Over the past several weeks, the markets have sobered up to the unpleasant reality that the implosion of the twin bubbles of residential real estate and credit is still an ongoing phenomenon and remains a primary risk to the economy. As the likelihood for a second half recovery diminishes, the prospect for softer economic growth, if not outright recession, has weighed on the outlook for corporate earnings and stock prices. The challenge for investors in this environment is to find those companies with earnings that are most resilient to a weak macro-economy.
We believe that current trends and dynamics within the telecom networking sector will make merchant providers of network processors—namely, Cavium (CAVM), Netlogic (NETL), and EZchip (a wholly owned subsidiary of LanOptics (EZCH))—relatively immune to macro-economic troubles.
Of these, EZchip is our favorite stock as it has no analyst coverage, limited institutional sponsorship and is on the cusp of a multi-year revenue and earnings ramp.
Telecom Capital Spending Environment
Telecommunications and cable networks are experiencing enormous growth in network traffic driven by streaming video and IPTV applications. As a result, service providers have little choice but to invest in their networks to accommodate customer demand for bandwidth. In order to lower network costs service providers are transitioning away from the traditional network architecture of one network per service (voice, video, and data) to one multi-service network based on IP technology that is capable of routing all traffic.
At the heart of the transition to next generation networks is “application aware” networking equipment that can inspect, prioritize, route, and manage traffic flows. Network processors from EZchip and co-processors from Netlogic and Cavium are the critical path technologies in this next generation equipment.
Given the current competitive environment and bandwidth requirements of customers, service provider capital spending can be considered non-discretionary. As well, unlike the telecom capital spending boom of the late-1990s which was fueled by upstart carriers with fresh IPO proceeds, the current telecom spending boom is being driven by global telecom carriers out of operating cash flow.
EZchip on the Cusp of an Earnings Breakout
Over the past three years, investors have watched EZchip amass an impressive number of design wins for its network processors (in excess of 150 by our count), have seen the beginnings of a revenue ramp (78% year over year growth 1Q)—primarily off the shoulders of Juniper’s MX-series products—but have yet to be rewarded on the earnings line or in the share price. This, we believe, is about to change in a big way over the coming quarters as several very significant design wins are now moving into initial stages of production, including those with Cisco (CSCO) and Ciena (CIEN). As a result, the coming quarters should witness a significant revenue surge and an earnings breakout as the enormous leverage in the company’s financial model becomes apparent.
During the second quarter Ciena’s new ethernet services line cards for its hot-selling CN4200 went into production. These line cards use EZchip’s NP-2 processor and could translate into significant and immediate revenue traction for EZchip as the CN4200 chassis has already found significant commercial success.
As well, during the quarter Cisco began shipping its new ES20 line cards (20gig Ethernet Services) for its flagship Catalyst 6500 and Series 7600 router, with each line card containing two EZchip NP-3c processors. These line cards have shipped to carriers for field and lab trials and while only limited quantities of the ES20 cards have been shipped, the sheer size of Cisco and the ubiquity of its products in carrier networks could translate into a meaningful short-term revenue bump for EZchip and quickly qualify Cisco as a 10 percent customer.
Given the company’s lean operating cost structure and the fact that it qualifies in Israel as exempt from paying corporate income taxes for the next 10 years, EZchip has very significant financial leverage. Specifically, by making modest top-line growth assumptions we estimate that EZchip will exit 2008 earning approximately $1 per share on a run rate basis and will be earning $2 per share on a run rate basis by mid-2009. And this is before the revenues for commercial sales from the Company’s major design wins begin to flow. And oh how the revenues will flow! Consider the economics of just one design win, the Cisco Series 7600 router line cards.
By our estimate, Cisco has sold approximately 60,000 of its Series 7600 routers over the past 7 years and now sells approximately 10,000 new 7600 routers per year. Depending on the model, the 7600 has either 3, 4, 6, 9, or 13 slots which accommodate 1 or 2 supervisor engines with the other open slots for line cards. If we assume that on average Cisco sells 7 line cards for each 7600 chassis it sells then the ES20 design win would translate into annual NP-3c shipments by EZchip of 140,000 processors (10,000 chassis x 7 line cards x 2 NPUs per line card).
On top of this opportunity the installed base of 7600 routers is going to require upgrades as application aware processing and 1 gig and 10 gig ports proliferate. If we assume that 20% of the installed base of 7600 chassis is upgraded each year, the market opportunity for EZchip, from just this one design, win doubles to 280,000 processors. Assuming a $350 ASP this translates into a revenue opportunity of approximately $100 million per year.
(Of note: EZchip will account for sales to Cisco as royalty revenue from Marvell (MRVL), with Marvell making the actual product sale to Cisco. As a result, we estimate that the actual ASP recognized by EZchip will be closer to $220 but since gross margin on these sales will be 100%, gross profit calculated under either methodology—product sales or royalty sales—is unchanged.)
This suggests that this one design win at maturity could translate into annual earnings of $1.50-2.00 per share for EZchip.
Multi-Year Wealth Creation Opportunity
While the company’s current NP-2, NP-3, and NP-3c design wins will continue to move into production at a steady pace over the coming quarters, EZchip is simultaneously building an impressive roster of design wins for its recently announced NP-4 processor. While the NP-4 processor will not sample until 2009, we believe it has achieved design win traction with network OEMs faster than any of the Company’s prior processors. Specifically, our research suggests that Cisco, Juniper (JNPR), Ciena - all current EZchip customers - have each chosen the NP-4 for several new designs. As well, we understand that Alcatel (ALU) and Redback, two companies that have relied on internal processors, have also selected the NP-4 for next generation products.
For the past five years, EZchip Technologies (EZCH) has been in stealth mode, developing network processors and accruing design wins with the tier-1 networking OEMs while maintaining a low profile with Wall Street analysts and institutional investors; the company has no analyst coverage and management provides no financial guidance. Over this time, despite what a casual analyst might consider tepid progress as measured by financial performance, the company’s underlying business fundamentals have been extremely robust as its NPUs are now designed into virtually every next generation networking platform.
This is about to become apparent big time as the Company’s largest design wins begin to generate revenue and the substantial earnings power of the company is revealed. How substantial is EZchip’s earnings power? Again, we expect the company to be generating $1 per share of earnings on a run rate basis as it exits 2008, $2 per share of earnings on a run rate basis by mid-2009, and many more dollars per share of earnings in 2010 and beyond.
Not bad for a $14 stock and a company just reaching the initial inflection point of a multi-year earnings and revenue ramp.
Disclosure: Author holds a long position in EZCH