Description
I first wrote up TranSwitch (TXCC) on November 8 of last year when the stock was $0.74. It is now $1.10 and I am writing it up again. In that period, I became the company's largest shareholder and have learned a great deal more about the company’s prospects. It remains one of the best speculative investment ideas I have seen in some time. While certain parts of the TXCC story are simple and obvious (e.g. valuation), other parts require a great deal of background reading. In either case, I believe TXCC is an excellent and timely investment idea. At current prices, I do not believe it is particularly risky, and has the capacity to return 3 to 5 fold, or more, over the next year or two.
BALANCE SHEET VALUATION
TranSwitch is a fabless communications IC manufacturer, and as such does not have a large balance sheet. At March 31, 2003, the capital structure was as follows:
Cash $191.6 million
Convertible Debt (114.1) million
With 90 million shares outstanding, net cash is $0.86 per share.
The company’s convertible debt is due in September 2005. It was my feeling that the company’s burn rate, combined with the pending debt maturity, have served to depress the company’s valuation. To that end, I have recently proposed that the company seek to exchange the convertible bonds for those with a longer time to maturity.
In response, the company has recently proposed to exchange each $1000 of the 4.5%’s of 2005 for $750 of the 6%’s of 2007. The details are complex and laid out in the recently filed S-3, but essentially, part of the new bonds will have an at-the-money conversion feature. The conversion price will be determined during a yet-to-be-determined five day pricing period. Total dilution at current prices is likely to be approximately 22-25 million shares. If the shares rally, maximum dilution will be proportionately less.
In my opinion, the exchange offer is fair and will be accomplished more or less as proposed. Assuming the exchange offer is effected as proposed, and assuming that an additional offering of $14 million in identical convertible notes is sold, the pro forma capital structure will be as follows:
Cash $206.0 million
Convertible Debt (100.0) million
With 90 million shares outstanding, net cash would be $1.17 per share.
INCOME STATEMENT VALUATION
As with all telecomm equipment providers, revenues have collapsed. I will not rehash here what should be obvious to all.
In my opinion, revenues bottomed in the second half of 2002. I believe revenues will recover sharply primarily on the basis of an important new product cycle, but also with some help from a more normalized channel inventory structure.
The future for TranSwitch is bright because they are well positioned for the changes that are taking place in the telecomm equipment market. It is too early, however, to quantify revenues in any meaningful way. Fortunately, the current valuation does not make that necessary right now.
The company has stated that an important new product would be expected to generate about $20 to 30 million in annual revenues for some significant number of years. I believe that their Ethermap-3 product can do far greater than this because of its technological importance and the fact that there is no competition in this niche. Furthermore, the company has stated that the Ethermap-3 is now beginning to drive sales of other, complementary products in a very significant way. I do not want to create any sort of false expectation for the near term, as the revenue ramp will not be overnight, but the possibilities are very significant, particularly for a company that is viewed as being three-quarters dead by many.
BUSINESS
TranSwitch is an important manufacturer of communications IC’s. Customers include all the important OEM vendors including Cisco, Tellabs, Nortel, Lucent, Fujitsu, Siemens, Huawei, as well as a large number of secondary vendors. The ultimate end customer is typically a large phone company such as Verizon or Deutche Telekom.
TranSwitch’s products are high-value-added chips featuring significant amounts of proprietary intellectual capital. Product cycles tend to be fairly long—approaching, in some instances seven to ten years.
The business model is basically a good one. Capex requirements are low, margins are high, and product cycles are long. Gross margin expectations are in the 60-65% range, and net margin expectations are in the 15% range.
The end markets have been in disarray for the past several years, but that is no secret and the worst is past. TranSwitch believes that the telecomm equipment industry will stabilize and begin to grow from levels about 50% of the peak in 2000. Semiconductor content has expanded from 17% and will approach 30-35% in the next several years. Therefore, even though the equipment market will be much smaller, the semiconductor market has a chance at approaching 2000’s peak size.
BUSINESS PROSPECTS
TranSwitch will benefit from two important trends in the industry:
1.) Difficult economic times have forced carriers to focus primarily on evolutionary, rather than revolutionary, approaches to the business. They are more concerned with lowering operating costs and better utilizing existing infrastructure than in greenfield buildouts.
2.) Packet (e.g. data) traffic is becoming increasingly important, and circuit (e.g. voice) is becoming marginalized. Next generation solutions are increasingly focused on ways to transport data more efficiently.
Three years ago, the talk was of building parallel networks optimized for data transport. Today, the talk is of adapting existing voice infrastructure to carry data more efficiently.
In the past two years or so, these forces have given rise to a suite of technologies known as Ethernet-over-SONET and Data-over-SONET. These technologies will allow carriers to more efficiently carry data traffic over existing infrastructure which has been optimized for voice traffic. These technologies will also allow carriers to offer new, revenue generating services at a relatively modest incremental cost.. Here is a worthwhile link which will discuss this:
http://www.tellabs.com/news/articles/telecomm11-02e.pdf
[The discussion here on these new technologies can become very complex, involving discussions of such arcane matters as high vs. low order virtual concatenation. I have decided to forego a substantive discussion, but will be happy to answer questions about the technology as well as TranSwitch’s competitive position. I will simply say that this is a very important technology that is being embraced within the industry and that TranSwitch has both important products and a leading intellectual property position.]
TranSwitch has designed a number of new chips which will focus the company on Ethernet-over-SONET. The most important of these chips are the Ethermap-3 and the Ethermap-48. The company has experienced tremendous interest in these products and has called the Ethermap-3 the most successful new product introduction in its history. Once again, a full analysis of the chip is beyond the scope of this write-up, but here is a link for those who are interested:
http://www.chipcenter.com/networking/products_200-299/prod287.html
CATALYSTS
I believe there are a number of important catalysts at this moment:
1.) The Ethermap-3 will begin shipping in July. Revenues will ramp throughout the next year. The Ethermap-48 is beginning to sample as we speak. It will begin shipping in the fourth quarter, adding a further growth component when Ethermap-3 revenues begin to flatten out.
2.) SUPERCOMM, an important annual industry trade show will take place in early June. Expect a great deal of attention on Ethernet-over-SONET type applications. Transwitch will most likely introduce several new products. I am expecting an introduction of the Ethermap-12, which could be another very important product.
3.) The bond exchange offer will stabilize the balance sheet and remove any solvency issues.
4.) The direct peer group of companies such as VTSS, AGR.A and PMCS, have advanced nicely. Customer companies such as NT, LU and CSCO have also been strong.. TranSwitch is a very cheap and very well positioned company for the next several years. The market has not yet begun to realize how well positioned TranSwitch is in these new technologies.
Catalyst
See full write-up.