Don't Miss The Coming Upside Move In Silicon Motion Technology

Silicon Motion Technology Corporation (SIMO, Financial) is a fabless semiconductor company that designs, develops and markets semiconductor solutions for mobile storage and mobile communications markets. It provides mobile storage products, including microcontrollers used in solid state storage devices, such as solid state drives, eMMCs and other embedded flash applications, as well as removable storage products, such as flash memory card controllers and USB flash drive controllers; and mobile communications products, such as mobile TV SoCs and handset transceivers. Its products are used in smartphones, tablets, digital cameras, notebooks, desktop PCs and industrial and commercial applications. The company's mobile storage products are marketed under the SMI brand and mobile communications products under the FCI brand. It markets and sells products through direct sales personnel and independent electronics distributors to original equipment manufacturers and module makers worldwide. Silicon Motion Technology Corporation was founded in 1995 and is headquartered in Zhubei City, Taiwan.

In short, Silicon Motion is designing and developing the products that drive the devices in the fastest-growing segment of the electronics industry today. The fact that they contract out the manufacturing aspects of these products helps keep their overhead and capital requirements to a minimum while maximizing the value of their intellectual property rights. This makes the business very capital efficient in that they can grow without requiring large amounts of the cash generated to be invested in expensive manufacturing plants and equipment. Less capital investment required to support growing sales translates to more profits that fall straight to the bottom line of the income statement.

A mountain of cash provides a moat of protection

Based on the company’s filing for the fourth quarter of 2014, SIMO is holding cash, short-term investments, receivables and inventory valued at $268 million. The total liabilities of the company are $62 million. This leaves the company with $206 million of reasonably liquid assets after covering ALL of the current and long-term liabilities of the company. Since there are 33,712,000 shares of stock outstanding, these figures equate to a $7.95/share hoard of cash, or 29% of the entire market value of the business at the current price of $27.40/share. There are few things that insure the safety of an investment and provide support to the share price of a business better than cash on the books. Since 2014, the company’s management has also rewarded shareholders with a very respectable 17% annualized return on equity.

Not only has the company been consistently building the shareholders’ equity stake in the business at a rapid clip, it has also grown its earnings per share at a scorching 20% annualized pace over the past five years from $162 million at the end of 2010 to $304 million at the end of 2014. Keep in mind that 2/3 of that equity is held in free and clear liquid assets made up of cash, short-term investments, receivables and inventory.

Better still, the analysts covering the company are predicting the future growth in earnings to remain on their blistering path for the next five years too, as indicated by the table below. Over the next five years, the company is expected to expand its earnings at an annualized pace of 21.90%. The fact that it has achieved annualized earning growth of 20% over the past 5 years adds confidence to my belief that these estimates are not some far-fetched number pulled out of thin air.

The 9 analysts covering the stock are projecting the Silicon Motion to earn $2.03/share in 2015 which place a quite reasonable P/E multiple of 13.49 times earnings on the stock. In reality, when the $7.95/share of liquid assets free of all debt is deducted from the share price, we are actually buying the operating business free and clear of debt for $19.45/share or only 9.58 times unencumbered earnings.

Using the net value of the shares as our base for calculation, the business is not trading for a price to earnings growth ratio (PEG) of 0.67 as shown in the table above; but a paltry 0.44 PEG multiple. Even if we ignore the massive cash hoard on the balance sheet, this stock price would have to rise by 100% to reach the industry average PEG ratio of 1.21 and almost 300% to trade in line with the average PEG ratio of the S&P 500.

But can we believe the analysts?

I tend to believe investors should be at least somewhat skeptical of the information produced by analysts. After all, they are paid by their firms to get us to buy and sell stocks, not to help us make money. Their job is to make money for their employers, and we do not fit into that category. However, maintaining a healthy skepticism does not mean their work is worthless to the average investors like us. We just need to see how well they have done in the past at predicting the performance of a particular business they cover.

As shown in the table below, in six of the last eight quarters, the analysts’ estimate of the company’s earnings has been on the conservative side of the actual results. This should give us at least some level of confidence that the company can meet or exceed estimates on a regular basis.

When reviewing the work of analysts covering a particular stock, I also like to see how there thinking about the business might have changed in recent times, such as the last 90 days.

When trying to determine where the price of a stock might be heading, reviewing the current trends in the thinking of analysts can provide some easy clues. The table above indicates that the analysts covering the stock are maintaining a stable outlook regarding their projected performance for the business. The estimates for the first two quarters of this year are unchanged and the estimates for 2015 and 2016 have both moved slightly higher.

What is the fair value?

The three primary questions that a prudent investor needs to answer prior to allocating capital to any situation is what is the business worth today, what the business will be worth in the future and what is the current market value relative to the first two figures.

If we perform these functions using the most conservative approach possible, we build a degree of downside risk protection into our decision that will also serve to increase our potential profit from the investments we make as well as improving the overall returns from the complete portfolio.

Many investors like to use the price to earnings ratio (P/E) compared against the same figure for the particular industry and the market in general as a way of estimating the fair value of a business. In the case of Silicon Motion, the mountain of liquidity on the balance sheet gives us enough downside protection so we don’t need to exercise excessive caution when developing our valuation metrics ... but that doesn’t mean I will not maintain my conservative bias when assessing the value of this, or any, business. Let’s get to the facts of the real value.

The average stock in the S&P 500 currently trades at a price to earnings multiple of approximately 19 times 2014’s earnings. At its current share price of $27.40, Silicon Motion is valued at only 13.5 times the 2015 estimated earnings of $2.03/share. There is an interesting fact within these numbers. Silicon Motion’s share price would have to rise by about 50% to trade at the same valuation as the average company in the S&P 500 index but that increase would still only price the stock at a multiple of 1 times its 21% projected average earnings growth rate (PEG) of over the next five years while the S&P index would have to fall by over 50% to trade at a similar PEG ratio.

If Silicon Motion reached a PEG of one based on the current year’s earnings estimates, it would trade for $42.63 or 55.6% above it current price but would still be holding 18.6% of its total market value in cash, short-term investments, receivables and inventory AFTER it had satisfied ALL of its payable and debt obligations, both short and long term. It would also only be trading on par with the average stock valuation in the S&P 500 even those stocks are valued at a PEG ratio of just under 2.

If instead of using earnings growth as our valuation metric, we were to substitute average return on shareholder equity over the last 5 years and assumed that the business will perform in a similar fashion over the next five years, we could expect to double our money every 4.5 years which would leave us with $21,900 for every $10,000 invested after five years without any increase in the overall valuation multiples.

Again, it is important to remember that none of these valuations give any consideration to the massive amount of liquidity that the business currently holds on its balance sheet. The liquid assets being held by the company creates the possibility that it could declare a special dividend or possibly institute a major share repurchase. From an investor’s point of view, a massive share repurchase would be the ideal use of the cash as it would vastly increase the value of the remaining shares without creating a taxable event for those shareholders. It would certainly light a fire under the share price.

Even using the most conservative valuation metrics available and completely ignoring the $7.95/share of liquid assets on the balance sheet, the share price should rise at least 17%/year over the next 4 to 5 years, which would be a stellar rate of return. Given the low current valuation of the business in respect to the broad market in general and its industry in particular, it seems likely that a 17% annualized return could turn out to be an ultra-conservative estimate.

Final thoughts and actionable conclusions

Based upon this analysis, I believe this stock represents a compelling value and should be purchased up to $30/share with the expectation of achieving a minimum annualized return of 17% to 18% annualized over the next five years.

Should the market suddenly realized that this business is grossly undervalued and move the price violently higher, I would institute tracking it with a trailing stop beginning at 10% when the stock crosses $40/share and then tightening that percentage by 1% for every 2% the stock moves higher. For example, at $40.80/share, I would tighten the stop to 9%. It is important to remember that trailing stops should never be entered in the open market but simply tracked on a manual basis and an order entered only when a price moved has triggered the stop loss price.