Authentec: Earnings Not a Disaster, Still a Hold

AuthenTec (NASDAQ: AUTH), the world’s leading provider of fingerprint sensors and solutions to the PC, Wireless and Access Control markets, released their Q3/2008 earnings and held their analyst conference call Thursday, October 30th after the market closed.

After the mid-quarter update that AuthenTec abruptly held, there were many questions that needed to be answered about AuthenTec’s business going forward.

While Q3’s results were ahead of expectations, AuthenTec’s guidance for Q4, coupled with their already lowered guidance for all of 2009, inclusive of a significant customer loss, still call into question whether or not AuthenTec has the viability and products to succeed without being folded into another company as part of a larger pie.

However, that being said, AuthenTec’s earnings release and subsequent conference call where decidedly upbeat in relation to their previous mid-quarter call announcing a significant customer loss as well as lowered guidance.

What follows is a summary of AuthenTec’s earnings announcement, conference call highlights, and my take on the company’s latest quarter and results, and what you should do if you own AuthenTec.

New to the AuthenTec story? 

AuthenTec, Inc. is a fabless mixed-signal semiconductor company that provides fingerprint authentication sensors and solutions to the high-volume personal computer (PC), wireless device, and access control markets.

AuthenTec offers a range of fingerprint sensors that enable users to access and control multiple functions on an electronic device by touching or sliding their finger across the sensor.

The company’s fingerprint sensors utilize unique information in fingerprints to verify the identity of the individual, as well as the unique, individual fingers on the same person.

With more than 35 million sensors sold worldwide, AuthenTec’s award-winning sensors take full advantage of The Power of Touch® by utilizing the company’s patented TruePrint® technology to deliver the most convenient, reliable and cost-effective means available for enabling touch-powered features that extend beyond user authentication.

These sensors are used in various applications related to security, password replacement, financial transaction authentication, and personalization applications.

The company’s products are used in a range of PC products and related peripherals, including laptops, desktops, memory keys, hard drives, keyboards, mice, and other devices.

In addition, AuthenTec’s products also integrate into various wireless devices, such as mobile phones, and personal digital assistants and personal navigation device, as well as access control devices comprising door locks, time and attendance devices, and remote wireless entry keys.

AuthenTec primarily offers its products to original equipment manufacturers, original design manufacturers, and contract manufacturers and sells its products through a direct sales force, a network of independent sales representatives, and distributors.

Hit Me With Some Numbers

AuthenTec Beats Estimates, Lowers Guidance, Margins Decline

Here are some of AuthenTec’s earnings highlights (growth from previous year’s Q3/analyst’s estimates where applicable):

• Quarterly sales of $18.4 million (up 22% from prior year/vs. $18.32 million projected by analysts)
• Non-GAAP quarterly income of $1.4 million, or $.05 per share (up 62% from $.86 million, or $.03 per share in the prior year/vs. $.03 per share projected by analysts)
• GAAP quarterly income of $.55 million, or $0.02 per share (up from $.52 million, or $02 per share in the prior year)
• Gross margin of 47.4% (down from 47.6% from prior year, and down sequentially from 48.5% in Q2/2008, and 49.6% in Q1/2008)

My Take: While this quarter was solid, our concern largely lies with the future, not the past.

Taking that into consideration, we see that AuthenTec has a disturbing trend of decreasing margins quarter over quarter, and year over year. AuthenTec attributes this to the ramping up of a new wireless packaging technology and the manufacturing inefficiencies that come with it.

Oh, and one more note: This year’s Q3 contained one extra week that was not included in the previous year’s results, goosing AuthenTec’s numbers.

This speaks to the problems that they are facing within their industry, as well as the overall market forces which are forcing their largest customers to delay or cut back on their purchases from AuthenTec entirely.

I’ll go into more detail below.

Other Business Highlights

Lower Guidance, Slowing Business Trends

• Q4/2008 revenue expected to range from $12.5 million to $13.5 million ($13.0 million midpoint) vs. analyst’s estimates of $17.85 million.
• Q4/2008 non-GAAP loss per share to range between (-$0.01 and -$0.03) in the fourth quarter vs. analyst’s estimates of $.02 per share profit.
• For the entire fiscal year of 2008, AuthenTec is projecting sales of about $65 million, vs. analyst’s estimates of $70.1 million.
• Operating expenses as a percent of revenue decreased to 47.1% from 49.53% in the year-ago quarter.
• Margins expected to range from 47-49% for the rest of 2008 because of the ramp-up of new chips with lower yields and inefficiencies typical of new product introductions and scaling.
• Operating cash flow: $1.9 million
• Ended Q3/2008 with approximately $67.8 million in cash and investments vs. $66.6 in Q2/2008
• Capital Expenditures (CAPEX) were $295,000 in Q3.
• Inventory was $6.9 million which represented 69 days on hand, compared to Q2/2008 which was $7.0 million or 68 days on hand.
• Sales breakdown was as follows: PC segment about 85% of total sales, Wireless segment about 10% of total sales, and Access Control was about 5% of total sales.

My Take: Revenue guidance was chopped significantly for Q4, largely due to the macroeconomic environment, but not, according to AuthenTec, as a result of customer or market share losses.

It appears that large OEM’s and ODM’s are scaling back their orders from AuthenTec as they attempt to work through the inventory that they have on hand right now.

In fact AuthenTec’s competitors, such as rival Atmel Corp. (NASDAQ: ATML), are experiencing the same declines in consumer demand, and OEM and ODM push-through.

I will say that AuthenTec has successfully battened down the hatches, and is conserving cash well, and even had a large cash surplus this quarter when many companies are having trouble staying afloat.

With the coming turbulence ahead, AuthenTec is going to need this extra cash.

Now let’s take a look at the analyst conference all highlights and management’s discussion of the business.

Conference Call Highlights

CEO Spoke of the softening economy, AuthenTec’s latest products

• CEO says that AuthenTec is making “rapid progress towards addressing the issues at hand.”: The CEO, in his opening remarks, touched on the problems that AuthenTec had previously announced, and what they were doing about it. Namely:

–> 1) AuthenTec is aggressively managing expenses and being conservative with their cash.

The CEO also went on to say that their midpoint of guidance for Q4 represents a loss of about $.5 million, which represents less than 1% of their total cash reserves.

This loss is at a revenue level that they expect to rebound, signaling that they are very capable of weathering this storm without having to tap into the equity markets for more cash, or having to take on debt.

–> 2) While they are lowering expenses and conserving cash, they are not doing this at the expense of their R/D budget, and are heavily investing in new technology.

Specifically, the CEO talked about a new product codenamed: “Rogers” which is on schedule for introduction in the first half of next year.

This sensor, for the cell phone/wireless market, is smaller, uses less power and offers more features than their current offerings and is more attractive aesthetically.

Most importantly, according to the CEO, they will be able to produce this sensor at a much lower cost.

The CEO also talked about another chip/sensor they are working on codenamed: “Marcy” which will also fulfill the needs of the low-end PC market.

Finally the CEO mentioned that they are also working on a higher end chip design for the enterprise market that will also include access control features.

–> 3) The CEO stated that they are not the only company facing pressure, but are in a very competitive position because of their large cash reserves.

My Take: The tone on this conference call was much different than the one a few weeks ago in which AuthenTec not only shocked the market and announced lowered guidance for the rest of 2008, but also the loss of one of their largest customers, which would severely impact revenue in the back half of 2009.

I think that now that the dust has settled and everyone has caught their breath a little bit and taken stock of the situation objectively, AuthenTec’s management sees that if they can conserve their cash, keep producing products that are in demand, and continue their market dominance, they will be able to weather this current storm, and eventually, make back the revenue that they will lose from the loss of that significant customer.

In fact, they stated on the call that they are actually still working with that customer, and have a good relationship with them.

• Significant customer loss won’t affect revenues till 2010: The CEO also stated that their previous predictions for the revenue decline due to their loss of a significant customer might not actually start to materially affect their revenue until Q1/2010, or about 5 quarters from now, or 2-3 quarters later than their previous guidance.

My Take: If this is true, then analysts will have to raise their earnings and revenue estimates for next year to be higher than this year, when they currently predict flat year-over-year revenue.

This also gives AuthenTec a longer runway in which to find other customers to fill the gap left by the loss of this customer, and more time to ramp up production of their newest offerings, and latest technology, the “Marcy” and the “Rogers” sensors.

• New Product Design Wins: During the third quarter, AuthenTec secured a design win for its newest PC sensor, the AES2550, which leading European PC manufacturer Fujitsu-Siemens Computers is integrating in five new Centrino 2 powered notebooks.

AuthenTec’s sensors are now designed into more than 100 new Centrino 2 PC models from the world’s leading brands.

This represents millions of business and consumer notebooks which will include AuthenTec’s small form factor AES1610, single chip match-on AES2810, and new AES2550 fingerprint sensors for features like password replacement, fast user switching, application quick launch and file/folder encryption.

Also during the quarter, AuthenTec began volume shipments of its AES1711 sensor in its new durable TouchStone™ packaging to a key wireless customer for integration into the world’s first fingerprint-enabled waterproof cell phone.

You can read about AuthenTec’s three newest sensors and sensor packaging technology called TouchStone, here.

You’ll also recall that AuthenTec introduced three newest PC sensors that are now being designed into new PC models from eight of the world’s top 10 notebook PC OEM’s.

These included PC’s from HP (NYSE: HPQ), who introduced five business notebook PC models featuring the AES2810 sensor, Dell (NASDAQ: DELL), which announced the first of their new laptops featuring the AES2810 sensor which included the new Studio 15 and Studio 17 notebooks, and Lenovo’s ThinkPad series of laptops.

My Take: This is continued good news, but nothing too surprising from our perspective seeing as all of these wins were largely expected.

What AuthenTec now needs to do is garner more wireless customers and start getting higher attach rates for the lower end PC market.

So What’s the Bottom Line…

AuthenTec still a hold

When AuthenTec held their mid-quarter update (my take here) where they announced that they had lost a significant customer and lowered guidance for the rest of 2008, both the tone of the conference call, as well as the shock of the announcement crushed not only the stock price, but Wall Street’s and my confidence level in management and AuthenTec’s ability to sustain itself as an ongoing concern.

In fact, on that call, management stated as such, and didn’t even know themselves what the future held.

What a difference a few weeks makes.

Management was much more upbeat on this call, had ready answers to all analysts questions, and actually delivered some good news in the form of higher revenue and profit this quarter, higher cash flows, and guidance that even though was lower that expectations, was not as shocking as it could have been.

Couple that with management’s guidance that they won’t see a significant decline in revenue from their large customer loss until the first quarter of 2010, and you almost got the sense that AuthenTec will be alright.

Certainly the facts back that up at least in the short to mid term.

Sitting on a vast hoard of cash and the very fact that AuthenTec’s share price sits below their cash value, the downside protection one would look for is definitely there.

However, there are some serious risks associated not only with the macroeconomic concerns, but more so with AuthenTec’s competitive advantages in the marketplace and whether or not they will be able to sustain those advantages given the increasing competition in this tight and fiercely competitive environment and market segment.

Let’s look at the cold hard facts:

• AuthenTec is trading for less than $2.00 per share.
• AuthenTec’s Tangible Book Value (TBV) is about $2.60 per share.
• AuthenTec has about $2.38 in cash per share.
• AuthenTec has enough cash from operations, and enough revenue, even accounting for the large customer loss, to sustain operations at a break-even pace for the foreseeable future.
• AuthenTec is still gaining market share in some segments and has yet to really tap into several markets such as low end PC’s as well as the wireless market here in the U.S.
• AuthenTec still offers a compelling intellectual property (IP) pipeline, patented products and systems, a large customer base, is profitable to break-even, and has steady design wins and revenues. This makes them an extremely attractive acquisition target for a larger PC manufacturer, or stand alone semiconductor company.
• If such an acquisition were to take place, it would be at a significant premium to today’s valuation and price seeing as AuthenTec trades for less than cash value.

What’s the downside?

There are several points of contention:

• AuthenTec might steadily lose market share, as they already lost a large customer which accounted for 30-40% of their revenue.
• AuthenTec might not be able to compete in this market as demand rises for smaller and smaller fingerprint sensors that use less silicon that are cheaper to install and produce.
• AuthenTec’s fingerprint technology might not be enough to differentiate them and fight off their fierce rivals as the market becomes more commoditized.
• Further macroeconomic headwinds might force some of AuthenTec’s other customers to cut back on spending even more than they have already, and throw AuthenTec into a cash depletion cycle.
• As a result of these conditions among others, AuthenTec might be forced to reduce their average selling prices further, eat into margins, and not be able to sustain a profitable business model.
• Fingerprint sensors might never become mainstream, and the growth curve could be at its zenith.

So where does that leave us?

It leaves my investment thesis exactly where it stood on my last AuthenTec company update.

I need to wait and see, gather more information, and let this whole malaise shake itself out.

I do know for sure that selling a stock once it has already declined 80% and is trading below its cash value on hand when there is a high chance of the company being bought out, is not a wise thing to do.

At this point, AuthenTec represents a small sliver, regrettably, of my overall portfolio, and therefore, holding shares to gather more information, and wait for my new thesis to play out, doesn’t cost my overall returns, but could greatly enhance them should things play out as I feel they will.

Once again, if you own shares of AuthenTec, especially at much higher levels, I would advise you hold onto them for now.

If you don’t own shares, I would advise not purchasing any, UNLESS you are a seasoned trader, or market veteran that has good liquidity, and would only buy shares as a speculative gamble on a takeover, or for the shares to realize their true worth in terms of cash on hand and book value.

Even then, a purchase of AuthenTec should represent the smallest portion of your portfolio, and should represent no more money than that which you can afford to lose completely.

As for me, I’m content to hold on to my shares for now, and see where things go from here and I advise you to do the same.

New to the AuthenTec story? 

• Start: with my initial company overview here.