Three months ago I expected the sale of the entire storage unit to fetch 3.5x revenue. Subsequent research and discussions led me to believe this estimate was inaccurate, something reflected in comments I made (see here).

In the end, the outcome was far less than what was originally anticipated. Instead of 3.5x overall storage revenue ($200M+), the company received 2.5x-3.0x (depending if the additional $12M is met) on $20M of it’s $73M in TTM storage revenue. But this $20M represented the vanguard of the product line growth. The 2G Fiber Channel products are an annuity, and Vitesse’s position in ROC without a full complement of storage products is tenable.

A Concentrated Focus

With this divestiture, Vitesse is essentially out of the storage business. Not that that’s a bad thing, but something that needs to be taken into account when valuing the company. One gets a clearer picture of the situation when you look at storage revenue ex-SAS/SATA.

Flat SAS/SATA revenue is assumed. If you assume growth then the falloff in legacy storage is steeper.

This transaction puts Vitesse in a position in which it can concentrate R&D and SG&A in it’s core networking businesses. This is where the operational DNA for the company exists and makes sense. The future of Vitesse now depends on it’s ability to grow replacement revenue in this area.

The company is almost certainly generating significant earnings at this point but my concerns about revenue inflation and Opex deflation temper my enthusiasm for this metric.

Concerns

In the short term the company is generating cash flow on investments made in the past. Adjusted opex is now at $20M on $56M (36%) in revenue, far below it’s competitors (PMC opex is 63% of revenue, AMCC is around 55%). It is unlikely that Vitesse has suddenly reached a pinnacle in fixed cost efficiency. This leaves investors with a decision – can the company make more efficient investments than it (and it’s competitors) have made in the past, or will operational expenditures rise in order to grow the top line?

Another effect to consider – the number one priority at Vitesse from dawn till dusk was to generate cash in the short term, particularly by monetizing existing inventory. This has the side effect of driving revenue forward. This is not a criticism of management as this is exactly what should have been done to ensure liquidity. The problem may be when investors assume top line growth is organic, rather than aggressive cash management. Some metrics from the company in this area would be helpful.

Go Forward

Unlike PMC-Sierra (PMCS), Mindspeed (MSPD), or AMCC (AMCC) which have broad product lines, Vitesse is now a pure-play optical networking component company. They must reach a level of R&D efficiency that can drive replacement revenue at existing Opex levels. No one else in the industry has managed to achieve this and I would argue some consolidation is needed before anyone, including Vitesse, can make it happen. The singular focus of Vitesse in optical networking makes it a virtual certainty they will play some sort of role.

Update 30 Aug 2007: The purchase agreement is now on Edgar. The earn out looks very achievable, it is simply a 1:1 payment by Maxim to Vitesse for every dollar of revenue they ship. I.e. if Maxim ships $5M in ex-Vitesse product in CQ407, they pay Vitesse $5M towards the earn-out. This should result in Vitesse realizing the full earn-out by July of ’08. As long as Maxim ships $12M in product by September ’08, Vitesse should recognize 100% of the earn out. It isn’t clear to me why this was made so complex.

Author is long Vitesse

One area that I strongly believe will see greater capex in 2008-2009 is Enterprise Access. (see “Enterprise Access Capex – A Ray of Hope?“) 

Cable modems forced the Telcos to dig DSL technology from the closet they were hiding it in order to remain competitive. The same forces are aligning today in enterprise access – but this time it’s dark fiber, PON, and even short range wireless that are the threats. What technology represents Telcos only hope of retaining business customers?

The quickest weapon the Telcos can bring to bear is Ethernet over PDH. It uses the venerable T1 and E1 line to deliver Ethernet services over the existing copper infrastructure.

EoPDH is a classic example of where a supplier ecosystem has developed in anticipation of large carrier deployments that haven’t materialized.

It’s possible that carriers will change their minds overnight, but the technology doesn’t address the two critical issues incumbent Telcos (who own the copper) will face in the coming Enterprise connectivity wars.

1. Insufficient bandwidth – While T1′s and E1′s can be bonded to deliver greater bandwidth at the end of the day it’s still 1.5Mb/s or 2Mb/s, data rates that haven’t kept with the times.
2. No Operational Cost Savings - There may be some savings associated with moving away from ML-PPP or Frame Relay but the amount of hardware in the field remains unchanged. FTTH brings substantial Opex in addition to higher speeds. EoPDH does not.

Technologies like hybrid fiber/VDSL, PON, or dark fiber Ethernet are the only real options that the Telcos have to defend their existing enterprise revenue streams. This is exactly what British Telecom concluded and is doing as part of 21CN. (see “BT’s 21CN – Reversing a Victorian Tradition“)

EoPDH is likely to remain a technology of last resort, used mostly in wireless applications more tolerant of slower pipes and potentially miles from any new infrastructure.

Corrections, Amplifications and differing opinions are welcome.

Update: In a rather odd co-incidence, Transwitch and T|Pack just announced cooperation and published a whitepaper on this very subject that is quite good.

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Breakdown of Markets and Players

EoPDH Markets:

• Enterprise - Use existing T1s and E1s to deliver Ethernet services to the existing enterprise. I estimate total volume in this market around 25k connections a year – virtually nothing compared with tens of millions of T1′s and E1′s deployed . Enterprise equipment suppliers need to offer EoPDH as part of their solution but carriers are not using it in material quantities today.
• Wireless – New 3G base stations are moving to Ethernet, particularly as wireless data proliferates. The only existing connection to remote cell sites is copper, so Ethernet over PDH is a potential solution. This is the nearer term and higher volume opportunity. Current volume unclear, readers are welcome to chime in.

EoPDH Component Suppliers:

• Enterprise – Adva (ADV.DE), Alcatel (ALU), Adtran (ADTN), RAD, Hatteras (pure play EoPDH company), Fujitsu
• Wireless – Nokia/Siemens (NOK), Ericsson (ERIC), Huawei, ZTE

EoPDH Component Suppliers:

• Transwitch (TXCC), Maxim (MXIM), Galazar Networks, PMC Sierra (PMCS), or developed in House; Nokia, Ericsson, and Adtran do this

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!