Description

Investment Summary

Ikanos Communications is a classic example of a hairy, under- followed stock with outsize return potential if the company can execute successfully. Formerly a tech IPO darling, IKAN now has only one analyst covering it despite the fact it just completed a transformative acquisition that dramatically increased the company's scale, consolidated its market into an effective oligopoly with 3 players and provided it with a clear path to a sustainably high operating margin. Additionally, investors purchasing the shares today get the benefit of investing alongside notable venture capitalist Dado Banatao of Tallwood VC- considered by many to be the smartest money in semiconductors- at a price not much above what he paid for IKAN at the depths of the bear market. At 2011E multiples of 0.4x revenue, 2.9x EBITDA and 6.0x non-GAAP earnings IKAN shares could be up 250% and still be reasonably valued if my estimates are realized.

Company Overview
Ikanos Communications is a leading global provider of high-performance silicon and software for interactive broadband, specifically designing and selling DSL chipsets and communications processors, which are the "brains" of the broadband home routers used in triple-play services. Expertise in the creation and integration of unique DSP algorithms with advanced digital, mixed signal and analog semiconductors enables IKAN to offer high-performance, high-density and low power DSL products. IKAN's flexible network processor architecture with wire-speed packet processing capabilities enables high-performance residential gateways for distributing advanced services in the home. IKAN's products enable carriers to offer enhanced triple play services, including voice, video and data, over copper twisted pair lines. IKAN's chips power DSLAMs (digital subscriber line access multiplexers), ONTs (optical network terminals), concentrators, CPE (customer premises equipment), modems and RGs (residential gateways) for leading OEMs. IKAN products have been deployed by carriers in Asia, Europe and North America. Ikanos is a fabless semiconductor company, which means its products are manufactured by independent third party chip foundries (specifically TSMC) and IKAN has limited capital expenditures.

Company History
During the late 1990's tech/telecom bubble, communications semiconductors were one of the hottest areas of investment for both private and public investors, as it was generally believed that great fortunes would be made by the communications equipment companies that sold the equipment that enabled broadband Internet access, as well as the semiconductor companies that supplied them. This widespread belief led to way too many companies chasing the same market. Back in the year 2000 there were numerous public companies pursuing the DSL silicon market- Broadcom, Conexant, Globespan, Virata, Analog Devices and Mindspeed to name the most prominent ones. At the same time, numerous private semiconductor companies were funded by venture capitalists to compete in this market as well.

Ikanos was one of these companies. As the Internet boom turned into the Internet bust, IKAN emerged as maybe the only startup survivor in the DSL chipset market by gaining an early technology lead in the emerging market of VDSL, which is the higher bandwidth replacement standard for ADSL. Think of ADSL as providing the standard broadband service we have come to expect in the U.S. from AT&T or Verizon, while VDSL is the speedier version that enables telcos to offer higher-bandwidth video, voice and data in a service like AT&T's U-verse. Japan and Korea were the first major countries to roll out VDSL, and IKAN went public in late 2005 based on its dominant share in these two markets.

After its $12 IPO, IKAN initially traded up to around $25/share. What followed for investors was a long, slow and agonizing decline as the VDSL build-out in the Japanese and Korean markets slowed down, and VDSL took longer than expected to be launched in other countries. Even when it was, other competitors won some high-profile slots such as Conexant's position in AT&T's U-verse deployment. At the same time, the DSL market in general continued to be oversupplied and the remaining players including Ikanos fought for market share in a slow-growth ADSL market. The market consolidated, as Analog Devices sold its DSL business to Ikanos and Globespan merged with Virata and then Conexant. IKAN eventually traded for around $1 per share in early 2009 as analysts dropped coverage and investors wondered if the company would be better off shutting down and returning cash.

Recent Developments
Two things have happened that change the picture for IKAN. First and more generally, worldwide telco operators are finally rolling out significant VDSL deployments outside of Japan and Korea. VDSL is powering the IPTV triple-play service from nearly every large traditional wireline carrier on every continent. So far, the only major carrier to run fiber optics to each individual home is Verizon as others have opted to make the most from their twisted-pair copper line investments. Using newer technologies pioneered by Ikanos such as pair bonding and vectoring, VDSL should be able to deliver 200+ and then 300+ Mbps over traditional copper lines, plenty of bandwidth for concurrent HDTV, voice and data services. IKAN estimates that running fiber to a subscriber's home in the U.S. costs around $1,350 vs. $360 for DSL- so if sufficient bandwidth can be achieved, the DSL vs. fiber decision should be a no-brainer for carriers going forward, even in greenfield deployments.

More importantly, IKAN took a significant step towards rationalizing the DSL competitive landscape and achieving scale by purchasing Conexant's Broadband Access (BBA) business for about $59.5M. This deal was struck in April of 2009, near the bottom of the market. The BBA acquisition more than doubles Ikanos' scale- in CY 2008 Ikanos had $107M of revenue while Conexant's BBA  had $159M. Remember, this business also includes the remains of former competitors GlobeSpan and Virata. The combined company will be #1 in VDSL and #3 in ADSL after Broadcom and Infineon, along with significant share in home gateway communications processors. At the new scale Ikanos will be able to realize significant cost synergies. GMs will be improved because the wafer volume going through contract foundry TSMC will more than double and the assembly and test volume will be consolidated among fewer vendors, resulting in improved pricing. Combined annual opex will be reduced by $12 to $16M as overlapping functions are eliminated, duplicative software tool licenses are cancelled, the product development roadmap is aligned and facilities and occupancy costs are rationalized.

Funding for the Conexant BBA acquisition was provided in the form of a PIPE done by Dado Banatao's Tallwood Venture Capital. Tallwood has over $500M under management and focuses almost exclusively on semiconductors. Banato is considered by many to be the smartest and best-connected semiconductor investor out there. Tallwood boght 24M shares at $1.75 apiece and also received 7.8M warrants at $1.75. The firm has the right to appoint 3 of 7 directors and owns 52% on a fully-diluted basis, although they are restricted to 35% of voting rights. Banatao and Tallwood partner George Pavlov are already on the board. Their involvement is a significant validation of Ikanos' strategy and should ensure there is an effective and shareholder-oriented board going forward.

It is important to note that while the combination of Ikanos and Conexant's BBA business has created the leading DSL business, the company has also been gaining share in the home networking communications processor market, which is approximately equal in size. This is a naturally complementary product line, as along with a DSL transceiver every broadband home router/gateway needs a processing unit to perform the quality-of-service, security, routing, etc. necessary to access triple play services. Ikanos' communications processors are sole-source designed into the gateways used several of the leading triple play deployments, and management expects this portion of the business to grow faster than DSL.

On Monday February 8, Ikanos reported its first full quarter of results with the Conexant BBA acquisition included. Revenue and earnings were ahead of the lone analyst covering IKAN's estimates, as was forward guidance. Importantly, as of Q4 09 IKAN had already returned to profitability on a non-GAAP EPS basis. The company believes that it can achieve a low double-digit non-GAAP operating margin by the end of 2010, increasing to 15% by the end of 2011. In Q4 DSL products were 60% of revenue, communications processors were 30% and other technologies 10%. The stock jumped about 12% today based on these results, but given the earnings power in 2011 and beyond I think it has a lot of room to run.

Valuation and Return Potential

IKAN trades at valuation multiples that are almost unheard-of for profitable, growing semiconductor companies with 40%+ gross margins. According to my estimates IKAN trades at 2010 Revenue, EBITDA and pro forma EPS multiples of 0.4x, 4.8x and 9.8x. Management has said it expects 2011 to be a year of margin expansion and more rapid revenue growth as some new DSL designs won in 2H 2009 ramp up and the faster-growing communications processor business becomes a larger part of the revenue. If all of this comes to pass the multiples look even more ridiculous for 2011: 0.4x revenue, 2.9X EBITDA and 6.0x earnings (taxed at 25%). I believe that IKAN could reach $6.00/share in the next 18 months and still be reasonably valued at 9.3x 2011E EBITDA. If growth investors really get excited about IKAN, look out. The shares I gave above are fully diluted using a treasury stock calculation so current FD market cap is $131.2M and EV is $103.6M. Below is a summary of the 2009, 2010 and 2011 multiples based on my financial model:

Investment Risks

• Merger integrations can be messy, and if IKAN fails to effectively manage the transition or realize expected synergies the financial performance I expect may not be realized.
• Although the DSL competitive landscape has significantly rationalized, Broadcom is a very tough competitor and share loss could adversely affect Ikanos.
• Economic difficulty and tight credit could prevent global telecom carriers from investing in their wireline service networks, hurting the demand for the communications equipment that uses IKAN chips.
• A shift in broadband access investment from DSL to fiber-to-the-home by global carriers would hurt demand for DSL chips.
• If all warrants were exercised Tallwood would control 52% of IKAN stock. Tallwood may have a different investment horizon and risk tolerance than public markets investors.

Disclosure: As you have probably guessed, I am long IKAN.

Catalyst

• IKAN should start showing up on both growth and value investors' screens in 2010.
• Company should attract new sell-side research coverage, because at a $250M+ revenue run rate IKAN will be a significant player in the communications semiconductor sector.
• Management believes that it can achieve a 10% non-GAAP operating margin by the end of 2010, and if this is realized investors should start valuing IKAN off of expected 2011 EBITDA and earnings later in the year.