How Strong Is Actual Demand for Atheros Communications' Wi-Fi Chipsets?

Atheros Communications, a leading designer of chipsets used in Wireless Local Area Network (WLAN) devices, put up a 13 percent gain in sales for the quarter ended September 30, resulting in a nearly three-fold rise in quarterly profits to $38.6 million. Notwithstanding the challenging economic environment worldwide, Craig Barratt, president and chief executive officer, boasted in the third-quarter earnings release that the strength and diversity of the company's products enabled Atheros to achieve record top and bottom-line results. Unfortunately, in my opinion, Barratt's comments spoke more to his magniloquence and hubris, and less to actual results.

At a glance, Atheros' financial performance suggests the company is weathering the downturn well, due to increasing acceptance for both newer 802.11 products (a set of standards carrying out WLAN computer communication in the 2.4, 3.6, and 5 GHz frequency bands) and Ethernet solutions, somewhat offset by slackening demand and lower average selling prices for older equipment, such as the 802.11g and 802.11ag wireless networking products. In actuality, the impressive year-on-year quarterly profit gain was mostly due to a one-time income tax benefit, which boosted net income from 11 percent (of net sales) to 25 percent, up from seven percent last year, according to the 10Q regulatory filing with the SEC:

In August 2009, the Company settled a foreign tax liability related to a prior acquisition resulting in a one-time income tax benefit of $21,706,000 in the three months ended September 30, 2009.... In addition to the one-time $21,706,000 tax benefit, the Company recorded a tax benefit of $290,000 and $1,051,000 for the three and nine months ended September 30, 2009, respectively, relating to certain discrete tax benefits received from employee stock incentive and stock purchase plans.

1. As bandwidth-intensive applications such as video streaming have become more commonplace, Wi-Fi has evolved with higher speed technologies such as 802.11n. The single-stream 802.11 Align product family has been the fastest and largest ramping chips in Atheros' history. Offering the fastest Wi-Fi connectivity for netbooks and value-class notebooks, Align is currently used by seven of the top 10 PC OEMs and in access points/routers of the top 5 retail networking vendors.
2. Atheros provides its extensive customer base of PC OEMs and network equipment customers a diversified and growing portfolio containing both Gigabit and Fast Ethernet controller solutions enabling PC makers to deliver high-performance, market-leading low-power, and cost-competitive notebook and desktop LAN-on-Motherboard designs.
3. The Radio-on-Chip for Mobile (ROCm) platform, is a recognized bright spot for the company, with comparable year-to-date sales up an impressive 155 percent to $68 million. ROCm delivers the smallest WLAN solution footprint (in design flexibility) for a wide array of (more than 100) mobile devices requiring high-performance and low-power consumption, including consumer products such as dual-mode cellular phones, portable GPS navigators, MP3 portable media players, digital still/video cameras, and (in particular) gaming consoles.

However, a known risk is that the strong growth projected in the WLAN market for chipsets will attract plenty of competition. Ergo, success is not guaranteed for Atheros, as it could face fierce competition from better-capitalized companies like Broadcom, Texas Instruments, and sometime partner Qualcomm. Whether or not Atheros can recover with the economy and grow its revenues, credibility, and influence in the Wi-Fi semiconductor market -- or stumble from the weight of carrying too much inventory of has-been products -- will depend on timely new product design wins and collaborative agreements to embed its Wi-Fi connectivity technology in laptops for OEM vendors, such as Hewlett-Packard, IBM, and Toshiba. If Atheros is forced to maintain market share and units sold at the expense of margins, it could send a shock wave through its income statement and crush profits and cash flows.

Two variables, in my opinion, currently cloud accurate forecasting of that inflection point -- when chipsets become like legacy products, living and dying on razor-thin commodity-like margins: (a) length of life cycle of existing product relative to next-generation product(s) and (b) accurate assessment of comparative utility of the 802.11n chipsets made by different companies. As explained by Victoria Fodale, an analyst for multi-media consultant In-Stat: "ASPs for draft n/802.11n chipsets are complex, as there are more options that can impact prices. These options include support for the 5GHz spectrum and the number of data streams, which can range from 1 to 4."

Atheros is expecting a robust fourth quarter, calculating that strong demand for personal computers, wireless handsets, and consumer gadgets -- combined with a rebound in networking equipment -- will deliver share-net of 51 cents to 54 cents, on revenue of $170 million to $175 million.

Irrespective of Victoria Fodale's comments on the pricing of 802.11n chipsets, however, I am left wondering if Atheros is already discounting -- or offering rebates -- on its 802.11n wireless products: despite increased unit shipments of the 802.11n, the company quietly reported (deep in its quarterly filing) that it experienced "decreases in average selling prices during the three months ended September 30."

On the bright side, the company still holds approximately $36.6 million of unused tax benefits going into its fourth quarter!