Ikanos: Lessons Learned

Ikanos (IKAN, $1.00) is a stock that has lost half of its value since my previous article on June 4th. The overall positive article seemed to make sense, and was supported by meetings with top management. The shares appeared attractive at the time with EV/Revs 0.4x, P/E of 9x 2010 and 5x 2011 EPS (non-GAAP), a large net cash position, and a reversal of fortunes with positive non-GAAP earnings in the last few quarters.

So, What Went Wrong? And Where Do We Go From Here?

A few lessons learned:

1) Value investing in technology is very tough. Value investing requires more certainty in numbers. Technology, however, is dynamic and more uncertain than most sectors. Thus, the numbers should not be overly relied upon as I did with Ikanos.

2) Know what you don’t know, and maximize what you do know. As a research-focused institutional investor, perhaps I knew 10% of what was happening. That still leaves 90% that I did not know. I should have known more and not taken short cuts. I should have walked the floor at some trade shows where I could have talked to the sales people, competitors, and customers. This would have increased my “understanding” to a hypothetical 20%, still not 100%, but would have improved my perspective and lowered my stock-specific risk. The other 80% is really beyond one’s control; creating the need for a diversified portfolio (and if possible, a long-short portfolio, which we have done with our Quan Technology Fund).

3) Respect the tape. IKAN’s market action was weak since April, and I did not respect the tape. It did not help that I rationalized that the stock was too cheap to sell when top management was let go.

On August 4th, the new management team dropped the bomb, announcing a projected Q3 $15M revenue shortfall versus Q2 (and related restructuring charges to accommodate the lower expected revenues). The stock tanked.

What am I doing now:

I have learned more about what is going on at Ikanos, and have added to our fund’s position recently. There is no short-term fix to some of the problems that Ikanos has had in the marketplace. But the correct measures were implemented, and I am comfortable with the team and the path they are taking.

I am taking a long-term view. In the interim, the stock may weaken more despite today’s extremely low valuation. Investors always overreact on the downside as well as the upside. Furthermore, the Rule of Three says that there is never just one bad announcement, but a series of three. So, there could be more bad news ahead. While I am tempted to say that it is in the price, rule #1 above, makes me less adamant.

It is also possible that IKAN can move up in the months ahead. The lower opex and higher gross margins milestones should begin to appear in Q4, which may create stock support. The revenue growth measures will take longer to implement.


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