VDSL chip leader falls from grace

After running away with the VDSL chip market, Ikanos Communications hit a wall last month, potentially shaking up the sector. In early October, a range of problems led the company to cut its third-quarter revenue expectations. But three weeks later, Ikanos admitted those problems were worse than they'd originally thought and would continue in the fourth quarter.

Ikanos blamed its revenue freefall on three things: First, one of its foundries is not producing enough fourth-generation VDSL2 chips; second, back-end testing problems are choking shipments of its new fifth-generation chips, unveiled in July; and third, sales dropped off in Japan, where Ikanos gets at least 40% of its revenue. Vendors typically see a lull this time of year as carriers slow their equipment purchases and drain excess inventory, but Ikanos' fourth-quarter drop-off in Japan goes well beyond historic trends.

To make matters tougher, the company's CEO for the past seven years stepped down amid the debacle, adding to Ikanos' task list and potentially slowing its course correction.

“It's not a perfect storm,” said Charlie Glavin, who covers Ikanos for Needham & Co., “but it's a pretty good Nor'easter.”

Ikanos was, perhaps, a victim of its own success. The company boasts 85% of the current VDSL market to date, having claimed just about every design win there was in the second and third quarters. Although AT&T's VDSL deployment is a notable exception, (employing legacy Conexant Systems chips), some sources believe Ikanos picked up Verizon and BellSouth as customers in the third quarter. In the fourth quarter, former chief financial officer and interim CEO Dan Atler admitted that Ikanos probably won't be able to fulfill all its orders.

“We think we have a solution to this, but we don't have it in place exactly right now,” he said. “If that solution comes out, we'll be in much better shape.”

Though Ikanos will probably keep its lead, it probably won't be able to boast 85% market share for long. Earlier this year, Think Equity Partners analyst Eric Kainer described Ikanos' larger and more moneyed competitors, Broadcom and Conexant, as “distant shadows in [Ikanos'] rear-view mirror.” But those objects could soon be closer than they appear. Broadcom may be best positioned to capitalize on Ikanos' woes — it's expected to unveil its own VDSL2 chips this week and may be successful combining them with its already-established wireless local area network and voice-over-IP products. As a result, Conexant could be relegated solidly to third place, Glavin said.

Atler has promised a first-quarter rebound in 2007 but won't be specific, leaving investors in the dark. Also unclear to Glavin is how the company can insist it has a strong backlog despite predicting a more than 30% sequential revenue drop in the fourth quarter.

The fact that Ikanos' “days sales outstanding” (the average time it takes to collect revenue from a sale) jumped from 59 to 69 in the third quarter — its highest level ever — suggests to Glavin that “Ikanos was either stuffing the channel as much as possible to make the quarter, or it really does have poor visibility into end demand.” And it remains to be seen why the remedy Ikanos said it put in place when it lowered its revenue projections apparently didn't work.

If Ikanos simply found itself unable to keep up with customer demand, some would say that's not the worst problem a company can have. “Long term, Ikanos should be fine,” Glavin said.

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IKANOS' WIPEOUT