Article from MSN Investor today.
Merylee
Terayon has right connections for cable Internet
Despite the delays, high-speed access over cable TV lines still looks like the
wave of the future. And Terayon's technology gives clear signals of leadership in the field.
By Michael Brush
Waiting for the rollout of cable Internet access is starting to be a bit like getting your luggage
after a flight: The delays are tedious.
Reader Alert! Company Focus will move to Mondays after the week of the July 4 holiday. Look for the next
Company Focus on July 10.
But if you still have faith that it really is all just around the corner -- and there is little reason you
should not -- now is a good time to consider shares of firms behind the equipment that makes
cable access work. Many are relatively weak, in part because of those misplaced concerns
about delays.
A good place to start is Terayon Communication Systems (TERN,
news, msgs), which designs and sells modems and the "head-end"
gear used in cable-company plants, as well as the chips that go into
these products. The Santa Clara, Calif.-based company stands out for
a number of reasons. First, industry experts believe it has superior
proprietary technology. And second, it has excellent
earnings-estimate revisions. This is very often a winning combination.
Terayon shares also recently reversed from a sharper-than-average decline during the spring tech
sell-off. That carnage took the stock from highs of around $135 to about $30 in mid-April. Now it
is in a convincing upward trend, closing recently at about $78.
However, I like Terayon for more than just a short-term trade, because of the way the company is
positioning itself ahead of trends in broadband Internet access. At the heart of the Terayon story,
for the moment, is a technology it owns called Synchronous-Code Division Multiple Access
(S-CDMA), which delivers a clearer broadband signal over cable. Farther down the road, Terayon
should benefit from an acquisition spree that will put it in the right place to take advantage of the
much-ballyhooed convergence of voice, data and video over cable, DSL and wireless. First, let's
take a closer look at its proprietary technology.
Squeaky-clean signals
The cable guys like this squeaky-clean way of delivering signals because it allows for more
powerful data transmission over "noisy" systems. This helps them save money. "You can put it
in with lower-quality equipment and it works just as well," explains Ken Smith, a portfolio
manager who holds shares of Terayon in Munder NetNet (MNNAX), up 75% in the past 12
months. "So they don't have to spend as much money upgrading the equipment."
Despite advantages like these, the U.S. cable industry opted for a standard called Docsis 1.0, or
Data Over Cable System Interface Specification, which does not make use of S-CDMA. Instead,
it incorporates the less robust TDMA (Time Division Multiple Access) technology behind
broadband chips produced by Broadcom (BRCM, news, msgs) and Texas Instruments (TXN,
news, msgs). Short sellers like to fret about how this hurts sales at Terayon, but it is not clear
the company would be that much better off if its technology gets into future Docsis standards
currently under review.
For one thing, that would force the company to open up its vaults and share its S-CDMA
technology. That means other firms would start making money from it, once they figured out how
to apply it a few years down the road. Instead, under its "embrace and extend" strategy, Terayon
now takes the current standard and adds better features using its own technology. "We have
proprietary extensions that are fully interoperable," says Shlomo Rakib, the president and
chairman of Terayon. "We are not dependant on whether S-CDMA gets accepted or not.
S-CDMA will be used either as part of the standard or as an extension."
Next, there are lots of cable plants both in the U.S. and elsewhere, which are too inefficient to
send data using TDMA. "The whole Docsis debate misses the point that cable operators need to
deploy equipment today, and Terayon is the best solution out there," says Smith. "If S-CDMA
does not become part of the standard here, Terayon still has opportunities in Canada, Europe
and Asia, where Docsis is not an issue."
Indeed, major customers like Rogers (RG, news, msgs) and Shaw Communications (SJR,
news, msgs), the largest and third-largest cable operators in Canada, have higher penetration
rates than cable operators elsewhere, in part because they are using S-CDMA, says Rakib.
Other big customers include United Pan-Europe Communications (UPCOY, news, msgs) in
Europe and large cable operators in Brazil, Mexico, Japan, Korea, Hong Kong and China. In the
U.S., Terayon sells to Cox (COX, news, msgs), Time Warner (TWX, news, msgs),
CableVision Systems (CVC, news, msgs) and (Adelphia (ADLAC)) among others. North
America accounted for 65% of revenue in the most recent quarter.
The shopping spree
Another reason to downplay the S-CDMA-Docsis standard debate is Terayon's acquisition spree,
which will help put it out in front of upcoming trends in broadband. "The company's business is
doing very well, but the nice thing is that they are thinking ahead," says Ayelet Oron, an analyst
who covers the company for the brokerage Oscar Gruss & Son in New York. "Eventually cable
modems will become a commodity. So they are positioning themselves to get into other parts of
the broadband revolution and become a total broadband access provider."
Out of several recent purchases, here are four that top the list. First, Terayon's acquisition of
iMedia moves the company into broadband digital video delivery. This company's Cherrypicker
video router permits cable users to select channels they want sent from the source, so that
cable companies don't have to broadcast all channels all the time. "This is one of the big
differentiators for Terayon, because this will free up lots of broadband," says Rakib. Customers
include Time Warner, Cox, Comcast (CMCSK, news, msgs) and MediaOne (XVF, news,
msgs).
Next, two other recent acquisitions help move Terayon into DSL. The purchase of Access
Networks Electronics from Tyco International (TYC, news, msgs) and another firm called
Radwiz bring in technology that delivers voice and data over DSL. Finally, buying an Isaraeli
company, Telegate, adds voice-over-cable capabilities. All these businesses are still ramping up,
since they are in cutting-edge technologies. But Oron and other sell-side analysts expect them
to turn in 25% of revenue by the end of the year.
The urge to converge
Strategically, these acquisitions should help the company benefit from the expected trend toward
"bundling," or the convergence of voice, data and video services under the roof of a single vendor.
"They are positioning themselves to be sure they are providing the product no matter how the
service provider wants to access their customers," says Smith. "That is why we like the
acquisitions, because they start Terayon down that path to an integrated solution. It makes them
more of a one-stop shop."
All of this should transform the makeup of revenue over the next three years dramatically. Right
now, Terayon gets about 85% of its sales from products used to provide data, or Internet service,
over cable. Within three years, that should drop to about 25%, says Rakib. By that time, another
25% will come from video and voice over cable. (The numbers are somewhat imprecise, in part
because by then, some products will combine voice and data.) Rakib also expects 35% of
revenue to come from DSL and 15% from wireless, three years out. Terayon currently has a
market cap of about $3.7 billion on $141 million in trailing 12-month revenue.
Risks remain
While Terayon's overall strategy seems sound, keep in mind there are several risks to watch.
First, a big part of the story is now acquisitions. It is not always easy to integrate new
businesses smoothly. Second, Terayon has four customers that account for more than 10% of
revenue: Rogers and Shaw in Canada, UPC in Europe, and Cox in the United States. True, new
customers are coming on board. But orders in the cable business have the potential to be lumpy.
Any hiccups at the big four could spark a short-term sell off.
Another risk is a slowdown in cable spending overall, especially in light of downbeat news
recently on this front from AT&T (T, news, msgs). "People are worried about AT&T, and spending
may slow down for a month or two," says Smith. "But these companies are going to spend
money on cable systems. They have no choice."
Finally, watch out for more antics from short-sellers, who have been particularly aggressive on
this stock. Consider what happened during the company's most recent quarterly conference call
in April. Unscrupulous short-sellers used fake names to pose as Lehman Brothers employees
and float questions designed to terrorize investors. Terayon's S-CDMA technology does a good
job of taking the noise out of cable transmissions. Until it comes up with something that can do
the same thing for conference calls, this stock will be vulnerable to attacks from the short side.
At the time of publication, Michael Brush owned or controlled shares in the following equities
mentioned in this column: Tyco International. |
