Facebook cuts Cisco loose

Chip maker EZchip bets on companies like Facebook and Google cutting out router providers like Cisco.

Yokneam - Shares of EZchip Semiconductor have been stuck in a multi-year slump on concern large customers such as Cisco Systems would become competitors. Now they’re rallying on the prospect it may not need Cisco at all.

EZchip, which makes processors for edge routers in cable and phone networks, won its first deals to supply chips to cloud data centers in the second quarter, CEO Eli Fruchter told investors. That, along with an earnings report that beat estimates, helped fuel a 22 percent rally last week, the biggest since 2008.

Technology giants including Facebook and Google have been developing their own networking-equipment systems to save money and handle an increasing volume of Internet traffic. While the new systems threaten to displace traditional hardware makers such as Cisco, the world’s largest maker of networking gear, they represent a new market for EZchip, which can now skip intermediaries such as Cisco and sell directly to data-center or telecommunications customers, the company said.

“This has been a multi-year strategy and we’re just beginning to get evidence that it was likely a good pursuit,” Steve Bierker, a trader and analyst at Muhlenkamp & Co which manages about $450 million, said by phone from Pittsburgh. “This is a market expansion opportunity for them.”

Shares of EZchip, based in Yokneam, Israel, have slumped 54 percent from their peak of $45.27 in March 2012. Part of that was driven by Juniper Networks’s decision to drop the company as a vendor and build chips in-house. Then, in the first quarter of 2015, came another blow: EZchip announced that its largest customer, Cisco, was foregoing the company as a partner to develop processors internally for its next-generation routing platform. The stock fell 24 percent that day. The shares closed at $20.66 on August 14.

EZchip’s stock reflects those losses, and after better- than-expected earnings on lower operating expenses, the shares look like a buy, said Mike Burton, an analyst at Brean Capital Markets in New York who upgraded the company after its last quarterly results.

“We think it’s adequately discounting the risks related to the transition away from Cisco,” Burton said in a phone interview. EZchip’s new cloud customers are “encouraging,” but it’s still “years away from revenue,” he said.

EZchip reported $11 million of net income on $28 million of revenue in the second quarter, compared with an $8 million average profit estimate from four analysts, according to data compiled by Bloomberg. Sales were in line with forecasts.

Just because Cisco snubbed EZchip for one routing platform, that doesn’t mean the company won’t win future contracts, Fruchter told investors last week. And Cisco isn’t sitting on its hands while the networking equipment landscape is being reshaped by software developers at Facebook, Amazon.com Inc. and Google.

“The software defined network threat to Cisco has clearly been overstated,” David McCulloch, a spokesman for the San Jose, California-based company, said in an e-mailed response to questions. “Our networking businesses have continued to show good growth.” Cisco’s SDN solutions to data centers have seen 200 percent growth year over year, he said. He declined to comment on Cisco’s relationship with EZchip.

Analyst ratings

Most analysts are still cautious on EZchip. Just two of six recommend buying the shares, with three rating them hold and one advising clients to sell, according to data compiled by Bloomberg. They project less than a 3 percent increase in the stock price over the next 12 months, according to the average estimate.

It’s doubtful EZchip will be able to win Cisco back as a customer, and too early to say if its wins in cloud infrastructure will offset lost revenue from Cisco, which made up 35 percent of sales in the second quarter, Jay Srivatsa, an analyst at Chardan Capital Markets in New York, wrote in an August 13 research note maintaining his neutral rating on the shares.

EZchip has done a good job staying on top of innovation in the semiconductor industry, and that has positioned it well to survive the potential loss of Cisco as a customer, Bierker said.

“This is a name that has always been on the edge of tremendous promise, but hasn’t brought it home,” he said. “The design wins validate the market expansion opportunities and raise the probability they may be able to replace the Cisco revenue if it does entirely go away by 2017 or 2018.”

BLOOMBERG