INVESTMENT THESIS
Silicon Image (NASDAQ:SIMG) presents a compelling risk/reward investment opportunity for investors to buy a leading provider of connectivity solutions with great growth potential for the long term. In my view, investors should take this opportunity to build up positions as the stock is worth at least $7.30 per share, which implies a 40% premium above current share price of $5.21 as of closing 6/13/2014. Furthermore, the company has a rock solid balance sheet with no debt and $138 million, or $1.8 per share worth of cash that offers investors strong downside protection.
COMPANY SUMMARY
SIMG, based in Sunnyvale, CA, provides video, audio, and data connectivity solutions and manufactures wireless and wired connectivity products that enable the distribution and presentation of high-definition and 4K ultra high definition content (4K UHD). SIMG, in cooperation with other companies, has driven the creation of some global industry standards such as DVI, HDMI, MHL, and WirelessHD. The company has diversified revenue streams both in terms of geography (47% US, 43% East Asia, 9% Europe) and market segmentation (54% Mobile, 24% Consumer Electronics, 5% PC, 18% from Intellectual Property Licensing).
COMPETITIVE POSITION
SIMG has driven the creation of High-Definition Multimedia Interface (HDMI®) and Mobile High-Definition Link (MHL®), which are the De facto industry standards in securing digital connectivity in devices such as smartphones, tablets, digital televisions, laptops and personal computers.
HDMI was developed by an industry consortium made up of leading companies that included Silicon Image, Hitachi, Sony, Panasonic and Toshiba. HDMI Licensing, LLC is a wholly-owned subsidiary of SIMG that enables the company to be the first and only supplier of the newest version of HDMI solutions. This essentially creates a monopolizing position that keeps potential competitors out of the market for a significant period of time when SIMG can charge a premium selling the latest HDMI solutions. SIMG's another subsidiary MHL, LLC shares similar competitive position in providing the Mobile High-Definition Link solutions in the mobile and consumer electronics space.
SIMG's competitive position has resulted in healthy gross profit margins, which have held steady and averaged 58% in the past 5 years. Furthermore, the company's management has executed a sound strategy to drive innovation, spending an average of 31% of its total revenue in research and development. As a result, SIMG has created some of the successful new market-leading standards such as WirelessHD 60GHz and the industry's first MHL 3.0 4K Ultra HD solution for mobile devices.
What's unique about SIMG's business model that separates itself from the other semiconductor manufacturers is that SIMG receives license fees and/or royalties in connection with the licensing of its intellectual properties. Any company that creates HDMI or MHL enabled products owes royalty payments to the HDMI or MHL consortiums. These royalties are then apportioned among the founders. SIMG, being one of the founders of the consortiums, participates in that apportionment. As of year end 2013, SIMG owned more than 460 issued United States and International patents and had 656 patent applications pending. The following excerpt from the company's 2013 Annual Report explains how SIMG monetizes its valuable intellectual property portfolio:
"We monetize our technology through the sale of semiconductor devices, licensing of technology cores (referred to as intellectual property licenses), services and patents. Where system level cost pressures demand the integration of semiconductor technology into system-on-a-chip devices, we continue to benefit through the licensing of IP cores which our customers integrate into their ICs. Additionally, we have an extensive portfolio of intellectual property patents and have developed programs that will optimize the utilization and profitability of these valuable assets."
STRONG GROWTH POTENTIAL
Individual electronics companies can rise and fall dramatically based on the result of one or two products. In contrast, SIMG provides electronic connectivity solutions and its business is very closely tied to the overall world demand for electronic products.
According to the Global Industry Analysts (GIA), "the global market for electronic components is expected to maintain steady growth over the next few years primarily driven by factors such as increasing demand for consumer electronic goods, especially mobile communication devices, and growing penetration of electronic systems in automobiles. Robust demand from developing markets, especially Asia-Pacific, also augurs well for the future of this market. Thus GIA projects that the global market for electronic components would reach up to $183.9b by FY15."
SIMG's revenue composition closely resembles the trends in the broader electronic products industry. Its revenue from Personal Computers segment fell from $22 million to $13 million from 2009 to 2013. During the same time period, its mobile revenue grew from $3 million to $149 million. This mobile growth opportunity will continue to play out as mobile devices continue to replace PC for productivity, gaming and entertainment needs.
From 2009-2013, SIMG's total revenue grew at CAGR 16% from $151 million to $276 million with improving EBIT and EBITDA margins. EBITDA grew from -$24 million to $32 million. However, SIMG' growth only required relatively small capital expenditures averaging $6 million per year for the past 5 years.
On the latest Q1 2014 earnings call, Management indicated that the company is expanding its presence into China, India and other emerging markets through the collaboration with MediaTek, one of the leading semiconductor supplier in Taiwan. In addition, one of the key initiatives in 2014 for SIMG is to penetrate the mid-range smartphone market with MHL. This is encouraging given the pervasiveness of HD content on mobile devices and the high growth rates seen in the mid-range smartphone market. Furthermore, another key growth opportunity on the horizon for the company is the 60GHz WirelessHD technology, which offers a robust wireless connection between 4K displays and sources with near-zero latency. Management is not only incorporating the 60GHz technology into gaming and entertainment applications but also expanding the offering into enterprise applications. These product offerings and Management's initiatives bode well with the company's long-term growth both from a top line and bottom line perspective.
VALUATION
The SIMG shares are trading at an attractive discount both on a relative basis and absolute basis. Based on FY 2013 Free Cash Flow of 31mm, The company yields 11.5% relative to Enterprise Value. Even assuming conservative growth for the company at a $28.5mm FY 2014 Free Cash Flow, the company has a FCF yield of 10.6%.
The stock trades at 9.0x LTM EV/EBITDA, comparing with North American industry peers average of 14.8x. In addition, it is trading at 5.5x EV/Forward EBITDA versus industry average of 11.3x. Using a lower than average 10x forward EBITDA multiple, the company is worth at least $7.78 per share, 49% above current trading levels.
DCF Valuation
I have based my Discounted Cash Flow valuation analysis on conservative growth rate assumptions. SIMG's revenue growth has a CAGR of 16% in the past 5 years. However, only 6.3% CAGR revenue growth rates were assumed for the first five years of FCF projection. Using a 4% terminal growth rate for free cash flows, and a discount rate of 11.0%, the DCF approach generates a valuation of $7.30 per share, 40% above current trading levels.
For clearer version of the DCF model, click here
CATALYSTS
Share Repurchases
Management authorized $100 million share repurchase programs starting from April 2012 and has completed $40 million buy backs. There are $60 million remaining under two share repurchase plans. The track record of buy-backs shows that management is doing their job as capital allocator and will continue to buy back shares. Another encouraging sign is that the company insiders have been buying up the company shares themselves. Management and board directors as a group owns 3.8% of the company as of February 28,2014, an increased from 3.0% a year ago.
Activist Investor Involvement
Activist investor Engaged Capital bought 718K shares in Q1 2014, now owning 1.3% of total shares outstanding. The CIO Glenn Welling is a former partner at Relational Investors, which is an activist fund known for boosting shareholder values. Potential moves Engaged Capital will initiate include pushing for larger share repurchase programs or having the company pay dividends.
RISKS
Customer Concentration
The top 5 customers account for 67% of revenue in 2013. Samsung Electronics, its biggest customer, represented 40.2% of total revenue in 2013. Samsung just announced in Jan 2014 that it has designed SIMG's MHL receiver into Samsung's latest Ultra High Definition (UHD) TVs. Furthermore, Samsung and Silicon Image are both founders of long-term industry consortiums that jointly promote the HDMI, MHL and SPMT as industry standards. Their economic relationship is deeply interconnected.
CFO Departure
The former CFO Noland Granberry announced his resignation on 05/15/2014 to pursue an opportunity with a privately held company. On 05/17/2014, Noland Granberry sold $18k worth of shares withheld from the released restricted stock units to pay applicable income and payroll taxes. However, he still owns 124K shares (currently worth $648k) after the transaction. Based on his ownership position, I do not believe his departure signals operating or accounting challenges at SIMG.
Disclosure:The author is long SIMG. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
