IDTI Stock Pitch

Michael Bianco – Majoring in Finance & Investments at Baruch College

Position: LONG Integrated Device Technology Inc. [IDTI]

Price Target: $26.73

Horizon: 12-18 Months

Recommendation

In the current economic environment, I would recommend going long on Integrated Device Technology Inc. [IDTI] for a time horizon of 12-18 months with a soft price target of $26.73. This company is situated in the Information Technology sector (Semiconductor sub-sector) of the market. IDTI Currently develops system-level solutions that optimize its customers’ applications. IDTI’s market-leading products in timing, wireless power transfer, serial switching and interfaces are among the company’s broad array of complete mixed-signal solutions for the communications, computing, consumer, automotive and industrial segments. IDTI currently trades at the $20-$21 per share level (As of 09/05/16). Due to this current price level I believe it to be undervalued by 25-30%. The market has incorrectly overreacted to the loss of a main client, Huawei, generating 40% of their overall sales, an earlier earnings miss in February of 2016, wrongful valuation potential of the acquisition of Zentrum Mikroelektronik Dresden AG (ZMDI) for $310 Million as well as the continued growth in their other segment, Computing, Consumer, Industrial. The points stated above show signs for significant upside potential for this company’s performance over the next 12-18 months. Additionally, even if growth in its core segments (Communications) stagnates due to cyclical & Huawei concerns in the semiconductor space, their diversification through R&D and acquisitions set this company in a perfect position to weather any storm and capitalize on all opportunities, even in a multitude of other, non IT, sectors. Presented in a best case scenario, there is a strong possibility of at least 25% potential upside in the stock.

Catalysts to increase its share price in the next 12-18 months include the performance of their Computing, Consumer & Industrials segment as well as the outperformance of their recent acquisition of ZMDI. These catalysts along with the continued outperformance of their recent acquisition of ZMDI, spacious/stable margins, continuous revenue growths and R&D product creation, create the ideal situation for an increase in stock price over the next 12-18 month period in a normal or expansionary market, with a stable to slightly negative return in the event of a recession. All of which should be accounted for in the next earnings report.

There are four key investment risks. The cyclical nature of this sector. The possibility of missing their operating metric targets which relied heavily on Serial RapidIO (Combine lower revenue overall and narrowing margins could result in a short-term downturn until they are able to fill the gap left by Huawei’s departure). And the Huawei fallout being worse than indicated with current products and future products no being able to fill the gap left by Huawei. We could mitigate those risks via protective put options or covered calls, such as a straddle, or by longing the stock of peer companies that have invested more heavily in other geographies or in competitive products, such as a mature and large cap company like Intel, which operates in the chip-producing space as well. However due to cyclical concerns this as an allocation to a portfolio, should not be more than a 5% total position in a 60/20/20 allocated portfolio.

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Company Background

IDTI is a global semiconductor supplying company that operates in 2 general markets: Communications and Computing, Consumer & Industrial, the latter of which is where they feel is the area for opportunity through sensors, memory interface and wireless charging (Which they believe they can combine with automotive design). Total revenue in FY 2016 was $697 million, with EBITDA of $176.96 million (25.39% margin), The company has grown revenue at 18-20% for the past 2 years, with EPS increasing 85%(FY 2015) & 116% (FY 2016) in the last two years. This can be attributed to a higher demand seen in their current products (Specifically wireless power) as well as their acquisition of ZMDI in December 2015, which exposed them to the automotive sensory portion of the market. According to their CFO they intend to give great focus to this newly acquired portion of their business. They believe these drivers, as well as an increase in demand for their environmental sensory technology will propel them through 2016-2017.

IDTI’s current free cash flow stands at 25% as a percentage of total revenue. They currently operate with a 30% operating margin (Including & excluding ZMDI acquisition is a 50bp difference) and believe this margin will not be compromised by a change in technology or clientele(Huawei).

Its Communications segment accounted for 43% of net revenue in FY 2016, but its percentage of total revenue has declined from 60% in FY 2014. Its Computing, Consumer & Industrial segment accounted for 57% of net revenue in FY 2016, this portion has grown from 40% in FY 2014.

IDTI currently trades at multiples of 4.26x EV / Revenue and 16.77x EV / EBITDA. It currently trades at a 16.54x P/E where the industry average is a 27.57x P/E meaning there is room for price increase on a linear basis. It also retains a 4.03 P/BV with an industry average of 4.65 which also supports the theme of being undervalued in terms of peer to peer analysis.

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Investment Thesis

Currently, the market view of IDTI is in a “Hold-Buy” sentiment, as according to Bloomberg. This could be for many factors from systematic risk to company specific risk as discussed above. It is a 75TH percentile Market Cap company for the sector, however has greater operating margins then most competitors. It also trades at valuation multiples close to the 50th to 75th percentile, and its multiples are close to those of Xilinx Inc., its closest peer (This peer has been rumored to be an acquisition target, valuations may be inflated).

However, the stock is priced imperfectly for the following reasons:

1. There is tremendously more upside to the ZMDI acquisition than the market has priced in. IDTI acquired ZMDI for $310 million, however they have outpaced their growth targets after the acquisition, along with providing $20 million of quarterly revenue at 57% gross margins to IDTI. However, the prospect of future cash flows I feel was miscalculated and should presumably be growing quicker than anticipated by the market due to the unforeseen and higher demand seen by management of the automotive sensory segment of their portfolio of products, which ZMDI was presumably acquired for.

2. The market has overreacted to the end of IDTI’s relationship with Huawei. Huawei represented 40% of IDTI’s total revenue, the bulk of which was in the sale of Serial RapidIO. Management has stated they will lose $12 million for the September quarter followed by $11 million every quarter after that, with the relationship going to zero. Although this an impactful event I feel it was overreacted to. IDTI grew revenue by 19% compared to this quarter last year and have had 11 consecutive quarters of positive growth (Albeit they will finally have an expected negative growth in revenue for next quarter due to this deal). However, when factoring in Huawei’s loss, they still expect only a loss of 4% of revenue growth, down to $184.5 million expected for the December quarter due to the picked up growth of their acquisition as well as other existing products in the Computing, Consumer & Industrial segment. For this reason, IDTI expect this gap in growth of revenue to be filled relatively quickly and the actual gap left by Huawei to be filled in the long term. IDTI benefit from timing of this event. IDTI have become diversified over the last two years to be able to weather the fallout from a relationship of this size. IDTI have gone from a heavy allocation to Communications (60% two years ago) to a much more diversified, de-levered broad allocation, attributable to the continued focus on growing their environmental sensory, automotive sensory, wireless charging & memory interface products. Huawei has also told them numerous times they do not plan on bringing their chip to market and it is solely for an internal use of reduction of cost. Another note regarding Huawei, Huawei stated it is not a product issue, simply a cost issue, IDTI has already tested and sampled their next generation Serial RapidIO with no complaints and a bright prospective.

3. Revenues in our Computing, Consumer and Industrial segment increased 52%, to $395.2 million in FY 2016. The increase was primarily due to a $80.2 million increase in memory interface product revenues as a result of higher demand combined with a $42.9 million increase in shipments of wireless power products, and a $24.4 million revenue contribution from the ZMDI business (22% higher than anticipated).

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Each of these reasons ties in directly to the company’s valuation and will make a substantial impact.

Even if some of these reasons turn out to be incorrect, any one of the factors above represents a significant difference from the current market view of the company and could result in substantial upside potential for investors.

If all of the factors above turn out to be incorrect, then IDTI is valued appropriately at its current stock price and an investment would represent minimal downside risk in the event of a continued cyclical nature in the economy, even if there’s no room for share price appreciation.

Catalysts

Catalysts in the next 12-18 months include:

The continued outperformance of their Computing, Consumer & Industrials segment as well as the outperformance of their ZMDI acquisition.

The company’s next earnings announcement after learning of Huawei’s departure Continued stable or growing operating metrics.

Catalysts #1, #2, and #3 are interrelated and are all equally significant in terms of valuation. However, the acquisition of ZMDI resulted in $24.4 million in additional revenue($4.4 Million more than expected) in FY 2016 and over $13.9 million in EBITDA, with revenue growing to over $697 million and EBITDA growing to $176+ million in FY 2016.

Using a Discounted Cash Flow model, the following values state that with current value levels, consistent revenue growth of 13.1%, an EBITDA margin of 30% as stated by management, and a 12.8% weighted average cost of capital the following states that the implied stock price should be 26.73, not the current 20.76 that IDTI is currently trading at.

The following sensitivity table suggests, IDTI’s implied share price should be in the $24.00 - $30.00 range:

It also suggests the risk of an increase in WACC would be able to hold the price at current levels.

As shown in the table, even if IDTI’s revenue grows slower than anticipated, there is still upside of at least 22.65%. A $24.00+ per share price is expected with the current factors of the business model.

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As seen in the table below a consistent 13% growth in sales annually as well as a maintained EBITDA margin of 30% will create the most likely scenario, management has continuously stated that a 30% margin is accurate and should be used and expected going forward, this should boost IDTI’s share price once the market gains knowledge of thess and prices it in appropriately.

The second catalyst, the company’s first earnings announcement after losing Huawei as a client, and having a full year past since acquiring ZMDI, is significant because this event may make the market realize the pricing imperfection in IDTI’s stock once the company provides higher-than-expected guidance for FY 2017 as a result of the acquisition and Huawei’s departure.

However, if the metrics stated above are missed, revenue for the December quarter misses and the growth of its Computing, Consumer & Industrial segment slow then next quarter could see a slight decline in price, or a minimal increase in price appreciation.

Finally, catalyst #3, the continued diversification of its products & its stable and attractively growing margins, is significant because it is what has allowed for the amount of free cash flow to be originated. If demand stays consistent or grows at least 3% excluding and Huawei related declines then the price of this stock should still be able to meet target and be priced in accordingly once the market realizes the over assumption of outside factors and that IDTI still has a producing, growing and sustainable business model. I continue to expect IDTI’s acquisition of ZMDI to attribute to revenue but more so to be better seen in its EBITDA margins where it is currently feeling a 57% margin

All of the above represent catalysts that could boost IDTI’s share price to our targeted range of $26.73 per share in the next 12-18 months; if they all come true and work as expected, the price may reach this target sooner than expected, and if one or more is false, there is still potential upside in the stock but it we should see the price at a lesser price target of $22-$24.

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Valuation

We have valued IDTI using public comps, precedent transactions, and the DCF analysis.

To select comparable public companies and precedent transactions, we have used the following criteria: First they must operate as a semiconductor company or supplier of semiconductor materials. They must have at least 50% of revenue from the Asian markets. They must have at least $1 Billion in Market Cap. The company can be no younger then 5 years old. They must produce more than two products; these products must be catering to more than just the enterprise level clients or the consumer level clients. Finally, its debt/equity levels must be within 25% of IDTI’s current debt/equity levels.

The discounted cash flow analysis uses the following “base case” assumptions:

EBIITDA Margin of 30% over the next four years A continuous revenue growth of 13.1% No increase in current CAPEX, and average growth consistent with the growth of the last four

years for assets & liabilities. A 12.8% WACC is deemed appropriate assuming an 8% average return on market..

Here’s the DCF down to the Free Cash Flow line so that you can see the revenue and free cash flow growth over the last four years.

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Key Takeaways: The analysis is highly sensitive to both WACC and revenue growth – however, these show no signs of change from future expected rates.

Here is the same table from above for the revenue growth in IDTI along with the company’s overall operating margin:

Key Takeaways: If you look at the highlighted area, you’ll see that even in downside scenarios, the valuation implies, at worst, approximately a 10% discount to IDTI’s current share price.

The more optimistic scenarios and implied values over $35.00 per share are less likely, but from this table it certainly seems like the potential upside exceeds the potential downside.

Based on our research and channel checks, we believe there is a high likelihood that actual revenue growth will meet or exceed these numbers due to IDTI’s favorable geographical & segment split and strong competitive advantage in the semiconductor space.

Investment Risks

The top risk factors include:

1) The Huawei fallout will be worse than anticipated2) Operating metrics missing their target due to a lack in revenue and fallout from Huawei 3) The company’s new and existing products creating lower demand due to the cyclical nature of

the sector of business they are in.

We’ll address each of those risk factors in turn and explain how to mitigate them:

The Huawei fallout will be worse than anticipated

If the Huawei fallout is worse than anticipated, then lower revenue growth will be seen reducing the share price down to the $16-$18 price level.

While that is not dramatically different from its current price of $20.76, there is a chance that the market may overreact and send the stock price down, or that the stock price could fall as the company guides to lower revenue and EPS in FY 2017 as a result of the fallout.

To hedge against this risk, we could buy protective put options on Mylan’s stock at a strike price of around $18.50 to limit our losses to 8%; this is an investment that can see massive upside, so we don’t see a reason to accept greater than 8% losses if the potential gain is only 25-30%.

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Operating metrics missing their target due to a lack in revenue and fallout from Huawei

As shown in the tables above, this investment thesis is heavily dependent on revenue growth being a consistent 13.1% and the expected EBITDA margin being reached of 30% and being consistent into the future.

If that does not happen, the company’s implied per share value would be closer to what it is currently trading at, around the $20 price level where revenue growth and EBITDA margins are closer to 9% and 26% respectively.

This doesn’t represent a potential loss in dollars however it would imply a stagnation in wealth generated, but we could hedge against this outcome by longing a competitor with greater margins such as XLNX, or even a much larger IT company with a more diversified pipeline, such as Intel which produces chips of its own.

The company’s new and existing products creating lower demand due to the cyclical nature of the sector of business they are in.

Due to the cyclicality of the semiconductor space the major macro concern is a turn in economic growth and reduction in sales due to stricter budgets at its customers which range from other IT companies to automotive to retail and including but not limited to other chip producing companies. A lower demand for its current products will result in a downturn in demand which means less revenue into R&D which is currently at $36 million for the September quarter alone, less R&D means fewer opportunities in the future.

This would require additional research on the market and peer companies to execute properly.

The Worst Case Scenario

Another risk is that we could be wrong about everything outlined above, from the revenue growth rates and margins to the acquisition, new product launches, and more.

A true “worst case scenario” might result in an implied share price of between $13.00 and $17.00 if you assume dramatically lower revenue growth, lower margins, a significantly higher discount rate, and a terminal FCF growth rate of less than 2.0%.

Assets minus Liabilities on IDTI’s Balance Sheet is currently $677 Million, which equates to the remaining being shareholder equity. There is room for the company to take on more debt and improve its operating leverage without affecting shareholder’s equity value as its current debt-to-equity level is currently at 62.33%

Additionally, there is another way to hedge against the downside with IDTI: since it has a few proprietary products, it could sell the rights and patents to those specific products (such as its Serial RapidIO product) which will help in increasing its margins, to the extreme it could also sell ZMDI, or the factory they have located in Germany to produce these products even after acquiring it so recently

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We would need to conduct additional research and do more valuation work on what these divisions might be worth, but the company spent $307 Million on acquiring ZMDI and has continuously invested heavily in R&D with its most recent quarter topping $36 million in investments – on the surface, that is also a low per-share value, but potentially they could be sold for significantly more than that $307 million, especially after beating IDTI’s own expectation of what they expected to receive in terms of revenue per quarter. Depending on how market values change over time, the possibility of liquidation of some of these assets could be a possible option, however there has been no discussion of this in the past.

Technical Analysis of IDTI’s current position

To touch on the possibility of upward movement of IDTI, all else constant the price movement supports the fundamental analysis of this company. A favorable price entry for this particular company would be in the $19.50-$20.00 range, however this is a rough range for price entry, further analysis should be made.

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Documents

IDTI Stock Pitch