Wedbush Morgan analyst Craig Berger recently sent a note to clients on fabless semiconductor firm PortalPlayer (NASDAQ:PLAY). According to Berger, the company is working to reinvent itself after announcing it lost the iPod Nano socket. Excerpts follow:
Several interesting comments were made recently that could drive a positive trading bias to the stock in the short-term including:
1) Implying that it would likely remain in the iPod Video business through year-end 2006.
2)Saying it had won a wireless socket deal (but with no other details provided).
3) Noting that it has increasing traction with traditional and detachable Preface systems at Quanta and Compal.
We still think the stock is worth $10 absent greater visibility into revenue streams associated with these efforts.
• The firm’s prospects depend on its ability to:
1) Maintain sockets in other Apple (NASDAQ:AAPL) iPod products like the coming iPod Video (high-end) and the Sandisk Sansa e200 players.
2) Ramp its Preface notebook chip solution with the rollout of Vista in 2007.
3) Grow shipments with non-Apple customers.
4) Leverage its IP into new markets and applications.
5) Be willing to consider sensible business combinations.
• PortalPlayer reported Q2 results that were better than consensus and our estimates as Apple continued to buy PLAY chips for the iPod nano and Video. PortalPlayer recorded revenues of $34.6 million (-52.2% QoQ, -22.5% YoY) and pro forma EPS of $0.08, 4.3% higher than our $33.1 million revenue estimate and beating our EPS estimate by $0.04. Pro forma gross margins of 41.2% decreased -10bps QoQ and -80bps YoY. Operating margins of 2.6% dropped -1670bps QoQ and -1490bps YoY.
• Management guided Q3 revenues to a range of $32-42 million, substantially higher than consensus estimates of $26 million as some iPod nano and all Video shipments likely continue to Apple in Q3. Pro forma EPS was guided to a range of $0.07-0.17 per share, greatly exceeding consensus estimates calling for a pro forma net loss. We were surprised when management announced that it will not use its cash on the balance sheet to burn through operating expenses but fund its operations through its own revenue generation, thus implying that it will continue shipping into the iPod Video at least into Q4, a short-term trading positive.
• Gary Johnson, the firm’s CEO, announced he will be leaving by year-end to pursue other startup opportunities (even though PLAY feels just like a start up again), possibly signaling his belief that the firm’s growth recovery prospects are poor. Gary Johnson, CEO, announced he will be leaving the firm by year-end, which we think reflects his negative assessment of the firm’s intermediate term recovery prospects. PortalPlayer’s recovery prospects depend on its ability to: 1) maintain sockets in other Apple iPod products like the coming iPod Video (high-end) and the Sandisk Sansa e200 players, 2) ramp its Preface notebook chip solution with the rollout of Vista in 2007, 3) grow shipments with non-Apple customers, 4) leverage its IP into new markets and applications, and 5) be willing to consider sensible business combinations.
• Increasing 2006 EPS estimate from $0.12 to $0.65, maintaining 2007 EPS estimate at ($0.70), HOLD rating, and $10 price target. Our price target is based on a $90 million value for PortalPlayer’s intellectual property and software assets, plus net cash of $190 million, less an assumed $40 million cash burn through 2007. We feel this valuation is justified given valuations for publicly traded chip peers SGTL and PXLW, and given other recent private company acquisitions including Protocom, Oasis, Equator, and AlphaMosaic.
• Risks to attainment of our share price target include: the further loss of Apple iPod sockets, Apple iPod market share losses, inventory and demand risks, increased competition and product commoditization, chip price declines, acquisition-driven dilution risk, and other design and execution risks.
We Rate PLAY a HOLD Given Limited Revenue Visibility into New Product Thrusts
We rate PLAY a HOLD given its strong cash position, low enterprise value, but limited revenue growth visibility. We think PortalPlayer’s Windows Vista Sideshow software stock, its Wi-Fi interface software stack, its cellular interface software stack, its (nascent) video processing capabilities, its audio processing capabilities, and its 130nm low power chip design are worth between $75-125 million to an outside firm possibly interested in acquiring PortalPlayer. That comes out to roughly $3-5 per share of enterprise value. If one chooses to base PLAY’s valuation on today’s net cash of $7.50 then PLAY is worth about $10.50-12.50 per share. Alternatively, if an investor wants to base PLAY’s valuation on a level of projected cash per share (we model cash at $5.62 in Dec’07) then PLAY’s value should closer to $8-10 per share.
PortalPlayer could still maintain its Video iPod socket, which would likely cause the stock to bounce into the low teens range. It is possibly that PLAY will retain its socket in the soon-to-be-released Video iPod given Apple’s design schedule constraints, likely Video iPod device processing requirements, and the execution risk Apple faces should it change processor suppliers. With respect to any forthcoming Video iPod, we believe nVidia’s and Broadcom’s video processing solutions are probably not well suited to drive both the video processing, audio processing, and applications processing within the Video iPod. Also, a new operating system would have to be written and debugged very quickly. Finally, we think that any savings in battery life is minimal versus the current solution. We still believe Apple is focused on delivering best-of-breed products with cuttingedge features, and is not overly focused on cost reduction for its high end products..
Background – PortalPlayer previously announced that Apple Computer did not choose its nextgeneration chip for use in their mid-range and high-end flash based iPods (Nano). Commentary by executives at Samsung suggest that it has won the iPod Nano socket, likely by bundling its MP3 decoders with the purchase of its NAND flash memory chips, which we believe ship in a majority of existing iPod Nanos. PortalPlayer believes that its current MP3 chip will be used in other members of the iPod family. This is one of the uber-bear case scenarios that investors have feared and has a disastrous impact on PortalPlayer’s profitability in light of the fact that iPod Nano chip shipments once comprised 70% of our 2007 revenue.
PortalPlayer Investment Thesis: We rate PortalPlayer a HOLD with a $10 price target. PortalPlayer’s recent announcement that it lost the high-end and mainstream Apple iPod business is disconcerting and seriously impairs the firm’s future prospects. With its smaller scale, lowered ability to invest, and still limited market opportunities, management should consider business combinations that make sense. We are maintaining our HOLD rating in light of the stock’s much lower valuation but do not recommend investors buy the stock here as management works to reinvent the company.
PortalPlayer Valuation Methodology: PLAY should now trade based on its (potential) ability to generate sales, or based on the value of its technology. We believe fair value is around $8-11 and have set our target price on the stock at $10. Our price target is based on a $90 million value for PortalPlayer’s intellectual property and software assets, plus net cash of $190 million, less an assumed $40 million cash burn through 2007. We feel this valuation is justified given valuations for chip peers SGTL and PXLW, and given other recent private company acquisitions including Protocom, Oasis, Equator, and AlphaMosaic.
PortalPlayer Investment Risks
iPod Socket Loss Risk - The biggest risk for PortalPlayer investors has now come true with PortalPlayer having been designed out of most of the next-generation Apple iPod devices. If PortalPlayer were to win any Apple iPod Shuffle business then losing that socket would again be a material risk.
Demand and Excess Finished Goods Inventory Risk - Some excess finished MP3 players may exist throughout the supply chain. If the magnitude of the excess inventory is greater than expected then PortalPlayer’s stock could be negatively impacted. Similarly, if end-demand is not as robust as the market expects, PortalPlayer’s stock will be negatively impacted as well.
Intense Competition - While PortalPlayer is a formidable competitor, we believe this market will be fiercely competitive given the somewhat surmountable barriers to entry for other competitors. Other competitors include SigmaTel, Broadcom, TI, Intel, Philips, Telechips, and Actions, among others.
Chip Price Declines - Significant competition leads to material ASP and margin deterioration. We are modeling mix-adjusted annual chip ASP declines of -18% and -15% in 2006 and 2007, a reasonable assumption in our view. If ASPs decline by 17-20% per year or faster, than PortalPlayer could have a difficult time achieving sufficient operating profits.
MP3 Player Commoditization - Many suppliers are getting into the MP3 player market, including ODMs, OEMs like Samsung, and major consumer electronics brands. These devices could become $20 walkmans, in which case PortalPlayer’s ASPs, and hence income, will fall dramatically.
Handset or SmartPhone Inclusion - It is possible that the handset or SmartPhone soaks up the MP3 player in the future, thus eliminating the need for discrete MP3 SoC solutions.
PLAY 1-yr chart: