Vitesse Insiders Hope a Higher Stock Price Follows 'Higher-Layer' Products

After falling steadily for more than six quarters, the chip industry may finally be stabilizing. However, the outlook for specific chip companies is widely divergent. Some firms will continue to struggle as their respective niches stay depressed or as key competitors build better products.

But some firms are making noise that a nadir has been reached, and the future is indeed brightening for their business. Vitesse Semiconductor(VTSS) appears to be in this latter camp.

Vitesse makes what are known as "bandwidth" chips. Any gear that transmits high-speed info is a candidate for the company's wares. But a glut of high-speed equipment from the likes of Cisco(CSCO) and Lucent(LU) meant that demand for Vitesse's chips slowed sharply over the past year. Now, however, it looks as if those inventories are clearing out.

Not only that, but Vitesse responded to the industry downturn by sharpening its R&D focus, and it is now in the midst of refreshing its entire product line. It has refocused its strategy to provide more "higher-layer" products that route and manipulate electronic signals. The old "physical layer" products the company relied on in the past merely translated analog signals to digital, and vice versa. This new focus, along with slimmed-down inventories and the fact that the company has cut a lot of costs, means that Vitesse looks set to march back to break-even and eventual profitability.

When the rebound finally comes, it's safe to assume that the go-go era of a few years ago, when Vitesse grew 40% annually, is unlikely to be repeated. But industry analysts think the company has maintained its technological edge and will still be a key contractor for future bandwidth gear, so a more modest annual growth rate of 15% to 20% appears feasible.

A Bright Outlook

Management has recently been meeting with sell-side analysts, telling them that its order backlog is finally starting to grow again and that the company should meet or exceed published forecasts for the March quarter.

Management is budgeting for sales to stabilize in the March quarter, and then start rising sequentially in the June quarter. Of course, the chip sector continues to lack visibility, so view management guidance with a slightly jaundiced eye. Indeed, many investors are taking a wait-and-see approach, which explains why shares are down some 40% already this year -- despite the more positive management guidance.

But a positive outlook doesn't mean that management is blindly tooting tech's horn. In fact, company controller Yatin Mody stated clearly that Vitesse is "not optimistic" about overall capital expenditure spending, and that he expects overall telecom investment to decline in 2002 and maybe even 2003. He further acknowledged that the bulk of Vitesse's 1999 and 2000 revenue came from physical-layer products, and that the company saw a collapse in this market in 2001.

"What we are optimistic about," said Mody, "is our new area of focus on higher-layer products. We haven't sold anywhere in upper layer [such that there would be] an inventory problem, and there is demand. As the economy recovers, we are not relying on growth in physical-layer products."

Needing to switch the core focus of one's product line is not an enviable task, but it appears to be working at Vitesse. While higher-layer products generated less than 10% of the company's revenue at the end of 2000, they have already climbed to 58% of revenue in the latest quarter.

Bolstering sales of higher-layer products like switch fabrics and network processors is the trend of OEMs to increasingly outsource these products to semiconductor vendors like Vitesse. If Vitesse can produce a satisfactory off-the-shelf solution, it saves its customers the time and cost of designing a custom application-specific integrated circuit (ASIC).

Putting Your Money Where Your Mouth Is

Backing their talk of a turnaround, CFO Gene Hovanec and CEO Lou Tomasetta each bought 25,000 shares for $7.79 on Feb. 22. The company assured me that neither was lent money for his purchase, which was the first for Hovanec since January 1995 and the first ever for Tomasetta. Both execs were heavy sellers throughout the late 1990s and into early 2001.

Back when the company was a 40% annual grower, investors afforded Vitesse a $13 billion market cap. These days, with growth prospects likely cut in half, the company is now worth just $1.8 billion ($555 million of which is cash). By my math, that's a much more attractive valuation.

As Lehman Brothers points out, Vitesse is also cheaper than peers like PMC-Sierra(PMCS) and Applied Micro Circuits(AMCC) on the basis of price-to-expected-sales and price-to-tangible-book-value.

Despite the expectation of losses both this year and next, Lehman and eight other firms rate VTSS buy. To be sure, more analysts still rate the stock merely hold, but I think the trend for Vitesse is toward revenue growth and analyst upgrades.

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