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PMC-Sierra – More on the Passave Acquisition

PMC-Sierra LogoI covered the PMC-Sierra Inc. (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. Alan will be providing more financial insight during his comments shortly.

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.

Discussion

Comments are disallowed for this post.

  1. A few further points:

    With respect to valuation, it’s worth noting that the October 21 IPO filing indicated a going public enterprise value of about $125mm. This IPO was halted because of the UTStarcom issue, and then along comes PMC to pay $300mm for the company. It sort of puzzles me what happened in the intervening five months to cause this sort of increase in value, but perhaps they all know something we don’t.

    The comparison to PMC’s sales multiple is a little bit misleading because PMC is paying with cash raised by a convertible issued when the stock was much lower. I am not sure where the convertible strikes but it isprobably around $8 or less.

    Finally, one thing nobody really seems to talk about is PMC’s overwhelming market share in ATM. I have read analyst reports where the analyst “conservatively” assumes that this is a low growth business. My personal thought is that this business could fall off a cliff. Any thoughts out there?

    Posted by Herb Chen | April 10, 2006, 3:41 PM
  2. PMC is paying with stock…. strike on the convert is around 8.

    From the con call:

    Topic four, I will provide a brief overview of the terms of the transaction. One, structure. PMC-Sierra shall deliver shares of its common stock in exchange for all the outstanding equities, shares, warrants and options of Passave. Two, aggregate consideration. Within a range of stock prices, the consideration to be delivered by PMC-Sierra shall be $300 million. If the stock price of our stock differs from an average signing price by more than 16.7%, something referred to as a collar, the number of shares will be increased or decreased to keep the total value of the consideration constant, or $300 million.

    Posted by Andrew Schmitt | April 10, 2006, 4:11 PM
  3. In the near term, I think the deployment of VoIP by NTT and KT in Japan and Korea, respectively, will be slow. Both operators should not be in a hurry to cannibalize their current POTS revenue stream. Therefore, I would not count on too much pull-through business for PMC-Sierra from Passave in the short term. If there is pull through business, it will not be for double the MAC revenue.

    Any of the ONU vendors selling to the large carriers are making little to no money on the ONU. There is a huge amount of pressure to reduce costs. I hear about it constantly. This is driving the MAC vendors to get to an “ONU on a chip” solution. Where I see the benefit of this acquisition is that PMCS will help to Passave get to an ONU SoC in a shorter amount of time without having to license a bunch of IP and develop a new software development kit. This will be a big advantage over Teknovus in the GE-PON space. In the G-PON market, most everyone is already integrating the VoIP functions. No big advantage for Passave, there.

    I think prices for a SoC will be priced comparably to today’s prices for a plain MAC. Again, I don’t PMCS would realize $40 of revenue for this solution.

    Posted by Brad_K | April 10, 2006, 4:14 PM
  4. I have a few comment on PMC’s PON market share in the future.

    Technical speaking GPON is superior than EPON and meet telecom service provider’s requirement much better.

    RHK and iData reported that NTT has announced that it will move to BPON, GPON. China Telecom and China Netcom have made decision to adopt GPON as their technology of choice. China Netcom has signed contrct with FlexLight to purchase GPON equipment from FlexLight and already started deployment in 15 cities. Huawei also announced to choose BroadLight as its chip supplier to develop GPON equipment. I believe Bell companies decision to adopt GPON technology will have profound influence on the decision making process on other parts of the world.

    EPON market may shrink quickly and PMC will have to fight for GPON market share from the very beginning

    Posted by David Wang | July 14, 2006, 4:29 PM
  5. Financials drive decisions, not pure technology.

    This is the same info trotted out many times before. I am an independent party and it is pretty clear that regardless of how many press releases Flexlight makes, China is going GE-PON for the majority of installs.

    I am starting to think that GPON won’t get deployed much at all even inside NA for the next 3 years.

    Posted by Andrew Schmitt | July 14, 2006, 9:16 PM
  6. “China Netcom has signed contrct with FlexLight to purchase GPON equipment from FlexLight and already started deployment in 15 cities. ”

    What is the volume of the total ONU contract? As in 2005, China Netcom deployed only 20 FlexLight ONU for business users in each cities. Would you consider this volume as mass deployment.

    FiberHome have shipped 10,000 GE-PON ONU to China Telecom and China Netcom.

    I don’t think China Telecom and China Netcom have made decision on xPON yet. They probably won’t make decision until 2008.

    Posted by David King | July 17, 2006, 5:33 AM
  7. PMC’s earnings will be dilutive near term but by year end this will be accretive and that is the bottom line .

    Good Opportunity for Growth in Storage and Broadband Communication due to the big move to video . The old “broadband” was made for text not video. We are in the inning 2 of a 9 inning game .

    This is a very good company to be in going forward .

    Posted by RK | November 7, 2006, 4:51 PM
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