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PMC-Sierra Q108

PMC-Sierra reported revenue at the high end of guidance but what caught investors attention was higher than expected revenue guidance for Q208. Of particular interest to readers should be PMC’s comments on FTTH in China and Japan, which we expand upon based on our in-depth knowledge of the area.

Summary

PMC-Sierra’s results are no longer the proxy they used to be for the Networking industry. It’s future, like AMCC, is increasingly reliant on the storage and MIPS CPU portions of it’s business. Wireline revenue continues it’s secular decline and all indications are this will not reverse as the company has made few investments outside of FTTH.  We also believe that the positive Q2 guidance is derived from one-time events, primarily EOL revenue and initial shipments to China.

Q108 Revenue of $125.04M was roughly flat with the previous quarter and edged out analyst expectations of $123M. Q208 revenue was projected at $135-$140M, an 8-12% increase from Q108.

PMC reported that this strength was from a significant increase in their Japanese FTTH business as well as MIPS processors for printers. It was a down quarter for wireline (Telecom ex-FTTH) but PMC believes it has reached bottom. This is notable as wireline revenue has been in steady decline since mid-2006 and we believe the company is pursuing an aggressive end-of-life (EOL) program for these products. It isn’t clear to us what would cause the downward trend in wireline revenue to reverse. We believe that, at best, declines in wireline revenue have slowed, and PMC’s comments do not neccesarily mean a return to revenue growth.

Other notable items:

  • Bought back $98M in convertible bonds (paid $95M, nearly par) leaving $127M outstanding.
  • PMC expects storage will be their #1 business by EOY. This pushes their traditional wireline business into #2 position.
  • Strong bookings appeared in late Q1, which we believe account for the strength they expect in Q2.
  • Expects to ship several million WiMAX amplifiers in 2008 (Based on the state of WiMax deployments we lack the willing suspension of disbelief required to believe this will happen…)

We believe a significant portion of the Q2 revenue jump at PMC is attributable to one-time EOL revenue, and that this revenue has already shipped in April. The remainder of the growth is coming from initial shipments of FTTH chipsets in China.

FTTH and China

PMC reported increased FTTH shipments in Q1 and expected 2008 to be a big growth year for this product segment. We believe this is being driven by two factors:

1. Increased deployments of OLTs in NTT’s network

The number of FTTH subscribers surpassed the number of DSL subscribers in Japan for the first time this quarter. NTT appears to be exhausting the capacity of existing OLTs as this growth drives increases in subscriber density. Passave saw a large revenue burst early in the NTT deployment as the carrier salted central offices with FTTH capacity, and PMC-Sierra/Passave saw this revenue decline once NTT waited for the capacity to be absorbed. The pendulum is now swinging in the other direction and should remain there for 3-6 months.

2. Initial shipment of GE-PON devices to Huawei and ZTE in China.

Contrary to what G-PON vendors are saying, G-PON continues to lack significant traction in China. G-PON has seen near universal adoption by Western ILECs and their CLEC brethren but has only limited success in Asia. India remains the last battleground but the most exciting broadband growth there is wireless, not wired. GE-PON dominates deployments throughout Asia, including Taiwan and Korea. Point-to-point Ethernet is a greater technology threat to GE-PON than G-PON, as Korea and Singapore are taking this path.

Over 10 vendors are qualified for deployment in China Telecom/China Netcom networks but shipments to-date have been concentrated among Chinese vendors only, primarily Fiberhome.  PMC-Sierra secured wins at both Huawei and ZTE for Chinese FTTH deployments. PMC has not secured Fiberhome, which has shipped the majority of equipment to date. These two new vendors should account for increasing share in 2008 and 2009, and we see little chance of additional outside vendors taking share in China as this appears to be a nationalistic decision, given the dominant vendors of GE-PON equipment are Japanese.

The majority of Chinese FTTH revenue is for OLT shipments. This is not a sustainable trend for the same reasons it was not in Japan and shipments should attenuate as the year goes on. Ultimately, as we have written extensively, the China FTTH opportunity is massive but should not account for more than $5M in revenue in FY2008 for PMC-Sierra.

PMC remains strategically well positioned to supply silicon for the Chinese GE-PON FTTH deployment with Teknovus providing the only capable threat. Hard numbers are not available but PMC-Sierra is at best matching Teknovus revenue in China and has lagged in recent quarters. Cortina Systems acquired Immenstar, a start-up provider of silicon but has made few inroads in China. Ultimately the largest threat faced by PMC-Sierra and Teknovus are the internal ASIC capabilities of Huawei.

Our internal belief, unsupported by any hard data, is that Broadcom will eventually acquire Teknovus. If this were to take place it would pose a formidable threat to PMC-Sierra because of Broadcom’s deep IP portfolio, and it’s ability to integrate features such as MPEG decoding right into the ONU gateway chip. We don’t think most PMC-Sierra investors take this threat seriously enough.

Conclusion

An enormous valuation gap exists between PMC-Sierra and AMCC and we see few distinctions between the two businesses outside of FTTH. PMC-Sierra sells for an Enterprise Value/Gross Profit nearly 50% higher than AMCC and has a substantially worse balance sheet.

Author holds a position in AMCC and Broadcom.