The transaction itself was not a surprise as it was something we viewed as inevitable (see "DSL Market Consolidation Dynamics" ). The price was a surprise.

Centillium recognized $6.1M in revenue from DSL products in CQ307, and a total of $20.8M in the first 9 months of 2007. Revenue was down substantially from the year before ($12.5M and $42.4M respectively), although the rate of decline slowed in the last few quarters.

FTTH vs. DSL in Japan. Source MICS

This drop was a result of Japan’s wholesale shift away from DSL to FTTH; a shift so dramatic that in 2007 there were net DSL disconnects, not additions.

Centillium’s failure to hit the market window with a FTTH chipset product sealed it’s doom (see "Centillium- Cheap by any Measure"). The next generation FTTH chipset revenue flowed to Passave, now part of PMC-Sierra. Teknovus has also made headway in Japan outside of NTT accounts.

Gross margins at Centillium increased in the last few quarters, most likely as the reduction in volume and the lack of significant future business allowed Centillium to extract more favorable customer pricing. Specific gross margin data on Centillium’s DSL products is not available, but our conservative estimate places it at around 55%.  Contrary to what many believe – as volume goes down in the low-volume communication semiconductor market – gross margin percentages go up. If a company is faced with declining business at a customer, there isn’t much incentive to lower price aggressively.

It is also worth noting that at one time, Centillium supplied the bulk of Japan’s DSL chipsets and included custom features required by NTT – creating a barrier to outside competition. This barrier still exists, and because of the declining to flat volume of the DSL chipset business in Japan, it is unlikely equipment manufacturers will design them out. The competitive situation is now static and what little business that remains is defensible.

Therefore, Centillium’s DSL chipset business should be viewed as a cash generating asset that generates $3.4M ($6.1M Revenue * 55% margins) in cash flow before paying engineers, sales, or marketing people. Considering Ikanos already has substantial DSL sales in Japan, it is difficult to see why it’s existing sales engineers cannot be leveraged to sell legacy Centillium product alongside newer Ikanos VDSL products. The fixed costs required to support and maintain this revenue stream for Ikanos are (or should be) nil. In conclusion, Ikanos paid $12M for a $12M a year annuity – or 1x annual gross margin dollars.

Ikanos did not assume any of the liability associated with a Fujitsu lawsuit, and assumes none of the approximately $20m royalty liability sitting on Centillium’s books. Plus Ikanos gets $3M in inventory of unknown utility, most likely good stuff, otherwise they wouldn’t be taking it.

We would be tempted to acquire this business and run it out of our own office for $12M. Keep the business alive for one year and you get your money back. Keep it alive for two years and you double it. That’s before any potential price increases are factored in. Ikanos as an operating entity cannot put the screws to the legacy customers for obvious reasons. An independent entity, driven by pure greed, could certainly extract better pricing. Equipment customers take notice and hope that any distressed supplier assets land in friendly hands.

Managers and investors should consider the impact of this transaction as it is a shockingly low price, reflecting a general breakdown in the market for acquiring assets.

We know from conversations with many operators and investors that they consider the price floor for telecom component revenue streams to be 2-3x gross margin dollars. This is based on the fact that telecom component revenue has 10 year product cycles, with pricing that improves as the cycle ends (through the use of aggressive EOL practices).

Centillium sold for less than 1x gross margin dollars, and to a buyer that could leverage the asset the best and therefore the one willing to pay the most.

This transaction sets a new floor in valuations, below anything we would have expected. It also marks to market the legacy Telecom businesses of Vitesse, Conexant, Exar, PMC-Sierra, Mindspeed, and others.

It should force investors to question whether company cash flows are being effectively invested in new products that will generate superior returns. Centillium spent $36M in operational costs in just the first 9 months of 2007, much of which went into VDSL – a rather unprofitable end.

Ikanos indicated it bought the business for the analog expertise the Centillium engineers have. We believe that Ikanos licenses certain portions of it’s DSL chipset from Aware, namely the AFE. Theoretically these new engineers would allow the reliance on Aware to end and perhaps enable a more compelling product.

But the last five years have engendered skepticism of the ability of component companies to leverage technology acquisitions into greater revenue streams. For every successful technology acquisition there are ten failures. If getting analog talent was the objective it is tough to understand how talented engineers at Centillium could not have been lured over the the more financially healthy and closely governed Ikanos.

As always, don’t listen to what someone says- watch what they do. Our hope and belief is that Ikanos views this asset as a cash cow; they lay off the dairy workers, bring the cash cow into their own existing barn, and sell the milk. Centillium indicated the sale of the unit will cut Opex by $18M – in April we will see what portion of this Opex Ikanos has assumed.

Finally, Ikanos did their competitors a huge favor by eliminating a marginal producer of VDSL chipsets that was setting an artificially low price floor the more established vendors were forced to bid against.

This transaction, coupled with the previous merger of TI’s and Infineon’s DSL business, is another step in a positive direction for the DSL business. Examining the dynamics of the DSL component business we see:

1. An improving supply chain with less competition and no remaining marginal players
2. A heavy push by European regulators to mandate unbundled facilities, thereby radically decreasing the likelihood of fiber deployment and driving demand for new DSL. We think this is foolish, but it is good for DSL.
3. A global upgrade cycle from older low speed and low density DSL chipsets.

Barring a global economic meltdown, there isn’t much not to like about the DSL chipset business at this point.

Author is long Ikanos and NTT

From today’s DSL Prime

Broadcom has 37% of the ADSL port shipments market in Q1, TI + Infineon 34%, and Conexant 24%, Steve Rago of iSuppli calculates. No one else has more than 3%. In VDSL, Rago puts Ikanos at 59%, Infineon at 27% and Conexant at 12%.

As broadband growth in developing countries picks up, DSL has the potential of entering the component goldilocks scenario of increasing volume combined with increasing margins with R&D costs largely sunk. This is the sweet spot of the telecom revenue cycle as marginal players are eliminated and the remaining companies turn the existing business into an annuity.

Marginal participants such as Centillium (CTLM) that lack market share tend to pollute pricing in the marketplace. Component companies with little or no market share typically engage in irrational pricing in an attempt to cover fixed costs, as opposed to operate a profitable business. This drives the market price lower, impacting the profitability of companies with much larger market share. Customers benefit from having too many suppliers chasing too little business.

As the number of market participants is reduced, either through elimination of marginal players or consolidation of larger players, pricing competition attenuates and gross margins expand.

The merger of Infineon and TI’s (TXN) DSL business is a huge positive force. While Infineon clearly benefits from the scale such an acquisition brings, Conexant, Broadcom, and Ikanos now face one less competitor at the bidding table. Huawei and Alcatel have fewer vendors to play against each other. All market participants benefit.

The Japanese transition away from DSL (see “The Proving Ground of NTT“) decimated Centillium’s DSL business and in our opinion the company has no reason to remain an independent operating entity. We expected (and so far have been wrong -  see “Centillium – Next on Someone’s Shopping List“) that an incumbent player such as Ikanos or Conexant or even PMC-Sierra (PMCS) would buy the company simply to remove another market participant.

Other markets following the trajectory of DSL components (but lagging in time) are the optical components industry and the WAN oriented semiconductor business.

Author holds positions in Ikanos

By the end of 2010, Japan expects to achieve 100% Broadband coverage, 90% of which will be ultra-high speed. The country currently has 95% coverage with 80% ultra high speed. The chart to the right illustrates the shift to high speed broadband through aggressive deployment of FTTH.

The resulting plunge in DSL deployment has crimped the revenue for companies such as Centillium (CTLM) and Ikanos (IKAN) as NTT (NTT) goes whole hog with GE-PON. Incredibly, DSL is now seeing net disconnects as households move to fiber, the only nation in the world where this is happening. Verizon’s (VZ) served area is moving towards this situation and should see net DSL disconnects within the next few years.

Ikanos does still recognize some revenue from FTTH installs as approximately 1/2 of them use VDSL for the last 100m. I’ve heard conflicting stories that NTT may/may not eliminate VDSL in future installations. My gut feeling is they will not, and that VDSL will play a major role in deployments, particularly in Asia. PMC-Sierra (PMCS) continues to be the prime silicon beneficiary of the GE-PON deployment in Japan.

From a more broad perspective, Japan provides insight into the evolution of overall communication trends in an advanced technological society. What is most interesting is that fixed lines are not being eliminated – from a macro perspective they are replaced by IP telephony. While this is bad for providers that rely on fixed lines for revenue it is indicative that the concept of a ‘landline’ is not going away, just evolving technologically. This is good news for other big PTT’s and RBOCs provided they have programs in place to cannibalize their POTS lines.

Underlying the shift in connectivity technology is a shift in user behavior. Despite having nearly instant access to voice communication via mobiles, Japanese are steadily cutting back on voice calls. One can speculate on what is filling the gap (email/SMS) but it is rare event indeed when technology reverses a well worn trend.

The article outlines high level plans for the Japanese Next Generation Network (NGN) spearheaded, of course, by NTT.

NTT is known as a technology trailblazer and was the first carrier to drive widespread adoption of FTTH and 3G cellular. They also championed stillborn technologies such as PHS and ISDN - but being an early adopter has it’s downsides. Their outlook for what the network of the future is notable in that appears to heavily rely on IP Multimedia Subsystem (IMS).

IMS stands to be one of two things – Telco’s last White Elephant project prior to being forced into commodity providers of connections, or a mechanism that transitions their incumbency to the next stage of the networks evolution. NTT, as well as British Telecom’s (BT) 21CN project will be the first real world bellwethers for the commercial viability of IMS. It is a process well worth watching.

Author is long IKAN and NTT

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

Passave (now owned by PMC-Sierra (PMCS) ) rolled up virtually all of the Japanese market for FTTH semiconductors at the expense of Teknovus and Centillium (CTLM). But the massive broadband greenfield opportunity in China is a  breakpoint that should allow a second GE-PON silicon provider to secure share. Teknovus realizes that they need to capitalize on this opportunity.

The playing field in China is leveled because they are implementing an enhanced version of the IEEE 802.3ah spec. This activity has been totally overlooked in the mainstream media and investment community, and is something I discussed in The Future of FTTH in China – Part IV. Teknovus is the first company to announce a production device that meets the requirements laid out during this conference by China Telecom.

It’s been a source of frustration to me that Centillium (CTLM) continues to put its energy into penetrating Japan and ignoring the rollout of FTTH services in markets where no incumbent chipset and equipment supplier exists. I wrote about Centillium before, and was shocked that they didn’t bother to show up at the China Telecom sponsored working sessions. Commentary from the company in July and on subsequent conference calls indicated all effort continues to be focused in Japan.

I continue to believe that 10 years from now, the GE-PON will be the dominant FTTH standard based on my assumption it will dominate in Asia and be the next generation access standard for the 2.5 Billion people that live there. Teknovus appears to realize this and is focusing their energy on the big opportunity rather than divide their efforts chasing both GE-PON and the ITU standard G-PON opportunities.

Full Disclosure – I am long CTLM.

Optical Components – Competitive environment still sucks. Too many suppliers trying to kill each other. Market divided into two sectors, low-end (1/2/4G SFP modules, including FTTH) and high-end (DWDM, Long Reach, Amps, ROADMs, exotic stuff). Cisco (CSCO) buys 70% of the low end and effectively plays the suppliers against each other. Suppliers need to stop playing their game. High-End fundamentally has a better business environment but I do not understand why those vendors haven’t finished their cost cutting. JDSU (JDSU) engaging in schitzophentic business plan pursuing both test equipment and optics. They need to decide what their mission is. Bookham (BKHM) talks the right game about consolidation but can’t seem to generate positive cash flow. Avanex (AVNX) is off my radar, last sighted with bloated French (legacy Alcatel division) opex and descending fast through 10k feet. Best investments here are the companies that own the technical high ground, the lasers, detectors, fabs etc. and have the unit volume to leverage those investments. That’s Finisar (FNSR), Bookham, and Avago (Owned by KKR/Silverlake). Still unclear what impact China will have.

Comm Silicon – Everyone I speak with indicates semiconductors for optical equipment are on FIRE. Forward Error Correction, SONET/SDH framers, PDH framers, PHYs, all going gangbusters. The problem is these businesses are buried in large companies (Vitesse (VTSS), Agere (AGR), Mindspeed (MSPD), Maxim (MXIM)) and it is difficult to get investing leverage on this trend. PMC-Sierra (PMCS) represents the best such opportunity. VDSL2, not optics, is the best way to play FTTH as millions of lines are retrofit – Centillium (CTLM) and Ikanos (IKAN) are the best plays here. Keep an eye out for Intel’s upcoming sale of their Telecom semi division.

PON – More heat than light. Problem is the market just isn’t as big as everyone thinks. Silicon is controlled by Broadlight (Private) and PMC-Sierra. Optics are pure commodiites – the number one supplier of PON hardware, Mitsubish Electric, doesn’t even buy modules. They make the optical sub-assembly themselves. There are around 5M PON modules sold a year, compared with 15M 1/2/4G SFPs. Gross profit on each is around $4. Big Effin Deal. Investors who hitch their hopes on FTTH pulling the optical wagon aren’t going to roll far until someone other that Verizon and NTT let loose, someone like China Telecom. GE-PON beats G-PON in volume 5:1 in 5 years.

Optical Equipment – Infinera is the real deal and represents the best example of innovation in the business. Unfortunately, this is not ‘unseen‘. Everybody know this and it will be hard for this equity (when it finally is one) to exceed high expectaions. Second best innovator is Huawei and represents the long term threat to Ciena (CIEN). Ciena has concentrated all firepower on being a transport company after sinking huge diversification investments that failed to hockey-stick. Only exception is Internet Photonics, which mothered the CN4200 product, a simple but effective Ethernet transport platform. It’s a great box, much like the revolutionary Cambrian box Nortel acquired (now called the 5200), but hardly the basis to support a $2B company. Ciena needs more technical innovation to survive and beat back Huawei, the ultimate commodity player. Lucent (LU) employees better learn French and Italian because Alcatel (ALA) plays better politics and is going to own them – 5 years from now very little of today’s Lucent will survive. The Nortel OM6500 is a hidden gem that could reverse the optical fortunes of that company. Cisco (CSCO) is still not a player. Adtran (ADTN) is a good way to play multiple trends we see in optical.

Carriers – The real estate boom is over, but the dark fiber real estate boom is underway. The consolidation in this business is finally underway and will result in improved margins for all. Dark Fiber in the ground is undervalued and future operators of that fiber will extract better margins. Abovenet (ABVT.PK) is our favorite. Companies with high-replacement cost fiber in metro areas are best positioned. Long Haul fiber is less attractive. The Bellcos have all the opportunity to dominate the next century but have not exhibited a will to adopt revolutionary business models. Either they will be the next airline industy, undercut by a telecom Southwest, or evolve into massive cash-flow organizations with huge infrastructure competitive advantages, like Big Oil. The sequel to Syriana might be about the big Bellcos. Too early to tell but they look good to me in the short term and we’ve been long telco and short cable (yes, ouch). Cable was created by Telecoms failure to act. They evolved (Cable Modems). They rebelled (VoIP). And they have a plan.

WHEW! Total working time for this post – 32 minutes. Extra points for whomever discovers the allegory used at the end of ‘Carriers’.

READ THE DISCLAIMER. These are opinions, NOT investment advice.

And discuss, discuss, discuss!

We were negative on Centillium after Passave was acquired by PMC-Sierra (PMCS). Passave, as readers of this site probably already know, is the market share leader for FTTH chips, and owns the majority of the Japanese GE-PON market. PMC-Sierra paid approximately $300M in stock for Passave (paid with $12 stock).

Investors mistakenly applied the transitive law of valuation to Centillium and bid the stock up to over $200M in market cap. Centillium lacked anything approaching Passave’s technology and market share. Most of this information is still unseen by the market.

FTTH Chips – The Centillium Saga

Centillium’s only major design win in Japan was with OKI. OKI is currently 3rd/4th in market share for FTTH equipment in Japan. A big reason for this low ranking is related to the fact that OKI initially built their system based on Centillium’s chip. Unfortunately for OKI, the chip never worked properly and Centillium was unable to fix it to their satisfaction. OKI has since then designed their own chip and in our opinion will never use another outside supplier.

Subsequently, I learned that Centillium neglected to attend a key meeting at China Telecom (see The Future of FTTH in China – Part IV) to discuss the enhancements being made to the IEEE GE-PON standard. Centillium was one of only a few companies invited. Given their lack of success in the Japanese market, I was baffled that they would pass on an opportunity to penetrate what may ultimately be the biggest greenfield FTTH opportunity in the world.

I spoke with the company and they informed me that they did not attend the China Telecom meeting because they were totally focused on near term opportunities in Japan.

Those of you who know how business is conducted in Japan would agree that after the debacle at OKI, no Japanese supplier will choose to invest time working with Centillium as a FTTH semiconductor supplier. It takes a great deal of time to build trust with a Japanese vendor, and this trust is not rapidly depleted during rough times. Destroyed trust is nearly impossible to restore regardless of price or technology advantages. Japanese vendors are slow to change their opinions of vendors. This works against Centillium for the FTTH business, but works in their favor for their DSL business (more later).

It is unclear why the company continues to pursue Japanese customers with their FTTH products. They should be targeting APAC ex-Japan and cutting their losses. Company conference calls for FQ106 and FQ206 indicated R&D is being expended trying to make good on commitments in Japan. That should be stopped immediately.

DSL and VoIP

The DSL products captured a significant portion of the Japanese market and provided healthy cash flow for the company. Centillium secured NTT’s business in the same way Passave did – by being an early partner and embedding custom features. Centillium delivered an extended version of ADSL called ADSL2++ that NTT used exclusively.

Centillium’s DSL revenue is now declining 20% a quarter in Japan. The company expects this to continue. Readers know that we track NTT’s FTTH deployment closely and it’s no surprise why this decline is happening. NTT simply isn’t deploying DSL anymore (see The Future of FTTH in China – Part II)

ADSL2 deployments by NTT are converging to zero. What deployments that do take place re-use the equipment in the central office that was vacated by a subscriber moving to fiber. Softbank’s DSL deployment growth has also stunted. DSL is over in Japan.

The good news is the ADSL products are gaining traction outside of Japan. We were pleased to hear that Huawei, 2nd in global DSL market share, is now a >10% customer for DSL chips. The DSL products are still valuable assets to customers or competitors.

Centillium is now focused on delivering a VDSL2 chip that also includes the legacy ADSL2++ features in the hope of rolling over their Japanese market share into the next generation technology.

This approach has two major problems:

1. Ikanos (IKAN) has already secured most of the market for VDSL in Japan. They have established the commanding heights and own the customer relationship.
2. VDSL is being deployed in Japan as a ‘pedestal’ technology where it is used in multi-unit dwellings to provide the last 100-500m of connectivity in fiber-to-the-basement applications. Sometimes it is prohibitive to run fiber to each dwelling in an apartment (though NTT does do this) and VDSL fills the gap. VDSL deployments in Japan are really hybrid FTTH/VDSL deployments. This application has no need for the legacy ADSL2++ protocol and we suspect is the key application driving Ikanos volume in Japan.

We’re not counting on VDSL2 to reverse Centillium’s fortunes in Japan. Regardless, a well executed VDSL2 device is a very valuable product to customers outside of Japan, or other chip companies that seek to enter the VDSL2 chip business.

I do not have unique, unseen information on Centillium’s VoIP products. Readers who do are encouraged to comment or contact us directly. I am specifically interested in what competitive advantages their products bring to the table vs. PMC-Sierra, Conexant, etc.

Valuation

The company’s enterprise value is less than $40M dollars. The market cap of the company is now $80M ($2 a share). $80M buys you-

• $46M in Net Assets, $31M of which is net cash
• $140M in R&D Expenditures since January ’02
• $18M in revenue last quarter w/ >50% gross margins
• $46M in Gross Profit in the last year

We feel consolidation of communication component suppliers is both a healthy and inevitable outcome. It is a core Nyquist philosophy.

This is not a recomendation, offer, nor solicitation of any offer, to buy or sell any security, investment, or other product. It reflects the opinion of the author.

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(?)