances by competitors on the low-end and high-end of the VDSL market plus Ikanos node-scale vectoring product delay, Ikanos is unlikely to regain a lot of market share over the next 3 years, unless customers rip-out existing VDSL equipment - which is not going to happen.

Ikanos* ($,M) 2008PF 2009PF 2010 2011 2012E 2013E
Sales 265.0 215.0 191.7 136.6 120.0 130.0
Cost of Good Sold 160.0 116.0 126.7 65.9 60.0 63.0
Gross Profit 105.0 99.0 65.0 70.6 60.0 67.0
Operating Expenses:
R&D Exp 86.0 65.0 59.1 54.1 58.0 54.0
SG&A Exp 45.0 38.0 25.6 20.6 17.0 18.0
Stock-Based Comp 10.0 6.0 3.3 3.4 2.4 2.4
Deprec & Amortization 22.0 12.0 10.6 8.4 8.0 8.0
EBITDA -4.0 8.0 -9.1 4.4 -7.0 3.0
Operating Income -36.0 -10.0 -23.0 -7.4 -17.4 -7.4
Interest Inc/(EXP) -8.0 0.6 0.1 -0.4 0.2 0.5
Other# -20.0 -2.5 -27.2 1.4 -1.5 0.0
Pretax Income -64.0 -11.9 -50.1 -6.4 -18.7 -6.9
Income Taxes 2.0 0.2 -0.4 1.1 -2.0 -2.4
Net Income -66.0 -12.0 -49.8 -7.5 -16.7 -4.5
EPS Non-GAAP -0.07 -0.34 -0.08 -0.18 -0.03
EPS GAAP -2.20 -0.22 -0.88 -0.11 -0.23 -0.06
Diluted Shares (M) 30.0 54.0 56.7 68.7 71.2 74.0
Gross 39.6% 46.0% 33.9% 51.7% 50.0% 51.5%
Operating -13.6% -4.7% -12.0% -5.4% -14.5% -5.7%
Tax Rate -3.1% -1.3% 0.8% -16.9% 10.7% 35.0%
Net -24.9% -5.6% -26.0% -5.5% -13.9% -3.5%
% Change:
Sales -19% -11% -29% -12% 8%
Operating Income -72% 130% -68% 134% -57%
Net Income -82% 315% -85% 123% -73%
* restated for merger with Conexant BBA
# includes one-time items & US GAAP amortization of acqd inventory and goodwill
NB: Needham projects 2012 revs of $110M, EBITDA of -$17.6M, & EPS of -$0.32.

With all this bad news, one would think that Ikanos shares would have crashed and burned. The nadir appears to be last month, when the stock hit an intraday low of $0.67 just after the Lantiq vectoring product announcement. But since then, the stock has rebounded, and is currently holding at $0.86 despite horrific forward guidance during a February 2nd quarterly conference call.

So, is the bad news in the price? No, it can still go lower. For that reason, we have sold most of our position in Ikanos, albeit at an average price that is higher than current levels. But we still maintain a position in Ikanos for the following reasons:

1) Underlying value. The company has $35M in cash, and a market cap of $59M, leaving an enterprise value of $24M. The cash balance should fall to around $25M by the end of 2012. But bankruptcy is not the major risk for the next few years, just a slow shrinkage of the company that stays just below break-even. Thus, a cash value of $0.35 per share ($25M/71.2M shares) provides a base. In addition, Ikanos has a strong patent portfolio, that so far produces no licensing revenue. The issue is that carrier customers could shut-out Ikanos if management decided to enforce its patents. But the patent portfolio has an inherent value nonetheless. As discussed, in Ikanos: Lessons Learned - a cheap valuation has limited importance in technology stocks. So there has to be other reasons to hold onto a tech stock.

2) Strategic value. Ikanos has a strategic value for companies wishing to enter the growing VDSL market such as Qualcomm/Atheros (NASDAQ:QCOM) or Marvel (NASDAQ:MRVL) which currently partner with Ikanos for a WiFi-VDSL solution for carriers. Ikanos also has a strategic value for existing competitors Broadcom and Lantiq. Dado Banatao, Chairman and 32% owner via Tallwood Ventures, is well-connected in the industry, especially with Marvel. Mr. Banatao's interests are aligned with other Ikanos shareholders to realize value.

3) The tape. Ikanos shares have acted particularly well over the past month, despite the horrible fundamental news. As a CEO still has not been hired and another headcount reduction was just announced, one could conclude that the Board could be preparing the company for a trade sale. A trade sale would be well above Ikanos' current enterprise value of $24M.

Disclosure: I am long IKAN.