Seeking Alpha
Long/short equity
Profile| Send Message| ()  

Shares of audio component maker Cirrus Logic (CRUS) have been hammered lately as a result of growth concerns at its largest (by far) customer Apple (AAPL). Shares plummeted from $28 just two months ago to just over $17 in the last couple of weeks, having since rebounded to $19 and change. The once high-flying stock has been beaten back down to earth on the assumption that Apple's growth is done and as a result, Cirrus's margins and revenues will be squeezed by the Cupertino giant. This has created an interesting situation for shareholders as the company is either in serious decline, as the valuation suggests, or a significant opportunity for value is upon us. This article will attempt to reconcile future growth expectations with current share prices.

To do this, we'll use a DCF-type approach that requires some assumptions: 1) discount rate of 10% 2) no dividends for the next six years 3) perpetual growth rate of 3% 4) earnings estimates matched to current price 5) no effect from share repurchase program. I have used what I consider to be reasonable estimates; you may disagree with some or all of my numbers, but keep in mind all forecasting is subject to conjecture and risk. I am attempting to err on the side of conservatism instead of what I think Cirrus can actually do. It is also important to note this model does not take into account share repurchases, which will prove to be a tailwind for earnings.

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$2.71

$2.59

$2.70

$2.83

$2.95

x(1+Forecasted earnings growth)

-4.50%

4.50%

4.50%

4.50%

4.50%

Forecasted earnings per share

$2.71

$2.59

$2.70

$2.83

$2.95

$3.09

Equity Book Value Forecasts

Equity book value at beginning of year

$8.58

$11.29

$13.88

$16.58

$19.41

$22.36

Earnings per share

$2.71

$2.59

$2.70

$2.83

$2.95

$3.09

-Dividends per share

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

Equity book value at end of year

$8.58

$11.29

$13.88

$16.58

$19.41

$22.36

$25.45

x Equity cost of capital

10.00%

10.00%

10.00%

10.00%

10.00%

10.00%

Normal earnings

$1.13

$1.39

$1.66

$1.94

$2.24

$2.54

Forecasted EPS

$2.71

$2.59

$2.70

$2.83

$2.95

$3.09

-Normal earnings

$1.13

$1.39

$1.66

$1.94

$2.24

$2.54

Abnormal earnings

$1.58

$1.20

$1.05

$0.89

$0.72

$0.54

x discount factor (10%)

0.909

0.826

0.751

0.683

0.621

0.564

Abnormal earnings disc to present

$1.44

$0.99

$0.79

$0.60

$0.45

$0.31

Abnormal earnings in year +6

$0.31

Assumed long-term growth rate

3.00%

Value of terminal year

$10.48

Estimated share price

Sum of discounted AE over horizon

$4.57

+PV of terminal year AE

$5.91

PV of all AE

$10.48

+Current equity book value

$8.58

Estimated Current share price

$19.06

According to the model, Cirrus shares are currently priced for a 4.5% decline in earnings in 2014 and 4.5% growth thereafter for several years, with 3% perpetual growth. If Apple is done growing and Cirrus cannot diversify its customer base, this is probably pretty close to reality. However, if you are like me and don't consider Apple to be a dying company then these estimates are probably quite conservative. In addition, Cirrus is currently, rightly or wrongly, viewed as a pure, leverage play on Apple's future. Considering Cirrus gets 85%+ of its revenue from Apple this reputation is probably deserved. However, it discounts the substantial efforts management is putting into diversifying its customer base. The fruits of this effort aren't known yet but the fact that management realizes it's a problem and is working to rectify it brings some solace. Consider also that Apple is simply so huge that any efforts to diversify the customer base simply aren't enough, given the size of other potential customers. That is not an excuse for being nearly completely reliant on one customer but it could be the cause of Cirrus' reliance on Apple.

Regardless, this analysis shows that you don't even have to believe Cirrus will ever grow earnings again in order to justify the current valuation. I happen to believe that is too pessimistic, obviously, but even if you believe the company will continue to only make ~$2.70 in EPS per year, the shares are a good buy here. Given the company's strong position in the marketplace and the gigantic buyback program that is currently in place, I think steady earnings is probably a long shot.

There are risks, of course, for these forecasted earnings. Given that Cirrus is so reliant on Apple, if the company decided to get its audio components from someone else, Cirrus shares would probably drop 50% to 70% in one day. This is a huge risk for the company and something that must be carefully considered before you initiate a long position in Cirrus's shares. I think the risk of this is extremely remote given that Cirrus makes very specialized components for Apple products, and switching costs for Apple would be quite high in terms of a learning curve with the new supplier. It is something to be cognizant of, though.

This reliance could also lend itself to margin compression for Cirrus. Indeed, we saw a bit of that in the last couple of quarters. However, I feel like the stock is pricing in far more margin compression than is actually taking place. This is understandable because when margins begin to erode, nobody knows where the bottom is and a worst case scenario is usually discounted. However, this provides enterprising investors an opportunity to pick up a great business on the cheap. Make no mistake, though, if margins are compressed far enough, Cirrus could produce losses instead of earnings. We are a long, long way from that happening but in a few years, if Apple turns the screws on Cirrus, we could see gross margins dive and profits evaporate. Again, given Apple's potential switching costs, I don't think this will happen to the extent it is being discounted currently.

The bottom line is that Cirrus is very cheap at $19. However, it's only cheap if you think Cirrus will continue to earn ~$3 per share for the foreseeable future. There is enormous risk in owning this stock due to its dependence upon Apple. However, that risk is also a catalyst for potentially huge capital gains if Apple isn't on its death bed. I think Cirrus is ultimately worth at least $30 based upon its earnings potential. However, customer diversification and gross margins will be the metrics to watch going forward and we will eventually see either a huge move up or down in shares; you can bet I am positioning for the former.

Source: Cirrus Logic: Reliance On Apple An Asset, Not A Liability