Small Cap Comparison: Orckit and LanOptics/EZchip Each Has Strengths

Includes: MLNX, ORCT
by: Shlomi Cohen

One month on from the nosedive by the markets and the switch to negative annual returns, Federal Reserve Board Chairman Ben S. Bernanke has managed to pull off a turnaround.

Using different wording, less hawkish than that of his predecessors, in the announcement released last Wednesday by the Federal Reserve's Open Market Committee which he chairs, Bernanke delivered the reassuring message that no further interest rate hikes were in the offing. For jittery investors, this all-clear sign was the signal that they had been waiting for, and the stampede for shares was soon in full swing, with indices moving back into positive territory.

Yesterday morning, the Russell 2000 Indices showed a return of 2.7% since the beginning of 2007, the Nasdaq 1.6%, the S&P 500 Index 1.2%, and the Down Jones 0.1%. The present trading week is also the final week of the first quarter of 2007, and after the severe profit warning issued by Motorola Inc. (MOT) last week, more companies are likely to follow suit over the coming weeks.

The index returns I mentioned give a clear picture. The small cap shares, such as those in the Russell 2000, are the first to undergo a sharp upturn just as they are the first to plummet in crises, unlike the heavier Dow Jones and S&P 500 stocks.

An outstanding example in my portfolio of small stock that made a sharp U-turn is LanOptics Ltd. (LNOP). It has risen 36% from the $11.40 low it reached during the slide on February 27 to an annual high of $15.57 during last Friday's session.

Any irregular movement in LanOptics draws an instant response on the site of tech stocks guru George Gilder. "Gilder has been aggressively buying the stock for his hedge fund," was how the investors logging on to his forum saw it. Gilder wasted no time in responding and said that he was indeed "guilty" but not of buying stock for one fund or another, but because in recent days, 'I met with investors that have been moving stock and I talked to them about the EZchip Technologies Ltd. potential.'

I, on the other hand, believe that in addition to the phenomenal marketing that Gilder has been doing on behalf of the small network processor developer from Yokne'eam, last Friday's steep gain for LanOptics could well be a sign that the final stage has begun in the process of discarding the name LanOptics, under which it has been traded since1992. It will then adopt the name of its subsidiary, EZchip, and could be re-listed under a new ticker (perhaps EZCH). This is not mere semantics but rather a sign that the company's managers feel that they have good visibility and that they can start behaving like any other Nasdaq company with proper conference calls and quarterly guidance.

At the end of December, LanOptics increased its holding in EZchip to 78%, when it allocated some of its own shares to EZchip's shareholders, among them Star Ventures, and BlueRun Ventures in exchange for their holdings in EZchip. The remaining 22% is held largely by company managers and employees and Goldman Sachs. These will probably also agree to a stock swap in the near future, and once this is complete, LanOptics will wholly own EZchip and make a fresh start. This will also entail a secondary offering, to finance the tremendous growth that it will experience.

The first hint that this process is already in motion came two weeks ago with the announcement that Chinese telecommunications equipment giant ZTE had selected EZchip's NP-2 and NP-3 network processors for the platform it sells for broadband infrastructure. The most important part of this announcement was the explicit statement that "ZTE is already shipping several products for the high-end enterprise, carrier access and core based on EZchip's network processors." This leads me to conclude that ZTE has been an EZchip customer since the fourth quarter, in which the company reported $3.4 million in sales.

ZTE one of EZchip's lesser known customers, and since this announcement is a departure from the company's standing policy of not disclosing its customers' names, another potential announcement of a customer of a different scale altogether could work wonders for the stock and lift it to levels where a secondary offering would be much more feasible. Juniper Networks (NYSE:JNPR), for example, is almost certainly an regular customer, and Cisco Systems Inc. (NASDAQ:CSCO) will also become a key customer through Marvell Technology Group (NASDAQ:MRVL) next year.

Moreover, in its presentation from last month which now appears on its site, EZchip states explicitly that its potential customers are Cisco, Juniper, and Alcatel-Lucent (ALU). It adds a clear hint that two of them already are customers, so one does not need to be Sherlock Holmes to assume that the reference is to the first two. The company adds that in the third quarter of 2006 it began deliveries to a leading customer, with another customer joining in the fourth quarter. It now expects to add a new top-flight customer every quarter.

Overall, EZchip's target market for its network processors is the broadband telecommunications infrastructure sector, primarily in metro networks serving large cities. Through this equipment, telecommunications services providers plan to offer what are now called triple-play services, especially video. This is the same market as is targeted by Orckit Communications Ltd. (NASDAQ:ORCT) subsidiary Corrigent Systems.

EZchip, as mentioned earlier, is just beginning its commercial development, with sales of processors totaling a few million dollars a quarter. Orckit, on the other hand, has already sold $150 million worth of equipment to KDDI Corp., over 2005 and 2006. Despite this, not many people know that EZchip's value is double that of Orckit, since EZchip will have 24 million shares once all the stock swaps and dilutions have been completed, even before the secondary offering goes ahead.

The gap in values between these two companies is even larger when one takes into account that Orckit has more than $80 million in cash, while EZchip has just $15 million. Why is the gap so large? Because EZchip has George Gilder and Orckit has a multitude of investors that find themselves frustrated by its volatile record and treat it warily.

An example of this was seen in the convertible bond issue that is due to close this week on the Tel Aviv Stock Exchange [TASE], a move that has confused investors even further. If Orckit has $80 million cash and "half a dozen contracts" in the pipeline this year, why does it need another $25 million? And if it is issuing convertible bonds, why do so at such a low conversion price, when the "half dozen contracts" could very well lift the stock back up to its January 2006 high of $30?

My explanation for the bond issue is simple. First of all, more than $100 million cash sounds a lot better to company owners than "just" $80 million. Given that the TASE is hot, and that there is no need to disclose all the company's commercial secrets in a prospectus that will in any case not be required until such time as the bonds are listed, why not make a quick issue that won't be overly diluting? When the stock reaches $30, Orckit will hold a secondary offering, and the TASE will look back favorably on this bond issue, in contrast to the $100 million one it made during the bubble years.

I once asked Galileo Technologies founder Avigdor Willenz why the company had $100 million in cash, which he wasn't using at all. There was a tone of cynicism in his reply, which I actually understood only too well. "Because I'm the son of Holocaust survivors. Look out of the window; we're surrounded by Arabs," he answered. If there was ever a company that really appreciates how important it is to have more than $100 million cash for a rainy day, it is Orckit, which went through a traumatic time during the bubble days. Were it not for that $100 million bond issue, Corrigent, with the big dream that is now on the verge of becoming reality, would never have come into being.

LNOP 1-yr chart


ORCT 1-yr chart

Published originally by Globes [online], Israel business news -
© Copyright of Globes Publisher Itonut (1983) Ltd. 2006. Republished on Seeking Alpha with full permission.