Tessera's Short-term Problems Create Long-term Opportunities for New Investors

Many investors have been gnashing their teeth in anguish over the past three weeks as the market has produced the worst returns in history to open a new year. Value investors have been watching with growing excitement as what was a relatively expensive market began to come a bit closer to earth.

Some of the worst carnage has been in technology stocks. Interestingly enough, many of the technology stocks that have been hammered were not really overvalued before the latest fall.

I am sure it has been an unpleasant experience for many market participants who live and die with each tick of the tape during the trading day. However, some of us have simply seen it as an exceptional opportunity to add shares of exceptional businesses at bargain basement prices.

Tech bellwether stocks like Cisco Systems (CSCO, Financial) fell from reasonably valued at $27.15 on Dec. 31, 2015, to a just stupid cheap low of $22.47 on Jan. 20. This valued the dominant global provider of routers and switches at less than 10 times projected earnings for the fiscal year ending in July of this year.

One of the most valuable and innovative technology brands in the world, Apple (AAPL, Financial), crashed from a 2015 closing price of $105.26 to a low of $93.42 just 20 days later. This placed the value of this cash-gushing business at just 9.82 times its projected earnings of $9.51 for the fiscal year ending on Sep. 30.

However, while many household names of the tech industry were decimated to bargain bin prices, a lesser-known name, Tessera Technologies (TSRA, Financial), maintained a much higher valuation at 12.56 times projected earnings for its current fiscal year ending Dec. 31, 2016. As with Cisco and Apple, Tessera is a cash-gushing machine and holds a massive amount of liquid assets on its balance sheet.

Tessera’s balance sheet is so solid the business could retire all of its debt obligations and still be holding 26% of its market capitalization in cash and receivables. Even though the business faces some short-term headwinds regarding near-term profitability, its longer-term prospects remain exceptional according to the analysts covering the stock.

During the recent collapse of prices in the technology sector of the market, even though Tessera was carrying a higher valuation than some of its better known brethren, it only fell in line with the broader tech sector and just slightly more than Apple.

What is Tessera's niche in the tech industry?

Tessera is a holding company with operating subsidiaries that create, develop and license innovative semiconductor, interconnect and imaging technologies. Tessera and its subsidiaries generate revenue streams from manufacturers and other implementers that utilize its innovative technology.

Tessera’s semiconductor packaging technologies have been licensed to more than 70 companies. More than 100 billion semiconductor chips have shipped with the company’s intellectual property. Tessera seeks to expand the use of its product and technology offerings in the tablet, laptop and smartphone markets.

Tessera’s operations are broken into various groups with each being focused on a different area of the technology field. Its customer base consists of a who’s who of technology giants such as: Intel Corporation (INTC, Financial), Micron Technology (MU, Financial), Panasonic Corporation (TSE:6752, Financial), Samsung Electronics Co. Ltd. (XKRX:005930, Financial), Sanyo Semiconductor Co. Ltd., Toshiba Corporation (TSE:6502), LG Electronics (LSE:LGLD), Sony Corporation (SNE).

What helped Tessera’s valuation hold up so well?

In the technology field, most businesses seem to have rather concentrated exposure to certain customers or market segments. This high level of concentration makes their financial performances heavily dependent on a particular customer or area of the market.

As we have already seen, Tessera maintains a very broad base of customers that cushions any adverse impact from troubles with a particular customer. But Tessera has an additional layer of protection due to the diversity of the market segments they service.

The business is divided into five distinct operating units that serve very different aspects of customers’ needs. These units are comprised of:

Tessera pioneered chip-scale packaging solutions, which it licenses to the semiconductor industry.

Invensas Corporation develops and acquires interconnect solutions and intellectual property in areas such as mobile computing and communications, memory and data storage, and 3-D integrated circuit technologies.

Tessera Intellectual Property Corp. manages intellectual property licensing efforts, including for Tessera Inc. and Invensas.

FotoNation develops embedded image processing solutions that include FaceTools, face beautification, red-eye removal, FacePower, FotoSavvy, High Dynamic Range, panorama and image stabilization products.

Ziptronix develops low temperature direct and hybrid bonding solutions for 3D integration in areas such as image sensors, memory, FPGAs, RF and MEMS among other semiconductor applications.

Now, even with this broadly diversified structure, the business will have negative exposure in the event of an overall financial calamity but is far less likely to suffer badly during the more likely type of adverse event restricted to one customer or market segment.

When coupled with the fortresslike balance sheet, it becomes easier to understand why it would carry a premium valuation to the broader industry segment.

What has created the current opportunity?

The opportunity in shares of Tessera today has been created by two short-term issues. One has impacted the entire tech sector, and one is specific to Tessera’s business.

The selloff we have seen during the first three weeks of 2016 has certainly created a great deal of anxiety among investors who stay focused on day-to-day prices rather than on valuations. These situations always tend to create exceptional opportunities for value investors looking to open or add to positions when the average market participant believes the world is about to end.

Even though the broad market had become somewhat richly valued by the end of 2014, 2015 was a rather flat year for most stocks, and the valuations has begun to come back down to more realistic levels. However, large numbers of big names in the tech sector had not become excessively overvalued. The flat market in 2015 simply made them even less so.

For some reason, these reasonable valuation levels did not provide any protection for their shares as sellers did not discriminate based on valuation levels when they began to sell heavily. Good news for us.

The second reason for the opportunity in Tessera has been created by the project decline in earnings from 2015 to 2016. The table below from Yahoo! Finance shows the three analysts covering the stock expect the earnings of the business to decline by 16% on a year-over-year basis.

Some of this concern appears to be based on fears of a weakening economy as we move through this year. I don’t find those concerns to be without merit, and some of the early warning signs can already be seen by those who wish to look. However, it is difficult to imagine that the current valuation doesn’t more than adequately reflect those concerns.

Another concern is that consumer spending has been rather soft in general and in technology products in particular. These concerns also have some merit. However, they are largely priced into the stock at its current valuation.

Even if all of these concerns turn out to be legitimate, the market is not currently priced at excessive levels which should limit any downside driven by a large market decline and Tessera’s exceptional balance sheet and diversity of product lines and customers coupled with its already depressed valuation should provide an extra level of safety for new investors.

How is the business currently valued?

If the company were to pay off all of its outstanding obligations and use its remaining liquid assets to buy back its own shares, the remaining shares of the business would be priced at about 9.72 times 2016’s estimated earnings. Now, this is not going to happen by any stretch of the imagination, but it does illustrate how safe and cheap this business is compared to its present position and valuation.

Its closing price of on Jan. 22 of $27.50 per share placed the stock at a P/E multiples of about 11 times 2015’s earnings and 13.2 times projected 2016 earnings. While these are not bargain basement numbers, they are about 67% of the P/E for the Standard & Poor's 500. I am pretty sure the average business in the S&P 500 isn’t holding 26% of its market cap in cash and receivable either.

According to the stock research “Key Statistics” screen at Fidelity Investments, Tessera is currently valued at only 9.11 times cash flow based on the results from the most recent quarter and 9.46 times cash flow based on the trailing 12 months results. I typically consider anything under 10 times cash flow to be cheap for a well-run, established business. If the business is growing rapidly, that is just gravy.

What are the future growth prospects for Tessera?

Unless you think the world’s love affair with technology and entertainment products is going to disappear in the near future, all you have to do is review the type of products produced by Tessera and its customer base to see that the future looks solid for this business.

The balance sheet gives investors a level of comfort that the business is going to easily survive any periods of weakness in demand due to poor economic conditions in the market. It would also put the company in an extremely attractive position to make strategic acquisitions in a situation where an attractively priced opportunity were to be presented during a difficult period in the market.

Some might worry about the temptation to use that cash hoard to overpay for a new acquisition. This is always a concern when looking at cash-rich balance sheets, but Tessera’s management has managed to avoid this particular pitfall to this point, and I see no indication that it is ready to throw that past good judgment out the window just yet. Should it decide to, we can always sell the stock quickly.

I love growth through acquisitions. I just like to see businesses restrict themselves to making those acquisitions when the market is in panic mode, which it is not at this time.

Looking forward, analysts are expecting Tessera to grow earnings at a 20% annual pace for the next five years. Under normal circumstances, I would think this to be a reasonable expectation for a business that has expanded earnings at a 29.78% annualized rate over the past five years.

However, as stated earlier in this analysis, the concerns over weak consumer spending and a general softening in the economy need to be factored into the estimates of analysts who tend to have a buy-side bias in the first place.

The longer-term prospects for exciting growth with Tessera are better than the prospects over the next 12 to 18 months. The analysts seem to agree with that thinking based on their reduced expectations for 2016. However, they have not given the poor prospects for 2016 sufficient weight in their five-year outlook.

I expect to see annualized earnings growth only in the range of 15% over the next five years.

Can we have confidence in the earnings projections?

As previously stated, most analysts tend to be biased to the buy side of the equation. Therefore, when I am evaluating their forward estimates, I always look at the accuracy of their past projections.

According to Fidelity Investments, Tessera has met or exceeded the earnings expectations of the analysts covering the stock in seven of the last seven quarters in which estimates were provided. This does not mean the estimates are a lock. It does mean the analysts have done a good job projecting the results in the past based on the input they receive from the company and dig up on their own.

This should provide some level of comfort. While I would never base an investment decision solely on the projections of analysts, it is always a piece of the larger puzzle in the evaluation process.

What is the current and future fair value of Tessera?

I like to estimate fair values of businesses I review in the most conservative way I can. I don’t like to take excessive risks with my capital. I also know that, since I will not be correct with every investment decision I make, I need extra upside potential to offset the losses I will inevitably experience.

In the case of Tessera, I am comfortable assigning a current fair value of 1 times my projected earnings growth rate of 15% to the estimated earnings for 2016 of $2.09 per share. This multiple would produce a current fair value of 15 X $2.09=$31.35 per share or 14% above where the stock closed on Friday.

Please take note that the above calculation does not make any allowance for the projected average earnings growth beyond this year that will have to average 19% annually for the five-year average to be 15% after the 16% decline projected for 2016.

New investors could easily see 15% annualized capital gains over the next five years. No one should be shocked if the stock were to return 14% in capital appreciation this year and then closer to 19% annualized over the next four years following.

Right beside the Peter Lynch books in my book case is Joel Greenblatt (Trades, Portfolio)’s "The Little Book That Beats The Market." If you are not familiar with Greenblatt’s work, the time taken to acquaint yourself with it will be invested well. One of the metrics Greenblatt uses is earnings yield. This metric is simply the inverse of the trailing 12-month P/E ratio. The earnings per share for the most recent 12-month period are divided by the current share price of a stock. TSRA produces an earnings yield for shareholders of 16.5%.

Obviously, the higher the number produced by the metric, the cheaper the stock is valued in relation to its recent earnings. For me, I like to use this number in the same calculation I use to value stocks with a PEG. I will multiply the earnings yield number by the current year’s projected earnings and just compare the result to my other estimates of fair value. Using the earnings yield in this calculation would produce an estimated fair value of $34.48 per share. As with analysts’ projections, this is not something I use as a stand-alone indicator but is more of a reinforcement of my other valuation metrics.

But, wait, there’s more

A Jewish friend of mine once commented to me that he had noticed how much I liked the “glicken.” It seems that is a rather common term in his circles used to describe getting a little something extra. I love it because it is unusual and it describes me to a tee.

The management of Tessera has been kind enough to provide it to us.

The company also doubled its dividend in 2015 and now produces a very attractive yield of 2.91%. In addition, the company reduced its share count by 3.49% through the first three quarters of 2015.

Final thoughts and actionable conclusions

Tessera is now priced approximately 14% below my estimate of its current fair value of $31.35 per share. For new investors today, an expectation of 15% annualized returns based on future growth of the earnings is not unreasonable. In addition, there is the added opportunity for additional capital appreciation in the stock as the current discounted valuation is corrected.

On top of that, new shareholders will begin earning a 2.91% dividend yield which could result in total returns of about 18% annually over the next several years. This level of return is simply extraordinary.

The fortresslike balance sheet also provides us with a margin of safety in this business that should help us all sleep better at night. Don’t be afraid to buy this stock anywhere below $30.00 per share.