The Stock Price Is the Only Thing Falling at Silicon Motion

Advances in technology are constantly driving us toward faster, more reliable and more mobile technology. As part of this transition, the devices we depend upon for our access to communications and information are becoming smaller, faster and better. It is also becoming more common for manufacturers to outsource certain aspects of their products and development work in order to minimize cost. This can be seen in emergence of businesses that perform services such as circuit, flash memory and semiconductor design for multiple product manufacturers but do not actually fabricate the components they design.

Silicon Motion Technology Corporation (SIMO, Financial) is a fabless semiconductor company that designs, develops and markets high performance, low-power semiconductor solutions to OEMs and other customers in the mobile storage and mobile communications markets.

In the mobile storage market, their key products are microcontrollers used in solid state storage devices such as SSDs, eMMCs and other embedded flash applications, as well as removable storage products. Products for the mobile communications market consist of handset transceivers and mobile TV IC solutions. Its mobile products are widely used in smartphones, tablets and industrial and commercial applications.

The company’s flash card controllers are designed to support the vast majority of flash components, including SLC, MLC and TLC NAND flash manufactured whether from Samsung, Toshiba, SanDisk, SK Hynix, Micron or Intel. The wide range of compatibility is intended to provide OEMs with significant flexibility in using the flash of their choice. Also, because the firmware in their controllers can be upgraded, equipment manufacturers have the ability to bring new products to market very quickly using their latest choice of flash, without always having to change existing hardware. In the mobile technology space, we see the advantage of being first to market on a regular basis.

Silicon Motion also offers a family of Solid State Drive (SSD) controllers that target personal computing, consumer electronics, industrial computing, and other applications. Their SSD controllers are used in embedded systems, notebook PCs, tablets, and servers. Silicon Motion also offers AES (Advanced Encryption Standard) 128/256 secure SSD controllers that are TCG (Trusted Computing Group) Opal full-drive encryption compliant.

Its line of high performance USB flash drive controllers enable OEMs to achieve high levels of compatibility with host devices and the flexibility to use the vast majority of SLC, MLC and TLC NAND flash memory components manufactured, whether from Samsung, Toshiba, SanDisk, SK Hynix, Micron or Intel. For USB2.0/3.0 flash drive applications, our controllers support high memory capacity, write protection, PC boot-up, password protection and secure partitioning. Our controllers deliver high data transfer rates, integrate a highly reliable hardware ECC (error correction code) engine and maximize product endurance with the use of our proprietary advanced wear-leveling algorithm.

The recurring theme throughout the company’s offerings is full compatibility with the products produced by a wide range of manufacturers which allows for exceptionally competitive pricing while maintaining high margins.

The opportunity has been created over the past several weeks as the stock price has been falling and the price of the shares appears to be the only thing falling at Silicon Motion! As of August 23, 2015, the stock closed trading at $23.99/share.

How attractive are the margins?

Reviewing the company’s financial statements in the most recent reporting period, ended June 30, 2015, the company produced total sales of $87.213 million with gross margin of $44.484 million or 51.06%. This impressive figure allowed the business to produce a net pre-tax profit of $21.873 million or 30.5% of sales. These numbers are simply spectacular.

The fact that Silicon Motion is a “fabless” company, meaning they do not manufacture the products they design, also allows them to keep their requirements for capital investment to a minimum. Over the past five years, while generating $1.156 billion in sales, SIMO spent only a miniscule $39 million on capital expenditures; a paltry 3.37% of sales. By contrast, semiconductor industry giant, Intel (INTC, Financial), spent 21.86% of sales or $56 billion over the same period on capital projects.

A business that can grow and prosper with low capital costs will simply have that much more cash that can be applied to other productive aspects of building a business and increasing shareholder value.

The margins are great; but how profitable is the business?

When trying to assess the value of a business, there are several popular metrics that can be applied to various aspects of it to reach and estimated “fair value” of the stock. One of the most popular metrics to use for evaluating how expensive or cheap a business is valued is the price to earnings ratio or P/E.

This particular metric can be applied in several variations. One common application is the P/E based on the previous year’s earnings. Using this metric SIMO has a current share price of $23.99/share and earned $1.30/share in 2014 and trades at a P/E multiple of 18.45. This is pretty much in line with the broad market at this time.

However, another popular measure of P/E is to calculate the ratio based on the earnings for the trailing 12-month period or TTM. As this uses the most current information available and still encompasses a full calendar year, many investors and analysts prefer this calculation over simply using the previous financial year. Over the most recent twelve months for which SIMO has reported operating results (June 2014 to June 2015), Silicon Motion has produced earnings of $1.76/share or 35.38% better than the per share earnings reported for the year 2014. Using the TTM P/E ratio, the number drops to a much more inexpensive 13.63.

A third popular method of using the P/E ratio of a business to determine how cheap or expensive it is currently valued is based on the price compared to the earnings being projected by analysts covering the stock for the current fiscal year and the next fiscal year to come. These earnings projections are available on Yahoo!Finance and shown in the table below.

Since this information is based on future projections, it is obviously not as certain as the previously applied metrics. However, we invest in stocks based on our best estimation of what a business will achieve in the future and the analysts who study it on a full-time basis are often one of our best sources of informed opinion for predicting those future results. At the very least, those are opinions worth some level of consideration; especially when they can be reinforced though the accuracy of the past earnings predictions.

Based on these projections SIMO is currently trading at a very inexpensive 11.59 times projected 2015 earnings of $2.07/share and an even more attractive 10.04 times the $2.39/share earnings predicted for 2016.

We can also see from this table, that the trend in the earnings projections for 2016 from the analysts covering this stock are moving in a positive direction over the past 90 days. During that period of time, the earning predicted have increased by about 3%.

Can we rely on the predictions of the analysts?

Trusting the predictions of analysts is always a bit of a guessing game. We must always remember that they keep their jobs by not doing worse than other analysts in their predictions about the future of any given business.

When trying to determine how much credibility to assign to analysts’ projections for any given business, I like to review how that particular business has performed against those estimates in the past. The chart below shows the actual earnings reported by Silicon Motion for the past eight quarters compared to the projections in place by the analysts covering the stock. As you can see from the earnings chart available through Fidelity Investments, the company has exceeded the expectations of the analysts in 7 of the last 8 reporting periods.

As they love to remind us in the investment world, past performance is not a guarantee of future results, this chart does display and consistent tendency among the analysts covering SIMO to be on the conservative side in their estimates. As potential investors, that is what we prefer to see. A company that beats estimates tends to have a stock price that moves in our favor where a company that misses expectations can see its stock punished severely.

What are the future prospects for the Business?

It is nice to find businesses that are attractively priced related to their current and near-term prospects. But, as a value-oriented investor, I try to keep my focus on the longer term as well. I don’t want to invest in any business that is richly valued at its current price; but, I also am not interested in allocating my capital to any business that doesn’t have excellent future prospects for growth in its products and profitability.

As previously covered, being a designer in the semiconductor industry with a specialty in mobile devices places SIMO in a market segment that appears to be poised for continuing growth in demand for the foreseeable future as we become more information dependent and more mobile. Their ability to produce designs that are useful across the platforms of many of the major OEM’s (original equipment manufacturers) in the industry enables it to spread its risk across a broad base of customers and avoids it becoming excessively dependent upon a single customer.

The following table seems to confirm my assessment of the favorable position and growth prospects enjoyed by SIMO.

One attractive aspect of the information contained in this table is that the projections do not require some huge new increase in the earnings growth rate going forward, they simply predict that the company will continue to maintain approximately the same growth it has experienced over the past five years. I am always a bit hesitant to accept predictions of huge increases in growth rates without some obvious catalysts I can point to that will cause the growth. In this case, it is simply a continuous of the current trajectory.

What is the current fair value of Silicon Motion?

Most investors I know will consider the fair value of a business to be equal to a P/E multiple of 1 to 2 times the forward earning growth rate times the current year’s projected earnings. This is generally referred to as the PEG multiple. Based on 2015’s projected earnings of $2.07/share and the forward long-term growth projections of 21.90%/year for the next five years, a current fair value for this stock could be calculated at $45.33/share or 88.95% above the current price.

Even if we take a somewhat more conservative valuation approach and assign a value based upon the trailing 12 months' actual earnings of $1.76/share against the forward growth rate, we still end up with a current fair value of $38.54/share, or 60.65% above the current price.

Is there any extra protection from loss of investment capital?

No matter how good of an investment a business might appear to be, there is simply no such thing as too much security for my capital so I am always looking for that extra layer of protection. In the case of SIMO, that protection can be found on the balance sheet for the business in its relatively liquid assets compared to its total liabilities.

At the end of June 2015, Silicon Motion was holding cash and short-term investments of $201.633 million. It also had $49.992 million of outstanding receivables and $50.299 million of inventory (valued at cost). Against these very liquid assets, the company lists only $80.648 of TOTAL liabilities!

This gives the company a net liquid holding of $221.276 million net of all liabilities. This equals $6.86/share or 28.59% of the entire market value of the business in assets that could be readily converted to cash if needed. Even though there will always be inventory and receivables involved in any business, these numbers simply display the highly liquid nature of this particular business and the virtual financial fortress contained on the books. This is what lies just beneath the surface as a moat of protection for investors’ capital.

Final thoughts and actionable conclusions

Based upon the information presented in this analysis, it appears even a conservative valuation of SIMO should produce a return for new investors of somewhere in the range of 60% over the next 12 to 18 months. It is also easy to see that it would not be a stretch or require an excessively optimistic valuation for the stock to rise even 70% to 90% during that timeframe.

In addition, given the projected annual earnings growth rate of 21.9% for the next five years this company has the potential to deliver truly explosive gains for new investors who buy it today and hold it for the next five years or so. Buy it now and hold for big gains going forward.