PMC-Sierra and Passave Don't Deserve The Same Multiple (PMCS)

| About: PMC - (PMCS)
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I covered the PMC-Sierra Inc. (NASDAQ:PMCS) acquisition of Passave 6 days ago.

While I was not given the opportunity to ask questions during the conference call, I did receive a written response to questions I phoned in and left on voice mail.

Question #1 What products are expected to benefit from the acquisition, and what type of revenue multiplier is expected - i.e. for every $1 in Passave MAC’s sold we expect to sell $x.xx in existing PMC products.

We have not closed the acquisition yet and our team and Passave are working on combined roadmaps and pull-through opportunities. We are not commenting further on this, and you may see some of our CEOs comments in the transcript below referring to VoIP-related and Res Gateway-related opportunities going forward.

Question #2 Why was Passave acquired and not Teknovus?

The Company acquired Passave for many reasons which include the fact that they are the market leader today, they have a great engineering and sales team, they are moving forward into GPON, and they have a good growth platform, and the deal is expected to be accretive as we move into 2007.

They did send me a full transcript of the call. I’d love to post it here but it clearly would be a violation of the document’s terms of use. Instead, I’ll excerpt a few paragraphs and beg for forgiveness. Contact PMC for a copy.

Our acquisition of Passave helps accelerate PMC-Sierra’s mission to enable the next generation broadband infrastructure buildout by one, making PMC-Sierra the undisputed market share leader in PON and fiber to the home IC solutions. In 2005 Passave had a worldwide market share of approximately 68%. Two, creating pull-through and technological synergies with our VoIP-based residential gateway products. Three, providing us with an innovative team experienced in making PON-based networks work in the real world. Four, providing PMC-Sierra with a high-volume growth platform. And five, this deal will be accretive in a relatively short period of time, neutral in the next two quarters.

Passave provides gigabit speed Passive Optical Networking solutions, better known as PON, for fiber to the home networks. Through three key Japanese OEMs, Passave supplies NTT in Japan, where the most advanced deployment of PON networks have occurred to date. They also have key design wins with OEMs and Korea, China and North America. It is estimated from carrier announcements and industry analysts that between 45 and 60 million homes will be connected using PON technology by 2010, starting from a base of approximately 4 million today.

My take: 45MM connections is a realistic market goal, made easier by the fact that NTT is on the record as saying they plan to deploy 30MM connections by 2010. My expectation is NTT will do this regardless of any success-metrics, much like Japan deployed ISDN in a Kamikaze-like method 15 years ago.

The other 15MM will come from North American B-PON (and maybe a little taste of G-PON), and Korean/Chinese GE-PON. Of the potential 45MM PON connections in 2010, we estimate at least 80% will be GE-PON. North America and Europe (what little there will be) will be ITU based G-PON. Passave is very strong in GE-PON and is battling from behind for G-PON, although having PMC’s relationships with carrier equipment suppliers will make the G-PON fight much easier.

It is highly unlikely Passave will continue to enjoy almost 100% market share, though it is hard to see them not be a #1 or #2 player for the next five years. We estimate Passave will ship components for at least 25MM FTTH connections between now and the end of 2010. Assuming PMC-Sierra can double the bill of material revenue from $20 to $40 by selling adjacent silicon, that’s $1BB in 50% gross margin business over the next five years.

More from the transcript:

Passave recently delivered more than 2 million ONU devices to Mitsubishi Electric, Sumitomo Electric, and Fujitsu Access for deployment in NTT’s fiber to the home broadband access network. Last year Passave generated 43 million in revenue and was profitable. Mitsubishi and Sumitomo Electric are Passave’s largest customers and represent about 80% of Passave’s revenues in 2005.

I’ve written about who the real G-PON players are in the North American Market. Bob Bailey spills the beans on who the big suppliers are today for GE-PON. This will change as Chinese and Korean suppliers come on line to supply domestic markets. However, it’s a safe bet that the purchasing managers at Huawei and ZTE will want to select a supplier that has been qualified by one of the toughest carriers - NTT - and two of the premier quality equipment suppliers in the business. Why not free-ride on all the R&D and troubleshooting performed by the Japanese?

While one can justify buying Passave for 7.5 times sales based on their strong position in an explosively growing market, it’s hard to say the same about PMC-Sierra at these price levels- especially when you see the additional 20MM options and 25MM convertible debt shares that are now in-the money. This 20% dilution is something that a quick glance at Yahoo! Finance won’t reveal.

Add the 20M options, 25M shares of convertible debt, and 24M shares for Passave, and the total shares outstanding for PMC-Sierra grow from 185M to nearly 250M - and PMC’s market cap grows to $3.2B. If you annualize the expected Q1 revenue of $80M, add in $100M for the Avago storage acquisition, and perhaps $70M for Passave you get a 2006 revenue number of almost $500M. PMC sells for around 6 1/2 times my rough estimate of 2006 revenue - roughly the same price they paid for Passave (!) - but PMC is not growing anywhere near the same rate.

I like the Passave acquisition a lot. I believe it will reinforce PMC-Sierra’s leadership as a telecom chip supplier and as Bob Bailey said, expose them to the fastest growing high volume portion of market. But I am at odds with the market when I say I don’t think Passave and PMC-Sierra’s multiple of sales should be similar.