Author: Gehman Capital
Covestor model: Undervalued Growth Companies
Disclosure: Long EZCH
My top portfolio holding EZchip Semiconductor (NASDAQ: EZCH) is a fabless conductor company that provides Ethernet network processors (NPUs) for use in the rapidly growing Carrier Ethernet (CE) market.
In simple language, EZchip outsources production of their exclusive silicon chips that facilitate the speed and capacity of telecom networks, data centers and enterprise backbones to transmit internet information.
The company’s current chips (NP-3) are in demand because Carrier Ethernet technology allows existing (legacy) networks to accommodate the explosive growth of internet traffic that is being driven by video transmissions. EZchip’s business model demonstrates a product roadmap and design win momentum that has established a strong basis for future growth. Their mass produced “merchant chips” now offer the widest range of network architectural solutions that span a huge range of price/performance points.
Of greatest importance, customers can see that EZchip’s products are being designed to solve future requirements and provide a natural scale-up path that utilizes the significant software expenses of earlier chips. This year’s more powerful and more expensive NP-4 can easily replace the NP-3. The more powerful and more expensive NP-5 will test in 2012 and will replace the NP-4 for carriers. EZchip’s time to market provides a large competitive advantage over in-house designs that require ASIC (Application Specific Integrated Circuits) customization.
The NP-4, soon to go into production, has won two times the number design wins of NP-2 and NP-3 processors combined. It is twice the price and therefore is expected to generate four times the revenue of the earlier chips. The NP-5 (expected to go into production in 2014) doubles the NP-4’s processing power, triples the port density and is projected to generate significantly more revenue.
Wildcard: EZchip is developing a new, top secret product that is being developed in cooperation with a limited number of existing customers. No one will talk about details, but tech analyst George Gilder believes the product will be “fully aligned with the network processor business and could well double the long term value of the company.”
EZchip said in their Q1 2011 earnings conference call that “The new product line that we are developing there [Kiryat Gat, Israel] is high end, high ASP, and high margins and will significantly increase our total available market.”
Five of the six largest Tier-1 carrier networking equipment vendors (Cisco - through sales to Marvel, Juniper, ZTE, Huawei, and Ericsson) are major purchasers of EZchip’s high speed processors. EZchip’s newly developed low speed processors are now offered to 14 vendors, of which 11 are already EZchip customers.
EZchip offers the widest range of processors, from 1-Gibabit to 200-Gibabits per second. Once penetrated, the market is extremely inelastic. Intel stopped developing new NPU products 5 years ago, but still has the largest sales. NPUs (high speed) are used for 5 to 7 years and Naps (slow NPUs) are used for 1 to 3 years.
I believe that the following factors could cause EZCH to trade at significantly higher prices:
- Market cap is approaching $1Billion, which puts EZCH on the radar screen of many new portfolio managers.
- EZchip has demonstrated a discipline, expertise and ability to bring a new product to market and grow on a steady basis. The company is generating cash, makes a significant profit margin and is expanding its customer base.
- The NP-4 should generate revenues much larger than the NP-2 and NP-3 combined. NP-5 should generate significantly more revenues that NP-4. It will test in 2012 and should go into production in 2014. As portfolio managers project these earnings into future years, they will likely start trading the stock at multiples of those future earnings.
- EZchip has a long term “scale-up” model that builds on their existing customer base with better and more profitable products.
- EZchip will probably announce their new secret project later this year – that could double its market size.
- EZchip is operating in a market – internet traffic – that is growing at a fantastic rate and should continue to grow in the foreseeable future.
What can go wrong? A lot. The list is long. I will name just a few things:
- The market for small cap stocks is extremely volatile. If the stock market declines significantly from this level, investors will aggressively sell stocks that trade above original purchase price, as we’ve seen in the past. If margin calls become a factor, EZCH stock could go much lower in price.
- Time to market. EZchip products are extremely complex. In the past, delivery dates have been delayed beyond the initial expected date. This has caused the EZCH stock price to come under severe pressure.
- Limited customer base. In the past, EZCH’s biggest competition came from ASIC (internally developed) chips. Juniper, which has 18% of the switches and router market, was EZchip’s largest customer. Juniper announced a few years ago that their new products will not use EZchip NPUs. Now Cisco (with 50% of the switches and router market) is expected to be EZchip’s largest customer. EZchip must continue to do everything necessary to keep customers “on board.”
- The world economy declines such that internet traffic declines. This would cause the demand for EZchip NPUs to decline significantly.
The list could go on and on.
I believe, however, that EZchip has developed and is developing products that are going to be in demand for a long time. The company has been building its cash position and is broadening its customer base. EZchip stock will fluctuate, but I believe has a strong upward bias.
The George Gilder Friday Letter, 7/1/2011, http://sosthischild.blogspot.com/2011/07/gilder-friday-letter-v4610.html
EZChip Conference Call Transcript: http://www.ezchip.com/Images/pdf/EZCH-Q111%20Script-110504.pdf