Silicom: The Snowball

| About: Silicom Ltd (SILC)

Silicom (NASDAQ:SILC) -- Computer Hardware (Networking, Big Data, Cloud infrastructure, Wan Optimization)

This article on Silicom is a follow-up from my previous two articles that appeared in Seeking Alpha on June 12th and October 28th, 2011.

The buildup of Design Wins (DW's) over the past couple years has coalesced in the back half of 2012 and is set to gain further momentum in 2013 and beyond. In Q4 Silicom announced a 51% YOY rise in revenues and a 36% rise in EPS. Silicom's strategic vision continues to materialize as its new, innovative products reach an already strong and expanding customer base. In fact, the company, with its extraordinary products and impressive customer service, has never lost a customer.

Even though many of the large players in the networking infrastructure felt cautious about the macro-economic conditions in late 2011 through 2012 and delayed Silicom's product introductions, the company's products are now being distributed and sold at a rapid pace. After Intel's (NASDAQ:INTC) Sandy Bridge architecture and others have launched new product iterations, new products are coming to market and the DWs Silicom previously won are now being rolled out in massive new platforms. Not only are Silicom's traditional cards (NIC's) being used in more and more products, but now Silicom has its new SETAC line as well, which is currently being widely adopted within the networking space by its largest players. Once a product is designed in with Silicom's products, the flow of orders lasts for several years, at least. Over time, this new product platform has the potential to add tens of millions in annual revenue.

It is now the beginning of 2013, and we are witnessing the beginning of explosive rise in Silicom's revenue and profits as more and more of its products come to market at a rapid pace. In January, Silicom announced Q4 results, and management spoke very confidently about its growth prospect both in the short term and long term. Some, including Eric Savitz in Forbes, even wrote somewhat sarcastic articles about the choice of language used to announce the Q4 earnings release.

Those who have followed Silicom and its management team over the long-term recognize that the company's management has been both conservative and very forthright in its outlook for their business. As optimistic as it has been recently (rightly so), it has also been realistic when it foresaw potential difficulties back in 2007 through 2009. On the Q2 PR dated April 28, 2008, it recognized the sluggish market when it said the following: "We are pleased to report another quarter of record revenues and sequential revenue growth, especially in a market environment that has entered a period of slowdown." Also, on January 1, 2009 it candidly spoke of the difficulties in product visibility: "As we move into 2009, our visibility continues to be low due to the macro environment slowdown, and our results - together with those of the overall IT industry - may be impacted." To give one final example of Silicom's management team addressing and recognizing economic slowdown, it said this in 2009, just before its results turned up for the better in mid year:"We are pleased to report another profitable quarter of cash generation and strategic progress despite the global economic challenges of the past year, and see a number of signs that point towards a return of our business to growth in the second half of the year and beyond."

Silicom has demonstrated time and again their ability to (correctly) forecast its company's performance as well as recognize the economic changes that might affect it. In every instance, well in advance of actual results, it was correct in its forecasts. it does not give specific guidance, but the qualitative guidance can be relied upon when CEO Shaike Orbach sounds as bullish as he does today. It is to be taken seriously and not as an exaggeration.

On the R&D front, Silicom continues to innovate and create new and significant products. On February 19, 2013, it announced a new product category of time stamp adapters and have already secured its first DW with revenue coming in the near term. From the tone of the PR, it is confident that it will secure additional multi-million dollar DW's as well. This will, over time, likely add another $4 to5 Million in quarterly revenue, and the fact that it's a software based, patent pending NIC, it most certainly has a strong gross margin to help drive overall company margins in the 40% area or above. This new product announcement is yet another example of how conservative management is. On the Conference call Q&A in January Q4, management was asked about the R&D pipeline, and it demurely deflected the question, not revealing as much as it could have. Even though new DWs and new products were being launched, until the orders are secured and confirmed, the company will keep the information to itself so as not to over-promise and under-deliver. This is a change from the past when it would actually announce a DW before it produced revenue and when the product, including the DW, was released. Today Silicom remains quiet when it gets the win and, only after it attains the purchase orders, will it make its accomplishments known. I expect a very powerful year for 2013 with new product launches and strongly accelerated revenue growth. After the lull and push-backs during 2012, animal spirits are rising and companies are no longer waiting on product roadmap plans.

The 4th quarter had gross margins at roughly 38%, and while the company stated this is due almost entirely to product mix, my guess is that it is due to sales of SETAC kits. These kits are the basic housing of the SETAC appliance, and since it has no particular sophistication, the kits have an overall margin probably in the 20's, and drag down overall margins. The SETAC modules, however, have higher margins as that is where the IP is. I think it is fair to say that for a full year, to model at least a 40% gross margin is very reasonable and probably even conservative.

Silicom recently initiated an annual dividend of approximately 50% of its net income, as it has accumulated a vault full of cash at more than $50 Million, or nearly $7.50, per share in cash equivalents when you include its investments in government liquid securities. This will still grow its future cash on the balance sheet, albeit at a slower clip than otherwise. This also, quite ingeniously, provides for even better operating leverage. Why? Silicom employees all own stock and they, too, share in the dividends right alongside common shareholders, which reduces the pressure for bonuses in terms of cash G&A expense to the income statement. This is also a nice added bonus to drive additional investment interest to the security and is added proof of the earnings. I think it is important to point out how clean and neat the Silicom financial statements have been over the years, and is indicative of the conservative and well-managed operation of the company. No phony baloney massaging of results at Silicom. The employee and management option expenses have also been very fair and have had minimal dilutive effects. This company truly walks the walk when it comes to creating shareholder value and has its interests firmly aligned with its shareholders considering that management owning a very big stake in the company.

For 2013, I anticipate Silicom achieving revenues between $65-70 MM and EPS on the current 7.0 million shares outstanding of around $2.25. For 2014, I think they can do $90-$100 MM in revenues and drive EPS to around $3.50. Since revenue growth rates will most likely be upwards of the 40% range, the P/E could expand towards 40. For now, I will assume a 25 P/E. As this story crystallizes in the back half of 2013, the stock will discount 2014 EPS, so I will stick to my original stock price projection of $87.50 before adjusting for future stock splits, which I fully expect to happen this spring to add trading liquidity.

Silicom currently has no sell side analyst coverage, although that will probably change soon. The only other coverage is by Sidoti and Ken Nagy at Zacks, although Zacks does not provide any revenue and earnings forecasts for Silicom. Industry leaders and customers that are heavily covered by research include Riverbed (NASDAQ:RVBD), Citrix (NASDAQ:CTXS), Checkpoint (NASDAQ:CHKP), Juniper (NYSE:JNPR), Radware (NASDAQ:RDWR), Supermicro (NASDAQ:SMCI) and F5 Networks (NASDAQ:FFIV).

In summary, Silicom is enjoying the Lollopalooza effect of the virtuous cycle of new products. They are meeting the needs of a growing industry, which is expanding at strong, secular rates, as well as acquiring new and important customers and honing their existing customer relationships. Silicom is like a snowball rolling downhill, gathering more and more design wins that are larger and larger, and with bigger Tier 1 OEMs. The snowball has gained significant momentum and is rolling with gravity and hurtling with amazing force. As the CEO stated in the last conference call, they are just beginning to reap the harvest.

Disclosure: I am long SILC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.