Ikanos (IKAN) reached an agreement to acquire Centillium (CTLM)’s DSL chipset assets for $12M. This is a shockingly low price and it sets a new valuation floor for telecom component revenue streams that most people in the industry, including us, viewed as annuity assets worth much more. It should also force investors to question whether company cash flows are being invested in new products that will generate superior returns.
The transaction itself was not a surprise as it was something we viewed as inevitable (see "DSL Market Consolidation Dynamics" ). The price was a surprise.
Centillium recognized $6.1M in revenue from DSL products in CQ307, and a total of $20.8M in the first 9 months of 2007. Revenue was down substantially from the year before ($12.5M and $42.4M respectively), although the rate of decline slowed in the last few quarters.FTTH vs. DSL in Japan. Source MICS
This drop was a result of Japan’s wholesale shift away from DSL to FTTH; a shift so dramatic that in 2007 there were net DSL disconnects, not additions.
Centillium’s failure to hit the market window with a FTTH chipset product sealed its doom (see "Centillium- Cheap by any Measure"). The next generation FTTH chipset revenue flowed to Passave, now part of PMC-Sierra (PMCS). Teknovus has also made headway in Japan outside of Nippon (NTT) accounts.
Gross margins at Centillium increased in the last few quarters, most likely as the reduction in volume and the lack of significant future business allowed Centillium to extract more favorable customer pricing. Specific gross margin data on Centillium’s DSL products is not available, but our conservative estimate places it at around 55%.
Contrary to what many believe - as volume goes down in the low-volume communication semiconductor market - gross margin percentages go up. If a company is faced with declining business at a customer, there isn’t much incentive to lower pricing aggressively.
It is also worth noting that at one time, Centillium supplied the bulk of Japan’s DSL chipsets and included custom features required by NTT - creating a barrier to outside competition. This barrier still exists, and because of the declining to flat volume of the DSL chipset business in Japan, it is unlikely equipment manufacturers will design them out. The competitive situation is now static and what little business that remains is defensible.
Therefore, Centillium’s DSL chipset business should be viewed as a cash generating asset that generates $3.4M ($6.1M Revenue * 55% margins) in cash flow before paying engineers, sales, or marketing people. Considering Ikanos already has substantial DSL sales in Japan, it is difficult to see why its existing sales engineers cannot be leveraged to sell legacy Centillium product alongside newer Ikanos VDSL products.
The fixed costs required to support and maintain this revenue stream for Ikanos are (or should be) nil. In conclusion, Ikanos paid $12M for a $12M a year annuity - or 1x annual gross margin dollars.
Ikanos did not assume any of the liability associated with a Fujitsu (FJTSY.PK) lawsuit, and assumes none of the approximately $20m royalty liability sitting on Centillium’s books. Plus Ikanos gets $3M in inventory of unknown utility, most likely good stuff, otherwise they wouldn’t be taking it.
We would be tempted to acquire this business and run it out of our own office for $12M. Keep the business alive for one year and you get your money back. Keep it alive for two years and you double it. That’s before any potential price increases are factored in.
Ikanos as an operating entity cannot put the screws to the legacy customers for obvious reasons. An independent entity, driven by pure greed, could certainly extract better pricing. Equipment customers take notice and hope that any distressed supplier assets land in friendly hands.
Managers and investors should consider the impact of this transaction as it is a shockingly low price, reflecting a general breakdown in the market for acquiring assets.
We know from conversations with many operators and investors that they consider the price floor for telecom component revenue streams to be 2-3x gross margin dollars. This is based on the fact that telecom component revenue has 10 year product cycles, with pricing that improves as the cycle ends (through the use of aggressive EOL practices).
Centillium sold for less than 1x gross margin dollars, and to a buyer that could leverage the asset the best and therefore the one willing to pay the most.
This transaction sets a new floor in valuations, below anything we would have expected. It also marks to market the legacy Telecom businesses of Vitesse (VTSS.PK), Conexant (CNXT), Exar Corp. (EXAR), PMC-Sierra, Mindspeed (MSPD), and others.
It should force investors to question whether company cash flows are being effectively invested in new products that will generate superior returns. Centillium spent $36M in operational costs in just the first 9 months of 2007, much of which went into VDSL - a rather unprofitable end.
Ikanos indicated it bought the business for the analog expertise the Centillium engineers have. We believe that Ikanos licenses certain portions of its DSL chipset from Aware (AWRE), namely the AFE. Theoretically, these new engineers would allow the reliance on Aware to end and perhaps enable a more compelling product.
But the last five years have engendered skepticism of the ability of component companies to leverage technology acquisitions into greater revenue streams. For every successful technology acquisition there are ten failures. If getting analog talent was the objective, it is tough to understand how talented engineers at Centillium could not have been lured over to the more financially healthy and closely governed Ikanos.
As always, don’t listen to what someone says- watch what they do. Our hope and belief is that Ikanos views this asset as a cash cow; they lay off the dairy workers, bring the cash cow into their own existing barn, and sell the milk. Centillium indicated the sale of the unit will cut Opex by $18M - in April we will see what portion of this Opex Ikanos has assumed.
Finally, Ikanos did their competitors a huge favor by eliminating a marginal producer of VDSL chipsets that was setting an artificially low price floor the more established vendors were forced to bid against.
This transaction, coupled with the previous merger of Telecom Italia (TI)’s and Infineon (IFX)’s DSL business, is another step in a positive direction for the DSL business. Examining the dynamics of the DSL component business we see:
- An improving supply chain with less competition and no remaining marginal players.
- A heavy push by European regulators to mandate unbundled facilities, thereby radically decreasing the likelihood of fiber deployment and driving demand for new DSL. We think this is foolish, but it is good for DSL.
- A global upgrade cycle from older low speed and low density DSL chipsets.
Barring a global economic meltdown, what's not to like about the DSL chipset business at this point?
Disclosure: Author is long Ikanos and NTT.