Cisco announced it’s intention to sell $4 billion in debt, and unlike most following the company, we don’t think it is earmarked for acquisitions.

The Offering

The $4 billion in debt is divided equally between 10-year and 30-year notes, with the 10-year yielding 4.95% and the 30-year yielding 5.95%. This is +2.2% and +2.5% over U.S. Treasury yields. This cash will be used to supplement the $2.5B in domestic cash (Oct ‘08) Cisco has on hand. Of course, Cisco also has $24.3B (Oct ‘08) in overseas subsidiaries that hasn’t been repatriated to the USA in order to avoid corporate taxes.

Cisco last issued debt almost exactly 3 years ago. The $6.5B in notes issued then were used primarily to pay for the Scientific Atlanta acquisition. Cisco got a relative bargain then by today’s standard with the bonds yielding .75% to 1% above prevailing treasury rates at the time. Cisco had $15B in liquid assets then, most of it overseas.

We acknowledge it is entirely possible Cisco is filling a war chest for acquisitions. Everyone loves to play the who-will-Cisco-buy-next-game (our longstanding bet is Adtran). Cisco CEO John Chambers answered questions in his typical guarded way during an interview last month, indicating “The perfect target is a company with 100 people and a hot product that customers are saying they should go out and buy” and “We do not believe in the acquisition of large peers in any space.”

Cisco could fund such small acquisitions out of working capital, and any large acquisitions could be funded by a bond offering after the announcement, just as they did with Scientific Atlanta. This forces one to ask the question – why did Cisco just decide to triple the amount of cash it has for domestic use if we assume it isn’t for acquisitions?

The Environment

Cash is more valuable than ever because it is now very expensive to obtain for all but the best capitalized companies. Cisco can borrow against the billions in assets sitting offshore. The problem is that many of Cisco’s customers don’t have the same hefty balance sheets. Many of them can’t get money at all.

Contrary to what you would think, corporate bond issuance is up 38% in 2009. Corporate bond yield spreads have widened in the past 12 months but have retreated from the panic highs of fall 2008. Large, well capitalized companies are tapping the market’s demand for high grade debt.

It is a different story for companies with lower debt grades. While there has been some improvement in the past months, lower grade ‘junk’ debt is anywhere between 5-7% more expensive than it was a year ago- if a company can get money at all. The number one issue facing these companies in 2009 is the availability of cash.

Cisco’s channel partners, the folks who distribute Cisco to small and medium sized accounts, can no longer borrow at LIBOR +1%.  Many of the lines of credit they are using today would not be written today and if they were, written at much higher rates. In some cases lines of credit that existed one day simply vaporized the next- just ask anyone who had credit with Lehman brothers.

The Bank of Cisco

We believe Cisco is growing operating cash in order to serve as a lender of last resort to its distributors and customers. An expanded balance sheet will ensure adequate capital is available not just for its own operations, but also the operations of its channel partners and customers.

If a key distributor were to suddenly lose a line of credit because the bank underwriting it implodes, Cisco can step into the breach and act as lender. If a contract manufacturer cannot obtain inventory financing Cisco can extend terms. Just as the Federal Reserve is the lender of last resort for the nations banks, Cisco can become the lender of last resort for the supply and demand chain.

Section 6 of the Notes to Consolidated Financial Statements in Cisco’s 10Q details these financial commitments. Examination of these numbers shows that Cisco has increased its financing commitments in various areas by 50-75% over the previous year (October 08/07), a period in which total revenue grew only 5%. This is quantitative evidence that Cisco is stepping into the breach created by a collapse in the credit markets.

Competitive Advantage

There is no more powerful weapon than the cost of capital, a point often lost on the tech industry which tends to focus on datasheets and speeds and feeds. During the wars between England and France, England was able to consistently field more and better ships as a result of having a cost of capital 2% better than the French, due in part to the mercantilist nature of the English economy. Cisco, like England, is turning its lower cost of capital into a competitive weapon.

Take for instance, Hewlett Packard. Much hay has been made in the recent press about how HP is going to have a run at Cisco’s mid-range Enterprise business. But in the fiscal environment of 2009-2010 this isn’t a technology fight. It is a balance sheet fight. And Cisco can deploy billions more in working capital simply because HP is already significantly more leveraged than Cisco.

It is no secret that Huawei is aggressively taking global market share, particularly in second and third world nations. Many people mistakenly believe this is because they offer cheap prices. This is not always the case. What Huawei does consistently offer are attractive credit terms, and are often the only equipment vendor doing so. While Alcatel and Ericsson still feel the vendor financing wounds of 2001-2 Huawei has no such memory.

Case in point – Telecom Malaysia (TMNET) selected vendors for a well publicized FTTH rollout and initially selected GE-PON. Huawei, at the time, was a laggard in GE-PON technology and pushed GPON. While additional information is forthcoming from TMNET in Q109 we believe Huawei won the business with GPON not based on technical superiority but on the willingness to underwrite the financing for the deal.

Strong balance sheets are powerful weapons during times of tight credit and Cisco just loaded a fresh clip.

A photo essay of a step by step install of Japanese GE-PON FTTH. Good photos, other than the fact this guy has a serious issue with his Japanese doll fetish.

Deploying 1Gb/s FTTB to buildings in selected Chinese cities as part of it's acquisition of China Tietong. Unclear whether this is GE-PON or just plain GigE.

China Mobile is leveraging the Tietong assets they acquired and deploying GE-PON equipment from Fiberhome. This is a win for GE-PON, nearly sealing the dominance of the standard in China, and also a big win for Teknovus, the leading chip supplier to Fiberhome.

Good news and a potentially good win for Huawei, and Broadlight. Huawei announced that GPON sill no longer sell at a premium to GE-PON, erasing one of its weaknesses.

Discussion with a number of industry participants revealed an unannounced Broadcom GPON program in advanced stages of development, with a design win at Alcatel-Lucent, the upcoming primary supplier of Verizon’s FiOS hardware as the carrier transitions away from BPON.

Broadcom designed the device internally despite a lack of active involvement in FSAN, the carrier-run group responsible for GPON interoperability that leads the ITU standards body. The device was first prototyped in an FPGA and the company now has silicon samples destined for testing in Alcatel equipment as well as Verizon carrier labs. Target deployment is 2H2009.

The chip includes the MOCA transceiver (revision 1.1) functions required by Verizon and currently supplied by Entropic in a standalone device. Broadcom is not doing the central office (OLT) chip and is initially focusing on a highly integrated gateway device for the customer location that displaces the standalone router and optical ONU terminal.

This is not unlike similar Broadcom products made for the Cable Modem and DSL markets. As cable/DSL broadband growth slows it is no great surprise that it plans to enter the FTTH chipset market. Broadcom and Broadlight, a private chip company which makes BPON and GPON FTTH chipsets, partnered in June 2004 to deliver FTTH chipsets (press release here). This partnership failed to reach any public fruition.

The PON chipset market reached $100M in 2007 but hasn’t reached the growth rates many hoped for. It is clear that Broadcom made the decision to enter this market not for the $100M market size, but for the opportunity to seize the MOCA market and continue to position itself as the chipset supplier for the connected home.

For a discussion of the difference between GE-PON and GPON see here.

Impact on GPON Chipset Vendors

While GPON attracts a great deal of attention it accounted for only 18% of ports shipped in Q108, as deployments on the scale of Asia’s (GE-PON – 60% share) have yet to begin worldwide (source Dittberner Associates). As written before, we staunchly believe the majority of the market for the next 5 years will be GE-PON, due to its dominance of Asian deployments. While the GPON market is smaller Alcatel-Lucent is the lead vendor for Verizon, which is the largest planned GPON deployment.

• Freescale was the incumbent supplier of GPON silicon to Alcatel-Lucent (press release here) and according to checks has been displaced from future designs. It is possible that Freescale is exiting the GPON business as a result of being displaced by Broadcom.
• Broadlight was a successful vendor of BPON (standard previous to GPON) chips to Tellabs and encountered much stiffer competition in the GPON marketplace. Broadlight continues to make forward progress with a GPON design win at Huawei, which is making inroads in the EMEA region. At this point Huawei and Alcatel/Lucent account for most global GPON shipments.
• PMC-Sierra, while a market leader in GE-PON based FTTH chipsets, has not made significant inroads in the GPON marketplace. The emergence of Broadcom in a critical tier-1 account will make it difficult if not impossible for PMC to reach the level of dominance in GPON that it currently has in GE-PON.
• Ikanos occupies a niche within the GPON hierarchy, focusing on hybrid VDSL/FTTH applications that leverage its VDSL expertise. Ikanos also has a moderately successful home gateway chipset (acquired from Analog Devices) that gives it the ability to produce a full GPON system on a chip for the ONU. It also can mimic the features of a comparable VDSL gateway. Broadcom also has VDSL technology, essentially negating any technology advantage Ikanos had.
• Several other vendors such as Conexant and Iamba face yet another competitor.

One can make a solid case that Alcatel-Lucent and Huawei and perhaps Motorola are the only high volume GPON suppliers for the foreseeable future. The win by Broadcom locks up a significant portion of this future market share and will make it difficult for other vendors to reach a dominant position in GPON in the same way PMC-Sierra did in GE-PON. Broadlight appears to be the only viable competitor to Broadcom at this point

Impact on GE-PON Chipset Vendors

We have no information that Broadcom is making a GE-PON device but given its strength in access chips and its efforts in GPON, it is hard to imagine something isn’t in the works. GE-PON accounts for the majority of the market and is closer to moving to a “White Box” model, where equipment design and manufacture is outsourced to Chinese and Taiwanese ODMs. This is how Cisco/Linksys, Logitech, and Netgear get the hardware to sell to consumers. Broadcom excels at this market and has the size and experience to dominate it.

The GE-PON chipset market is more mature, with nearly most chips being supplied by PMC-Sierra and the rest by Teknovus. PMC-Sierra dominates Japan but Teknovus has secured significant share in China.

We’ve speculated in the past (see Teknovus and Passave at a Crossroads) that Broadcom would enter this market. If China continues its trend towards deploying GE-PON it is a certainty.

Impact on MOCA chip Vendors

While GPON chipset market is (was) fragmented there is only one dominant MOCA chipset vendor – Entropic.

Entropic recognized a whopping 75% of their revenue from Verizon FiOS suppliers in Q108, or about $31.5M in quarterly revenue. Entropic provides the MOCA chipsets in equipment used by Verizon as part of it’s FiOS deployment. These chipsets enable the Verizon set-top boxes made by Motorola to communicate with the FiOS FTTH gateway (Tellabs) or home router (Actiontec) over existing in-home coaxial cable. In some cases the set-top boxes connect to the standalone home router, in newer configurations its functions are collapsed into the optical gateway itself.

As Verizon transitions from BPON to GPON the Tellabs FTTH gateway business will transition to Alcatel/Lucent. This is the design Broadcom has secured.

Broadcom’s new GPON chip includes the MOCA transceiver, using technology acquired from Octalica (see Press Release), which eliminates the need for a standalone MOCA device in the FiOS FTTH gateway or a separate chip in the Actiontec router. This is the chip currently supplied by Entropic.

Entropic recognized 39% of their revenue from Actiontec (26%) and Tellabs (13%) i
n Q108. The loss of these sockets as a result of the availability and deployment of an integrated Broadcom device would have a dramatic impact on Entropic’s revenue.

Another 36% of Entropic’s revenue during Q108 was from Motorola. While the Broadcom GPON chip is not a replacement for Entropic’s Verizon/Motorola set-top box application, Verizon will qualify Broadcom’s MOCA technology in their labs prior to deploying the new Alcatel FTTH gateway equipment. Once Broadcom’s Octalica-based technology is qualified in the gateway, it becomes a viable supplier of standalone MOCA chipsets for the Motorola set-top box. At best this would have a downward impact on pricing, at worst Entropic could lose the design.

Broadcom is already a major supplier of silicon to set-top box equipment makers such as Motorola. They supply much of the bill of materials for these systems and can use kit pricing to squeeze other vendors out. Broadcom also has the intellectual property to integrate the MOCA technology into set-top box system-on-a-chips, similar to what they have done with their GPON chip.

Based on Entropic’s Q108 customer profile, 75% of their revenue is immediately at risk once Broadcom’s GPON/MOCA device is qualified at Verizon.

Summary

While the arrival of Broadcom as a GPON supplier is certainly news and will change the lines of force within GPON chipset, it is Entropic that stands to be impacted most. Broadcom will leverage it’s GPON win to dominate the nascent MOCA market. While a single GPON chipset might fetch $20 or so and will generate $40-60M a year in revenue, Broadcom is using this as an entry point to address the larger MOCA opportunity of $125M (and growing 50% a year) currently owned by Entropic.

The larger goal is to seize control of the nascent home networking market. The PON ONU, DSL Gateway, or Cable Modem represents the commanding heights. Broadcom wants to make sure they control the silicon in the set-top box and the Cable/DSL/FTTH gateway because that it the surest way to control the silicon in the myriad number of devices that will appear in the connected home in the next decade.

Author is long ALU, BRCM, IKAN and short ENTR

GE-PON continues to gain momentum, and now makes the jump to 10G. Turns out NTT doesn't want 10G because it is interfering with their 30M FTTH subscriber goal.

We have not written about Vitesse since last August, when we changed our opinion about the company after the announcement of the storage divestiture to Maxim (see “Vitesse Sells Storage“). The company’s valuation has dropped nearly 50% since then and merits closer examination.

Q208 Consumption was $55.5M, a figure that represents the dollar amount of product end-customers took delivery of. They expect to begin reporting a traditional revenue number once audited results are completed, though they expect to continue recognizing customer revenue on a sell-through basis, a move we applaud.

Revenue (Consumption) Breakout

* Nyquist estimates

Historical Revenue (Consumption) Reporting

* Nyquist estimates

The company has completed a remarkable transformation away from using distribution channels for revenue buffering and has sector leading DSO’s on receivables of 27 days- AMCC’s is 36 and PMCS’s is 33.

Vitesse indicated it has stopped offering 2% Net 10 incentives for rapid payment which will consume working capital while raising gross margins 2%. Their distributor, Nu Horizons, can borrow money at near LIBOR rates, and surely took advantage of this profitable arbitrage. Since Vitesse now has sufficient working capital it is a sensible move to end this practice. We see most small/mid cap semiconductor companies moving in the same direction (AMCC and PMCS are doing this) and expect this to impact the P&L of their distribution partners. (See (NUHC) )

Margin guidance was in the range of 55-60%, lower than what we had expected in the past. From the Q&A on the call it appears the company is not yet operating in this range but expect to shortly. The halt of payment incentives may accelerate this.

The company has opex of 23.9M with 3.0M of audit/legal fees included and is operating at it’s stated long term opex target is 21M, which is 38% of current revenue; AMCC is at 59% of revenue, PMCS is 49%. Vitesse’s operational efficiency is notable but what is not yet known is what whether the company can grow or even sustain revenues with this level of investment. We believe that focusing the company on Ethernet only and applying it to the carrier and enterprise markets should give it maximum cost leverage, but we do not believe that Vitesse that much more productive than AMCC and PMCS.

Other notes:

• Networking revenues were up but by our estimates not at the levels they were 9-12 months ago.
• Ethernet over SONET/SDH was highlighted as a growth area with revenues expected to ramp over the next 3-5 years. Vitesse claims 70 wins though this includes companion chips like Ethernet PHY’s and MACs.
• Huawei and IBM were the two 10% customers. China was strong compared with previous quarter
• The company won a GE-PON FTTH design in the ONU, or customer located box with their 6-port Gigabit Ethernet switch. This is almost certainly a design at Huawei or ZTE, which are two of the three leading vendors for the Chinese GE-PON deployment. Chinese GE-PON ONU shipments will not break 250k this year but this is a significant validation of the company continued leadership in low power Ethernet switch/phy technology. The likely silicon vendor alongside Vitesse is PMC-Sierra or Teknovus. More discussion of this topic can be found in the discussion of PMCS Q108 results.
• Vitesse re-iterated their success in the X2 module based EDC (referred to as 1st generation EDC on the call). Our checks conclude that while Vitesse is not yet out of the running for the next-gen SFP+ E
  DC (ultimately, a higher volume opportunity) they are not leading. Cortina and AMCC occupy this position.
• The company emphasized the potential of using EDC technology in backplane applications – referred to as KR. We believe this is the true high volume opportunity. Unfortunately for Vitesse it appears that Broadcom and AMCC have already made significant inroads in this area.

Conclusion 

While the progress made by the company over the last 12 months is admirable, particularly in supply chain management, we believe the company faces risk of a decline in non-core revenues. The cash flow issues of the previous 12 months without a doubt forced the company to accelerate the usage of non-core assets for cash through the use of aggressive end-of-lifes (EOLs). We cannot argue with this decision as it provided vital operating cash. But little detail has been provided on this issue and whether EOLs were conducted on products outside the “non-core” segment. The significant risk of a secular decline in revenues that we identified last August is still present.

Author is long AMCC and short NUHC

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.

Dittberneer: GE-PON share of the overall market declined to 67% from 82% in 2006 and is projected to drop to 54% in 2008. GPON expected to grow from 7% to 38% share in 2008. (I think this is optimistic given VZ is still shipping B-PON in March ’08)