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Zarlink CEO on Consolidation

We’ve been significant investors in Zarlink (ZL) since this fall and feel it is one of the stronger examples of an undervalued comm-semi asset poised to benefit from an inevitable consolidation in the industry. Followers of this site know this is a key theme for us.

Zarlink CEO Kirk Mandy managed to echo our logic in the Zarlink FQ307 financial results conference call last week.

At the equipment OEM level, we have Alcatel and Lucent merging, Eriksson buy Marconi and Redback, Nokia and Siemens forming a joint venture, and these are some of our customers and they are dealing with a great deal of uncertainty in their businesses. This uncertainty directly impacts our order book.

The other thing that is happening as a result of this consolidation phase is that each of the new entities is evaluating which platforms stay and which go as they have at least two sets of everything after merging. Two digital loop carriers, two DSLAMs, two media gateways, et cetera, et cetera. Again, this is a disruption to the usual OEM business and impacts suppliers.

The other thing that is missing in this cycle is the significant R&D projects that we have seen in the past. Instead of large-scale R&D projects that spur the development of new platforms, for example what many have said BT’s 21st Century project will eventually encourage, the OEMs are making incremental changes to their existing platforms, what is typically called value engineering, focused on reducing product costs.

The semiconductor industry is going through its own fundamental change as well. We have lived in an environment for the past 30 years that enjoyed double digit growth year over year. This is no longer the case. A new expectation has to be set and this industry will have to come to grips with working with single digit growth rates. In addition, there are too many players at the moment, all competing in markets that are too fragmented and earning a market share that is too small.

This type of communication is remarkable only in sense that other companies like AMCC (AMCC), Transwitch (TXCC), Vitesse (VTSS.pk), Exar (EXAR) and PMC-Sierra (PMCS)  have been silent about these trends, and why their business models have failed to return to significant profitability. While the message isn’t surprising, the fact that the participant companies are finally delivering it is.

Though few like to admit it, wireline communication is rapidly becoming a commodity business, from the component level right up to the service delivery of broadband itself. Unique widgets, protocols, and boxes tied to the transport layer are a liability, not a strength, unless they deliver a ridiculous amount of upside, and I can think of no such examples.

Full Disclosure: The author is long VTSS and ZL.

Discussion

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  1. I can see how in individual cases consolidation can be modestly beneficial, but I still fail to see how it will really make a difference.

    It seems to me that the industry is in an important transition from legacy products to next generation products. Revenues from legacy products are at the very best, going down slowly, and at the very worst, going down fast. What would be gained by cobbling together such businesses? All you would get is a somewhat bigger, slightly more efficient conglomeration of modestly interrelated business that are declining at some rate. Why would this really attract much investment interest? On the other hand, if you had a promising stream of revenue from next generation products, why would you want to combine it with a much larger stream of legacy revenue that was inexorably headed south?

    There have been a number of acquisitions in the comm IC business over the past five years, and it is unclear to me whether any of them have really created any value.

    Posted by HC | January 30, 2007, 4:57 PM
  2. You are ignoring the pricing power that having fewer competitors brings to the table.

    Right now Huawei can parade 5 different SONET silicon vendors in from of their R&D team. All development costs are sunk, so the companies have every incentive to price to marginal cost to win the business. Make that 2 or 3 companies and the equation changes.

    You also need to look at the duplicative SG&A that exists among these companies.

    The equipment folks have effectively outsourced their R&D to the chip companies. The chip guys love to walk around and talk about how they benefit – their customers converted from using ASICs to using ASSPs. In reality what happened was all of the duplicative R&D being put into ASICs was picked up by the ASSP folks. Meanwhile the equipment companies still want ASIC pricing.

    As for attracting investment interest – if people are looking for 20% Q/Q growth from consolidation – forget it. If people are looking to maximize cash flow from an existing asset, it’s a great move. The problem is the cash flow guys don’t get the tech business. They like the real estate, lumber, and other businesses that are hard to screw up.

    You can buy these companies for 2x Gross profit. Turn out the lights, send everyone home, and you get your money back in 2 years if revenues stay flat. If they stay flat for 3 years that’s a 15% return. Many of these Telecom products will ship for 10 years. And the prices go UP not down at the end of the cycle.

    As for comm IC acquisitions, name one that was a consolidation of like players.

    Posted by Andrew Schmitt | February 2, 2007, 5:08 PM