November 10, 2010 - 10:40pm EST by
2010 2011
Price: 8.90 EPS $0.31 $0.41
Shares Out. (in M): 91 P/E 28.0x 22.0x
Market Cap (in $M): 816 P/FCF 28.0x 22.0x
Net Debt (in $M): -54 EBIT 29 37
TEV ($): 763 TEV/EBIT 26.0x 21.0x
Borrow Cost: NA

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Entropic (ENTR) sells whole home networking chips to service operators. On the strength of relationships with DirecTV and Verizon they have proven that their technology works to deliver whole home networking services, and the market is betting that this will drive a new technology adoption cycle among all the service operators. This in turn has pushed the valuation of Entropic to 28x my estimate of '10 EPS and 22x my estimate of '11 EPS.  On the one hand, the market is likely to mature more slowly, and be smaller than what the Street estimates. On the other hand, Entropic has little patent protection, and new competitors like Broadcom will put margin pressure on Entropic's business.  Most executives are selling shares, including the CFO, CEO, CTO, senior VP of sales, and General Counsel.  You can see more detail on insider selling here: http://bit.ly/a1rlly




Entropic's main product is based on technology called MoCA, which is a way to send data across coaxial cables. Entropic was one of the pioneers of this technology, and helped create a standards body called the Multimedia over Coax Alliance.  By contributing some of their core IP to the alliance, they were able to drive the creation of the standard. However, the side result of this is that competitors can easily enter the space - indeed, Entropic is required to license their technology to others at "reasonable" rates. Broadcom got their first SoC designs approved by the MoCA alliance last year, and released additional products in the space this year. Broadcom's approach is to build in the MoCA functionality into a chip that also supports other networking features. This approach makes sense to me; it seems likely that over the mid to longer term set-top box manufacturers would prefer to use a single chip solution.


Although cable companies seem to have gravitated towards MoCA technology for the time being, there are a number of technologies competing to dominate the digital home. The incumbent technology is simply the Internet - more precisely TCP/IP protocols running over ethernet or (most likely) Wi-Fi -and  it is not at all clear that MoCA will be the winner. Increasingly, Internet connected TVs, game consoles, set-top boxes, and Blu-ray players are all delivering content into the home and from room to room within the home. MoCA uses a different physical layer and software networking stack, so requires different sets of chips in the consumer electronics products, and has less economies of scale in terms of cost.


The area where MoCA seems to be winning is specifically in terms of providing "multiroom video" services to service operators like DirecTV and Verizon. Basically, instead of providing two different set-top boxes in the home, the service operator can provide a main set-top box (usually with DVR) and a second receiver set-top box that is less expensive. Both boxes have the MoCA chip and the main box uses that to send video and other data to the receiver set top box. This generates cost savings for the service operators, although they are fairly minor (the difference between the price of a HD DVR set-top box and a regular HD set top box). It also can add installation complexity, as in older homes the wiring of the coaxial cables can be quite messy due to splitters and other poor legacy wiring.




The street looks at Entropic as if MoCA and multiroom video were going to become a standard feature, like HD and DVR. This fuels "hockey puck" projections of the market size. However, from a consumer point of view the value of multiroom video is more of a cost savings (since the second and third set-top boxes in the home can be cheaper receiver boxes instead of DVR's) than a real value added feature.  Personally, I don't see multiroom video as a core user need that is likely to drive the technology adoption cycle. Rather, what's driving this market is the need for service operators differentiate through value-added features. So the market size will really be driven by the technology roadmaps of the MSOs.


DirecTV, with 19 million subs, is one of Entropic's largest customers, and in the case of DirecTV multiroom video appears to be fairly successful: DirecTV is upselling HD subscribers nationally on the service. However, the DirecTV client base is somewhat different from the other service operators. My guess is that DirecTV customers, who are more likely to be sports fans (since DirecTV has exclusive content from the NFL), tend to have more TVs connected than the average. Furthermore, DirecTV sells the set-top box to the client, usually with a promotion to get 1-2 free set-top boxes at sign-up (similar to the model in the cell phone market).  This is different from the other MSOs who lease the set-top box to the client. In the case of a leased set-top box, the customer has a much lower incentive to go to a multiroom DVR model, when they can just get separate DVRs in each room at only a minor incremental cost.  It's likely that DirecTV will continue to focus on multiroom DVR, thereby driving revenues for Entropic. However, with the arrival of suppliers like Broadcom, DirecTV is likely to use that to put pressure on suppliers to reduce the costs of their equipment - hurting the margins at ENTR.


Verizon is another large account of Entropic. Verizon, however, has less of a focus of multiroom video in their marketing.  You can see for instance their cluttered marketing message here: http://www22.verizon.com/Residential/FiOSTV/Equipment/Equipment.htm#features Users are also expected to pay a premium ($19.99 vs. $15.99/mo) to get the multi-room DVR model, so users with 1-2 TVs only are not likely to get set top boxes with MoCA chips.  Since Entropic is part of the technology roadmap at Verizon, Verizon is likely to continue driving sales for them, although the pace will of course be limited by any slowdown in Verizon deployments, and the sales are just on the high-end multi-room DVR model.


Other service operators have much more heterogeneity in their set-top box architectures, compared to DirecTV and Verizon which have basically one single national technical backbone. That means that they will be slower adopting a new technology like MoCA, and indeed they are lagging behind DirecTV and Verizon in any deployments. Recent announcements by Time Warner, Cox, and Comcast have helped maintain excitement in the stock, however these should be looked at with caution. These service operators often trial things extensively in regional areas before launching them, and so full adoption of MoCA by the industry is still far from guaranteed. What's most likely is that they are responding to DirecTV by dipping their toe into the market for multiroom video.  For instance, reports are that Comcast's service, called AnyRoom DVR, will cost 19.95/month-a high price for that functionality, in line with what Verizon is doing.




There are around 40 million DVR households in the US. It's going to be a tough path for MSOs to encourage those households to upgrade to the multi-room DVR service, as they probably already have the necessary set tops in additional rooms.  Rather, it seems likely to me that the multi-room service is more likely to be sold when people add new DVR service.  Actually, certain trends like Internet connected CE devices that run Hulu Plus are likely to prompt fewer people to add DVR in the future. 


Despite that, if we take the highly unlikely assumption that the DVR market will double in the next 3 years, and then assume that a massive 50% of those households will select the multiroom service, then we get a total market size of 20 million homes.  We can also add optimistically an additional 10 million of "upgraders" - people who already had DVR who upgrade to the new multi-room service.  Looking at the number of chips per home, as indicated above it's likely that set-top box makers would switch to multipurpose chips, rather than using dedicated MoCA chips.  If we assume that the market for dedicated MoCA chips is 75% of the total, at three chips per home, and an ASP of $10 per chip, that's a $675 million dollar opportunity.  That highly optimistic number is a decently sized market, but too small to justify the valuation of ENTR.  The real market opportunity is likely to be much smaller.




If we look at semiconductor comps (BRCM, MRVL, PMCS, LSI, MLNX), they trade at 11-16x '11 earnings.   If we apply a similar multiple to Entropic's $0.60 of consensus EPS, you get a valuation of $7-9, and Entropic is currently trading at the top of that range.  My estimate, using highly optimistic revenue assumptions per the market size estimates above and not factoring in margin erosion, is for $0.40 per share in '11,which leads to a valuation of $4.4-6.4, suggesting the stock could fall by a third to a half from current levels.  As discussed above the revenue opportunity (market size) may turn out to be much lower, leading to a collapse in earnings and valuation even further.


Revenue from new customers falls behind projections in 1H next year.  The Street realizes that the revenue coming in from DirecTV is not going to be replicated with other service operators.
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