Vitesse Investment Thesis

I’ve been engaged in constant debate with readers and other investors about my position in Vitesse Semiconductor since disclosing it. Based on reader email, it was one of my more unpopular opinions. I thought it would be appropriate to share my investment thesis from early August with a wider audience.

This post is not a recomendation to buy or sell Vitesse. It is the reasoning behind why I personally purchased it. Please draw your own conclusions.
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Vitesse Semiconductor Investment Thesis

The breakup value of Vitesse Semiconductor (VTSS) is $2.50/share, net $170M debt and $20M cash this yields a valuation of $1.75/share. This is based on valuation of each of the three Vitesse business units.

There are three future outcomes for Vitesse:

1. Breakup and Sale of all business units. This would likely be catalyzed by an initial private party takeover by Tennenbaum/Chapman/others.
2. Sale of one business unit to generate operating cash and normalize cash burn.
3. Continued operation and turnaround of existing business structure

Scenario One – Breakup and Sale of all Business units

• Telecom – The annuity with a growth component. Generates $100M a year with approximately 65% margins. This revenue should be considered an annuity and would generate cash for several years in the absence of any incremental R&D and SG&A expenses. Products include competitive SONET/SDH and electro-optical components and large legacy revenue streams. Yesterday, AMCC acquired Quake for functionally identical technology at a cost of $69M, a 5x premium over annual revenue. Intel is seeking a sale of it’s Telecom unit at prices much greater than 2x revenue and has inferior products and customer penetration when compared to Vitesse. A valuation of 2x revenue for the Vitesse telecom unit is justifiable. Valuation $200M.
• Storage – The most attractive unit for prospective M&A. Generates $60M a year with 50% margins. PMC-Sierra paid 3.8x revenue for the storage semiconductor unit  of Avago in Fall ’05. Vitesse has products poised for a more significant product ramp than the ones acquired from Avago. An identical valuation of the Vitesse unit is conservative. Valuation $225M.
• Ethernet – The most difficult unit to value. Generates $40M (20% of total) a year in lower margin revenue but is estimated to consume 30% of R&D. Products include Layer 2/3 switch silicon and Gigabit Ethernet PHYs. PHYs are product of Cicada acquisition in January 2004 for $66M in cash and are a relatively unique product. Layer 2/3 switches are comparable from a technology perspective with Marvell (MRVL), Broadcom (BRCM) and Agere (AGR) devices. Likely outcome is acquisition of unit by large semiconductor unit looking to diversify into Ethernet – potential suitors include AMCC (AMCC), Freescale (FSL), TI (TXN), PMCS (PMCS), Atheros (ATHR), or Intel (INTC). Second likely outcome is an incumbent looking to remove competitive pricing pressure, most likely Broadcom. Removal of Vitesse as a competitor could improve Broadcom pricing by $0.25 per port resulting in $8-10M in additional product margins per year Conservative Valuation $80M, could be 25-75% higher.

Total break up value – $505M-$565M, or $1.75-$2.00/share

Scenario Two – Sale of One Business Unit

The Ethernet division is most likely to be sold to generate cash. Further operation and growth of this unit requires substantial cash investment that Vitesse cannot afford (current credit terms are LIBOR +9-11%).

Results from such a transaction at $110M valuation:

• Quarterly revenue goes from $50M to $40M
• COGS goes from $22M to $15M
• Margins go from 56% to 62% (before positive effects of better channel behavior kick in)
• Operating Expenses go from $40M to $27M.
• Tennenbaum note would be repaid ($52M + $20M make whole penalty). $98M in convert debt (1.5%) remains.
• Operating cash balance of around $50M.

This leaves a near break-even company with substantial invested R&D and future prospects in the storage and optical markets, $160M in annual revenue with 65% ($100M) gross margins. Peer company valuations (AMCC) (PMCS) are 3x-4x EV/Gross Margins, which would value the new Vitesse at $1.25 to $1.75/share, which should considered low given future prospects.

Scenario Three – Continued Operation

It is possible, but not likely, that near term growth in the Storage and Ethernet markets leads the company to cash flow break even. The threat of customer migration away from Vitesse has been overstated by conventional sell-side analysts, and analyst cash accounting metrics trend toward pessimistic. Better management of distribution inventory will result in near term margin expansion (1-2%).  Regardless, in the absence of near term operational improvements the company has options to resolve cash flow issues through the sale of business units.

Summary

Removal of duplicative R&D and SG&A in the specialty component space through M&A is an unrecognized method of generating shareholder value. Vitesse is either an excellent target for consolidation, or an undervalued head and torso that can be fitted out with the appendages of other companies, such as Intel’s Telecom business unit. The current Vitesse valuation leave investors with a lot of room for error.

At the time of posting, of companies mentioned, I am long VTSS and INTC.

This is not investment advice and reflects my personal opinions. Read the disclaimer.