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.

They shared the following data with me.

We estimate the total merchant market for PON ICs was about $90 million in 2006, up 20% from 2005. We estimate PMC-Sierra had a share of about 60%, and we rank Teknovus and BroadLight second and third, respectively. A host of other vendors accounted for the rest of the market. In alphabetic order, these suppliers include Centillium, Conexant, Freescale, and Immenstar.

I estimate Teknovus revenue was $10M last year, derived almost entirely outside of Japan. According to Linley, PMC-Sierra (PMCS) did $54 million, which was almost entirely GE-PON. I still follow Centillium (CTLM) though I am no longer invested, and they reported $4M in revenue last year, some % of which was not directly PON silicon. This puts the GE-PON market at about $65M.

PMC-Sierra revenue grew from $45M in 2005 to $54M in 2006. On an absolute basis, the $300M acquisition looks like a hefty price tag given the growth rate. I thought the acquisition made sense (see “PMC-Sierra Acquires Passave“) and still feel this way (if you read the linked article, I thought PMC paid with overpriced stock). PMC-Sierra needs to use this business to win more silicon content (VoIP, VDSL, Processors) and I still believe they can do this. The numbers do show they are facing a fight outside of Japan as Teknovus appears to be doing well.

As for BPON/GPON, Broadlight revenue was driven almost entirely by BPON sales to Tellabs (TLAB) and Motorola (MOT). The remainder of the merchant silicon market is served by Conexant (CNXT), Freescale (Alcatel (ALU) is their lead customer), and Immenstar (now Cortina). These players account for low single digit share percentages. AMCC (AMCC) appears to have exited the market.

Not quantified in the Linley report are equipment vendors which use in-house designed silicon (ASICs). ASICs play almost no role in GE-PON in Asia, with the exception of OKI which designed their own chip after Centillium failed to deliver working silicon (see “Centillium – Cheap by Any Measure“). While Broadlight supplies the lion’s share of silicon into the BPON marketplace it must navigate the transition of Verizon to GPON. Unlike the GE-PON silicon market, which is supplied almost entirely by two vendors, the GPON silicon market is oversupplied (follow link for details) and faces a much greater ASIC threat.

Contact us with questions or for further consultation.

Full Disclosure: I currently have no position in any of the companies mentioned.

From the Linley Wire:

Over the past three years, Cortina has acquired Azanda, Intel’s optical products, and now Immenstar—a strategy that sets the bulked-up Cortina apart from wimpier single-product-line startups. With the Azanda acquisition, Cortina consolidated its component business for Cisco’s high-end routers. The acquisition from Intel more than quadrupled Cortina’s revenue and gave the startup access to most major communication OEMs. Most of the product lines acquired from Intel, however, were addressing mature markets. Immenstar gives Cortina access to the fast-growing PON market. ….. Given the ease that Cortina raises capital, we would not be surprised to see the company add to its broadband play with the acquisition of small VDSL vendor.

Centillium has a market cap of $76M but an enterprise value of $37M, all liquid (More of my opinion on Centillium here). Centillium also carries a large $21M non-cash liability on their books that I believe may never need to be paid. Removing the liability, the company is currently valued at $16M, less than 2x the most recent (and ugliest) quarterly revenue. It’s also valued at 1/2 the $29M in R&D expenditures made in the last 12 months.

The big negative is Centillium is feeding cash into the flames at a rate of $4.5M a quarter. It needs to be consolidated into a larger, more efficient entity. It makes no sense for $40M/year revenue companies to be public given the fixed costs associated with a Nasdaq listing. I believe that placing the operating entities of Centillium into a more efficient host would make the business cash flow positive immediately.

Next on the list is VDSL market share leader Ikanos (IKAN) at around $120M enterprise value. It too has a large cash stash. That would be a large acquisition for a company the size of Cortina, and the VC investors still holding their stake in Ikanos firmly believe the company has a future as an independent entity. I agree.

At current valuations, any company (including Cortina) could acquire Centillium, milk the revenue stream, and make the acquisition work financially.

I believe a public company, like Conexant (CNXT), PMC-Sierra (PMCS), or even Broadcom (BRCM) are more likely suitors. As public companies, they can issue shares for Centillium and reap the large cash balance. They would acquire a revenue stream, some useful R&D and future products, and a lump sum of cash for stock. Think of it as an indirect secondary offering.

PMC-Sierra is the best match, given it would eliminate a desperate FTTH silicon vendor who is distorting pricing, acquire a DSL product to complete its access portfolio, and pick up an extremely complementary gateway VoIP product.

Even Ikanos would make sense as it would consolidate competition and give them FTTH products, though I would argue they don’t need the distraction now.

One thing is clear- There is no incentive for private investors to bankroll Cortina to acquire mostly cash. There is a better incentive for other public companies to issue shares to capture it.

Author is long Centillium and Ikanos

This acquisition is surprising. Cortina previously focused more on the core of the network and has either built or acquired products designed to enable the next generation of WAN equipment for carrier applications. Immenstar is tightly focused on fiber to the home chipsets, a much more access oriented application. I suspect that Cortina is looking to couple it’s carrier class ethernet solutions with Immenstar’s high density OLT solution. Still, it is not a pretty fit.

Immenstar is a hybrid Chinese-American company with strong ties to UT Starcom, a company that at one point was poised to supply NTT (NTT) with large amounts of FTTH equipment. They stumbled (or were tripped by Passave, now owned by PMC-Sierra (PMCS) ) and Mitsubishi Electric took the majority of the lucrative and prestigious NTT contracts. As a result, Immenstar has not been tremendously successful in the marketplace. I suspect that this acquisition was Immenstar’s only option.

Cortina is one of the more interesting startups out there today, and appear to be pursuing a strategy of strategically integrating underperforming assets acquired from both public and private companies with a goal of consolidation. This is a core Nyquist strategy.

It’s unfortunate that companies like Centillium (CTLM) are not actively engaged in attempting to sell their own FTTH assets. As an owner of Centilluim equity I find this extremely frustrating. It’s clear that Cortina would have been an interested suitor.

Hat Tip: Venturebeat

Author is a Centillium stockholder

Enter the Dragon

China Telecom (CHA) recently assembled a very quiet, closed door session of suppliers in order to orchestrate implementation of several extensions to the IEEE 803.3ah GE-PON standard. This event has gone totally unreported in the press. Obviously, knowing which companies attended would be valuable- this is what I have been able to conclude.

Chip Vendors:

• Passave – Well known, recently acquired by PMC-Sierra (PMCS)
• Teknovus – Another well known chipset vendor.
• Centillium (CTLM) – Invited, but no-showed. Has had poor success in Japan. Email from Nyquist to the company on this issue has gone unanswered.
• Conexant – Dark horse with significant complementary technology
• Immenstar – Startup. Recently profiled in Lightreading.
• GW Technologies – Chinese PON chip vendor. Interoperability agreement with Teknovus.

Equipment Vendors:

• Huawei
• ZTE
• UT Starcom (UTSI)
• Fiberhome
• One Additional Chinese Vendor

Note the total absence of any Western or Japanese equipment suppliers. China Telecom is clearly motivated to source the supply of FTTH equipment domestically. UT Starcom, with all of it’s financial warts, is the most experienced of the group, as it was a GE-PON supplier in Japan as well as a supplier of IP DSLAM equipment.

Most notably absent among western vendors were Alcatel (ALA) and Siemens (SI). Alcatel has invested significant resources in its Shanghai Bell group to develop a low cost R&D center for global products as well as a means to better secure domestic business. Siemens recently acquired Photonic Bridges with the same intent, and has been outsourcing the development of their PON products to Korea. Both appear to have come up short not only because of geopolitics, but also because of their heavy focus on ITU standardization, and G-PON.

China Telecom initiated the meeting seeking to extend 802.3ah to include the following features.

• Remote Code Management – The ability to remotely download new code into an installed ONU. This is not spelled out in the IEEE spec and a standard interface among ONU vendors is desired to ensure transparent ONU interoperability
• TDM Circuit Emulation – Contrary to the wishes of IP/Ethernet Zealots everywhere, the vaunted T1/E1 refuses to die. China wants to ensure there is a standard way to provide legacy circuit services over the new optical infrastructure. Several IEE standards exist and their implementation will be specified as a 802.3ah addendum. Circuit Emulation is one of the greatest strengths of the ITU G-PON solution, and it looks like that will disappear. This explains the recent announcements by Passave (Zarlink (ZL) partnership) and Teknovus (in house silicon).
• VOIP Management – Ability to remotely provision and control voice over IP services offered in the ONU, eliminating the need for an external broadband VoIP adapter.
• Encryption – It simply wouldn’t be China if they accepted a western encryption scheme. Rather than use the globally accepted AES-128 they want their own, unique encryption. Preferably something not developed by NIST and something they know the racks of computers at the NSA haven’t had a shot at cracking.
• Dynamic Bandwidth Allocation (DBA) – This is the ability allocate varying amounts of bandwidth to a single subscriber on the fly. NTT (NTT) implemented these features by partnering directly with vendors and conducting limited interoperability testing. It appears that China Telecom wants to ensure a wider base of suppliers from the outset and is orchestrating a standard DBA implementation.
• Optics – The original 10-20 km reach specification is out of date. GE-PON optics suppliers can now easily beat this spec and China Telecom wants to take advantage of that.

China Telecom is clearly leading an effort to organize a supply chain around a modified version of the 802.3ah specification in an effort to prepare for a rollout of FTTH services.

The last remaining question, one we will address in the fifth and final installment of this series, is what role active ethernet will play in China and how this will impact the amount of components and equipment consumed.

Continue reading part V (Link inactive until June 27th)

Companies Mentioned:
China Telecom Corp Ltd (NYSE CHA [ADR])
Nippon Telegraph and Telephone Corp (NYSE NTT [ADR])
Alcatel (NYSE ALA [ADR])
Siemens AG (NYSE SI [ADR])
Zarlink Semiconductor Inc (ZL)
PMC-Sierra (PMCS)
Teknovus – Private
Centillium (NASDAQ CLTM)
Conexant Systems (CNXT)
Immenstar – Private
GW Technologies – Private
Huawei – Private
ZTE – Private
UTStarcom Inc – (UTSI)
Fiberhome – Private(?)

• R&D in China. Helps win Chinese business
• Funding from UT Starcom, and likely their lead customer
• They have a quad OLT chip

They were recently profiled in Lightreading and in the comments a short debate ensued on the merits of a quad OLT.

I think the advantages of having a Quad OLT arise from the ability to more efficiently do statistical multiplexing onto the uplink side. If you have four discrete OLT chips the indivisual GE uplinks from each device need to be fed into an L2 aggregation chip that will make drop decisions. Having four OLT’s on one chip let you merge the control plane and make better decisions on DBA and discards as you forward. Theoretically, you would get better QoS and utilization.

BUT – as of right now, fairness on the upload side isn’t that important. Few applications exist that push the envelope in the upload direction – Enterprise applications and circuit emulation are two that would, but neither have been deployed over PON’s in any volume.

In short, nothing extraordinary except for Chinese heritage and a Chinese partner invested in their success. The complementary products that PMC-Sierra (PMCS) and Conexant (CNXT) bring to the table short circuit the advantages of a quad OLT, unless applications that make upload bandwidth the bottleneck gain popularity.

Companies Mentioned:
Immenstar – Private
Conexant Systems – (CNXT)
PMC Sierra Inc – (PMCS)