Synaptics: Buy the Dip

Synaptics Inc. SYNA lost more than 20% of its market cap in the last five days after acquiring Conexant Systems and Marvell Technology Group MRVL for a cumulative cash compensation of $395 million along with share-based compensation. You can see the detailed update here.

Synaptics also narrowed its midpoint revenue guidance for the fourth quarter of 2017. Cash spending, dilution and guidance revision were all too much for the market, and the reaction was ugly for Synaptics’ shareholders. The selling was not completely rational as the market just focused on the bad side and ignored the good one.

Acquiring growth bodes well for Synaptics

Synaptics has always been aggressive in terms of new acquisitions. This paid off for the company most of the time. In 2013 the acquisition of Validity Inc., a fingerprint sensor solution company, exposed Synaptics to the fingerprint market; that market started to take off. Further, the Renesas acquisition allowed Synaptics to built TDDI capabilities, which is currently another growing market for the company. The aggressive acquisition strategy allows Synaptics to stay ahead of the competition. The Conexant and Marvell acquisitions will exactly do that for the company in IoT space.

IDC’s recent forecast validates Synaptics’ strategic move

The latest report from IDC forecasts the IoT market will grow at 16.7% in 2017 to reach $800 billion; CAGR of 15% is expected during 2017-2021. Smart home technologies are forecast to experience strong growth (19.8% CAGR) in the five-year forecast period. It is worth mentioning that acquisition of Conexant and Marvell put Synaptics directly in that arena.

IDC, Worldwide Semiannual Internet of Things Spending Guide

Other potential benefits overlooked by the market

New acquisitions will, at the minimum, add $198 million in recurring revenue. But this is the base case as IoT growth and home automation growth will boost the revenue above and beyond that.

Post acquisition margin is expected to be stronger than the current margin as management confidentially said that margin expansion will follow as a consequence of this acquisition.

Acquisition will result in synergy and cost savings amid elimination of duplicate functions across the organization. This will improve the bottom line of the company, boosting the EPS.

Valuation adjustments reveal that the stock is undervalued. Valuation is discussed in detail below.

Adjusted valuation reveals upside

The initiation piece expanded on the valuation before that can be accessed here. Nevertheless, the model is updated to reflect new developments. The primary effect of the current acquisitions includes:

• Reduction in cash balance.
• Increased debt.
• Dilution of shares.
• Increased EPS.
• Improved margin.

These adjustments are made to update the valuation model. Cash balance is deducted from equity to adjust the economic value added. Dilution is incorporated as outstanding shares have been increased by 726,666 for the valuation purpose. Additional EPS was added from year ended 2018 as management expects the transaction to be accretive to the non-GAAP EPS in the first year following the close of the transaction. Net margin was assumed to be 5%. Note that Synaptics’ net margin stands at around 4%, which is expected to increase amid numerous reasons discussed here. Therefore, net margin of 5% is a very cautious assumption.

Further, the growth expectations of the new acquisitions have not been incorporated in the model. Therefore, the valuation is very conservative. See the details of the transaction below:

Focus Equity Estimates

The acquisitions are expected to add 28 cents in earnings per share given a 5% net margin. Note that the model that follows doesn’t incorporate the growth that is expected from these acquisitions.

EVA-based valuation

Other assumptions for the economic value added valuation include:

Consensus earnings are a good proxy for 2017 and 2018 EPS. Acquisition-related EPS is added from 2018 onward. Earnings are expected to grow at 12% p.a. in 2019 to 2022, which is based on weighted average industry growth in the fingerprint sensor market and Synaptics’ serviceable addressable market. Cost of equity is based on the risk-free rate and the balance of money circulation. Dilution is assumed in outstanding shares as the company paid some part of the Conexant compensation through its stock.

Focus Equity Estimates

Cash spend is adjusted in invested capital. Dilution is adjusted in outstanding shares and earnings are added from 2018 onward. Despite dilution and cash deduction, the stock is valued at around $69, an upside of 30% over Thursday’s close price.

Bottom line

The selling is irrational as the market focused on dilution and cash spend without giving regard to the benefits these acquisitions bring to the table. The acquisitions allow the company to stay ahead of the curve in IoT while adding strong margin and revenue. Synergy cost savings will also improve the bottom line. Adjusted valuation indicates that the stock is priced way below its fair value. Investors should hold on to the stock as the dip is a buying opportunity, not a correction.

Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.