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Cisco Systems, Inc. (CSCO): Is EZchip Semiconductor Ltd. (EZCH) Destined for Greatness?

Investors love stocks that consistently beat the Street without getting ahead of their fundamentals and risking a meltdown. The best stocks offer sustainable market-beating gains, with robust and improving financial metrics that support strong price growth. Does EZchip Semiconductor Ltd. (NASDAQ:EZCH) fit the bill? Let’s take a look at what its recent results tell us about its potential for future gains.

EZchip Semiconductor Ltd. (NASDAQ:EZCH)

What we’re looking for
The graphs you’re about to see tell EZchip Semiconductor Ltd. (NASDAQ:EZCH)’s story, and we’ll be grading the quality of that story in several ways:

Growth: Are profits, margins, and free cash flow all increasing?

Valuation: Is share price growing in line with earnings per share?

Opportunities: Is return on equity increasing while debt to equity declines?

What the numbers tell you
Now, let’s take a look at EZchip Semiconductor Ltd. (NASDAQ:EZCH)’s key statistics:

EZCH Total Return Price Chart

EZCH Total Return Price data by YCharts.

Criteria 3-Year* Change Grade
Revenue growth > 30% 8.5% Fail
Improving profit margin (42.4%) Fail
Free cash flow growth > Net income growth 13.1% vs. (37.5%) Pass
Improving EPS (44.5%) Fail
Stock growth (+ 15%) < EPS growth 77.2% vs. (44.5%) Fail

Source: YCharts. *Period begins at end of Q2 2010.

EZCH Return on Equity Chart

EZCH Return on Equity data by YCharts.

Criteria 3-Year* Change Grade
Improving return on equity (60.1%) Fail
Declining debt to equity No debt Pass

Source: YCharts. *Period begins at end of Q2 2010.

How we got here and where we’re going
Things don’t look quite so favorable for EZchip Semiconductor Ltd. (NASDAQ:EZCH) today, as it’s earned only two out of seven possible passing grades. EZChip’s tepid revenue growth and falling profit margins have contributed to most of the failing grades on this test. Despite these evident weaknesses, EZChip’s shareholders have enjoyed solid growth over the past three years. Are these gains sustainable, or will EZChip’s fundamental weaknesses catch up to it in the end? Let’s dig a little deeper to find out.

One recent event could do much to bring EZchip Semiconductor Ltd. (NASDAQ:EZCH)’s shares back to a level commensurate with its fundamentals: After Cisco Systems, Inc. (NASDAQ:CSCO) announced its own network application specific integrated circuit called “nPower,” which will directly compete with EZchip’s networking solutions, the market pummeled EZChip into submission, and its shares lost 22% of their value. Cisco Systems, Inc. (NASDAQ:CSCO)’s integrated network processor could easily muscle EZChip out of a core market, as the networking giant has been a reliable customer for some time. According to Bloomberg, Cisco Systems, Inc. (NASDAQ:CSCO) should represent 40% of EZChip’s total revenue for fiscal year 2013. Cisco Systems, Inc. (NASDAQ:CSCO) recently reported that sales of its ASR9000 series edge routers, which use EZchip Semiconductor Ltd. (NASDAQ:EZCH)’s NP-3 and NP-4 network processors, have been increased 69% year over year.