Ikanos – An Extremely Undervalued Stock

In my previous blogs, I have written about grossly overvalued stocks that should be shorted. Today, I would like to discuss an extremely undervalued technology stock, and briefly point out the stark valuation contrasts to our short candidates.

Ikanos (IKAN, 2.04) – market cap $113M with $22M net cash, EV/Revs 0.4x, P/E of 9x 2010 and 5x 2011 EPS (non-GAAP).

We are familiar with this company’s broadband xDSL chipset business, and in fact, made a venture investment in one of its predecessor companies – Virata – in 1998. Broadband demand will continue to grow. Broadband subscribers should jump from 469M in 2009 to 782M in 2013, creating a 2013 TAM of $3.2B for xDSL, fiber, and cable modem semiconductor vendors. One knock on Ikanos is its exposure to xDSL, notably ADSL, which gives them a lower growth rate than pure fiber peers. But Ikanos has a larger exposure to the faster growing VDSL market (and 73% VDSL chipset market share), a stealth PON program for FTTH/N, and steady-growing communication processors. We project revenues to grow 8% in 2010 to $233M versus pro-forma 2009 revenues (including some commoditized ADSL business acquired from Conexant that management has de-emphasized).

Ikanos should continue to benefit from economies of scale derived from last year’s merger with Conexant’s Broadband Access division. Previously, Ikanos was half the size and unprofitable. Post-merger operating expenses have decreased to 40% of revenues versus 60% pre-merger. Consequently, the company became profitable in the last two quarters, with non-GAAP EPS of $0.03 (Q4 2009) and $0.04 (Q1 2010). Sequential improvement should continue this quarter as gross margins are expected to rise 3% percentage points to 46%, with no decrease in sequential revenues and little change in operating expenses. We expect 2010 EPS to reach $0.23.

Ikanos is deeply discounted versus its peers’ EV/Revs of 2.4x (vs 0.4x for IKAN), and P/E of 22x (vs 9x for IKAN). Even applying a 20% discount to peer multiples, our target price is just below $5.40 (+163% from today’s closing price of $2.04). We took a blend of our 2010 and 2011 estimates for Revenues, EBITDA, and EPS, and then applied those discounted peer multiples with a greater weight on the P/E multiple.

Why is IKAN so cheap? First, the stock has historically been unprofitable and may need a few more quarters to prove itself and get a wider following. Secondly, gross margins unexpectedly declined sequentially from 44% in Q4 to 43% in Q1; while the CEO left at around the same time. The stock got whacked by about one-third since mid-April. Gross margins are expected to bounce back as product mix normalizes again. As for the CEO, he left on his own accord because of differences with Chairman Dado Banatao. Dado is the founder of Tallwood Ventures, the largest shareholder of Ikanos. Dado has a pedigree semiconductor background, and has a vested interest to maximize the value of Ikanos (and has successfully done so for similar companies in the past). In fact, previous SEC filings disclose that Tallwood and a number of other parties made pending bids as high as $4 per share for Ikanos back in 2008.

Dado is a self-made man, and may take a more aggressive approach than previous CEO Mike Gulett. This may ruffle some feathers among employees, which can be considered a risk or benefit. A medium term risk is the sinking Euro where 25% of Q1 revenues were generated. While Ikanos prices in dollars and even has some local Euro costs, ASPs could come under pressure. Management said that there was no price concessions from customers when the Euro previously rose; so customers should not balk at pricing now (and so far, have not). Still, it is a risk. Also, Ikanos will need to offset the maturing, lower-margin ADSL business with new products such as Vector-based VDSL, PONs, and digital home networking initiatives to sustain its competitive advantage and improve its sub-industry average revenue growth. That is, if the company is not sold beforehand.

Time is on our side if we continue to short the absolute worst technology stocks, while being long the cheapest, growth tech stocks in the world. Ironically, Ikanos’ enterprise value is between one-half and one-quarter of the EV’s of the two short stock candidates that we discussed in my previous blogs, despite the fact that both of those companies still have no revenues or marketable products, and are incurring heavy losses. It’s hard to imagine that such a wide valuation discrepancy is sustainable.


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