The Marked Madness of the Carrier Chipset Market

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 |  Includes: AMCC, AVCI, AVGO, MLNX, MSPD, PMCS, TXCCQ, VTSS, ZLKKF
by: Andrew Schmitt

There was an excellent editorial on Monday by Lee Goldberg that explores the lack of new R&D in SONET/SDH and PDH chip sets. While I don’t agree with the conclusion, it is a worthy topic of exploration and he highlights something missed by the mainstream tech media.

The networking industry may be about to hit a hidden speed bump as the number of semiconductor companies actively involved with developing products to support SONET/SDH, PDH, and other TDM-based technologies can now be counted on one hand.

Lee thinks this is a big problem. This is not a problem at all. It is the only logical solution to the madness of the past six years.

The previous situation of having 10 companies all supplying a market growing at single digit rates was the problem.

Each of these companies sunk huge amounts of R&D (often 40-50% of annual revenues) into developing SONET/SDH or PDH chip sets only to find that five others had done the same. Each company then priced products at marginal cost (not a smart thing to do when R&D runs at 40-50% of revenue) in order to achieve any of the following misguided goals:

1. Be a market share leader (lose money on each part but make it up in volume)
2. Establish a strategic vendor relationship (as in ‘Let’s outsource our R&D to this desperate chip company‘)
3. Win additional business in horizontal products (bomb the price on the high volume business to win low volume/profit business)

These ideas formed the cornerstone of PMC-Sierra (NASDAQ:PMCS), Vitesse (NASDAQ:VTSS), AMCC (NASDAQ:AMCC), and Mindspeed (NASDAQ:MSPD) business strategy between 2001-2007. Equipment vendors loved it and learned to play each desperate vendor off of another. Unit volumes today are at levels above where they were 10 years ago, but profitability has been completely destroyed.

No longer. Companies are refusing to invest R&D in the SONET/SDH and PDH area because the history of returns is so poor.

Either through consolidation, or self selection, fewer players are bellying up to the networking semiconductor market. Witness the destruction of the PMC-Sierra wire line telecom R&D behemoth, or as Lee Goldberg correctly points out, the depreciation of the once mighty Agere [LSI] (aka Lucent Microelectronics).

The result is a classic last-man-standing winner take all scenario. The few companies remaining face an end market with fewer competitors, better pricing, and - if you believe the endless ballyhoo of video - substantially better volumes. This is a positive development and is why we own companies like AMCC, Transwitch (TXCC) and Zarlink (ZL).

Madness

But all is not up-and-to-the-right. The damage is permanent. Big iron telco Equipment vendors are increasingly looking to chipsets used by Enterprise and even Consumer applications. Why would a vendor rely on a boutique technology like SONET/SDH when they can slipstream behind 1.21 gigports of Ethernet shipped every month? This is why Broadcom (BRCM) will emerge as the big winner in the Telco market without even trying.

The lessons learned in the SONET/SDH area will be relearned by others. L2/L3 NPU vendors like EZ-Chip (LNOP), Xelerated, and Bay Micro as well as vendors of custom switch silicon are traversing the seven stages of denial. Virtually every IPDSLAM today uses an Ethernet switch identical to the one sitting in your office wiring closet. This trend will accelerate. Optical module vendors face an even worse situation, with Cisco purchasing the majority of devices that have little to no technical differentiation. Consolidation is the only solution.

The move to Ethernet in core networks was never about technology, it was about economics. The carrier folks who fought the technology battles in the late 90’s are toast. It is Ethernet’s operational cost, deployment cost, and now, lack of supply chain risk that makes it so attractive. The growth in carrier traffic and massive bandwidth price erosion forced the change - not the wishes of 1999 RHK punditry.

We will see a spectacular revenue bloom as the misguided strategies of the past are buried. As Avici (AVCI) recently showed, the market misprices the effects of an End-of-Life event.

When the meteor hit, the Dinosaurs evolved into birds. The roaches thrived. It remains to be seen what will happen with the existing SONET/SDH vendors who bravely move forward. But I wouldn’t bet against Ethernet. It will outlive us all.

Hat Tip to Osxman in the Nyquist Forums for finding this great link.

Disclosure: Author owns positions in ZL, AMCC and TXCC.