Centillium – Cheap by any Measure

Centillium Communications (NASDAQ CTLM) has a troubled past and present but the market has mispriced even the most pessimistic scenarios at this point, short of accounting fraud. With proper investor activism this value could be extracted through consolidation, liquidation, or private turnaround scenarios.

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.