In March, we broke the news on Seeking Alpha that Himax (HIMX) was supplying microdisplays to power the visual aspect of Google (GOOG) Glass. In the two months since, the shares have risen from $3 to $8, a near-triple.
While many doubt the viability of smart devices (glasses, watches, etc), over 100 million smart TVs have already been sold into the marketplace. With momentum building, market researchers expect over 50% of all TV shipments to qualify as Smart TVs before the end of next year.
Major smart phone vendors have a major vested interest in attacking this market. Any device that can run a smart phone operating system (like Android, iOS, BB10, etc) is strategically important, because electronic devices are increasingly connected (to the Internet and each other). Missing a link in the chain could result in a significant loss of market share.
This is why shares of Himax have taken flight. By developing a critical component for smart glasses (the microdisplay), Himax is positioned to profit handsomely as a multitude of vendors race to win market share in that market. But microdisplays are merely additive to HIMX's business. Most of its revenues stem from supplying components to other products in the Internet-connected chain. In other words, HIMX is a broad-based arms merchant in a very big war.
Pixelworks (PXLW) Is Positioned To Benefit
We believe a similar story is brewing for Pixelworks. Just as we discovered that HIMX was powering the display technology for Google, we have now connected dots that suggest PXLW could drive the visual experience for Apple's (AAPL) upcoming iTV (an Internet-based television - widely expected to be AAPL's next major product).
According to PXLW's annual report, the company is a "designer, developer and marketer of video and pixel processing semiconductors and software for high-end digital video". In other words, PXLW provides the technology that enables moving image (video) to appear on virtually any kind of screen/display with the highest level of quality (sharp images with no blurriness, halo effect, etc). It excels at handling this complex task -- the last and arguably most important step in the video display process.
As we researched the emerging Smart TV landscape, here's what we found:
- The worldwide Smart TV market totaled 66 million last year. That number is expected to nearly triple over the next few years to 173 million units. At that point, two-thirds of all TVs shipped will be Smart TVs. Market share has been consolidating around a small number of vendors, with smart phone king Samsung (OTC:SSNLF) leading the way. This fact makes it clearer as to why Apple needs to make a speedy entrance.
- Recent reports have surfaced that connect LG to Apple's efforts to enter the Smart TV market. One analysis did a particularly good job of connecting the dots. The revelations came as no surprise to us. Apple used to rely heavily on Samsung for its iPad displays. However, Samsung has grown to become Apple's greatest threat. In response, Apple has been distancing itself from Samsung by shifting more of its business to LG.
- In October, PXLW publicly disclosed that it had been selected by a "tier-1 Korean TV OEM" for its 4Kx2K (8 megapixel) technology. The interesting thing about this is that there are only two tier-1 TV vendors in Korea - Samsung and LG. Thus, PXLW is either working with Apple's increasingly-close partner (LG) or the world's smart phone king, Samsung. Its investor presentation narrowed it down - LG was listed; Samsung wasn't.
Apple Needs Smart TV Partners
Having never been involved in the TV market, Apple needs experienced partners to help it enter and compete against Asian powerhouses like Samsung, Sony (SNE), LG, etc. The combination of LG and Pixelworks represent a perfect fit to help Apple deliver a world-class visual experience. In addition to its U.S. presence (PXLW's San Jose headquarters is a 15 minute drive from Apple's), PXLW has an extensive array of patents which could give any acquirer a notable advantage in the market. Indeed, the smart phone wars have seen several companies get acquired for their patent portfolios. We believe that the Smart TV wars will be no different.
The Timing Seems Right
Pixelworks could benefit from this space before Himax experiences a bump in its LCOS business. Indeed, Google Glass won't be available until next year. However, several Smart TVs are already available in the market. Thus, Apple is playing catch-up and expected to deliver iTV before year-end. Meanwhile, PXLW has been ramping up its TV efforts and expanding its capabilities to include mid-sized displays, like tablets and phablets (phone/tablet hybrids).
The timing for an investment in PXLW also appears ideal, for several reasons:
- The Smart TV market is crossing the chasm. 27% of all TVs sold are now Smart TVs. Samsung already has a major presence and Apple is set to follow suit. LG and Sony have also established themselves. There's good reason for this. The smart phone war isn't just about phones - it's about any device that a consumer can use to communicate, connect to the Internet, and/or access content.
- Like HIMX, the outlook for PXLW's core business looks to be turning up. The first quarter represented a low-water mark for PXLW, driven by "a severe inventory correction centered predominately in Japan, combined with an IP deal pushing out to Q2". Since then, monetary policy in Japan has kick-started demand for its exports. Meanwhile, PXLW gets paid in U.S. dollars, a major coup under the circumstances. Pixelworks also boasts an IP deal pipeline that has reached record levels. In its earnings release, the company stated that "we expect our robust IP licensing pipeline, strong design win activity, and ramping of new products to contribute to topline growth in the second quarter and for the balance of 2013".
- The TV market has been stagnant since the height of the housing boom, over 5 years ago. In fact, the last time the TV market had a strong catalyst (the move from 480i-based CRT TVs to 1080p flat panels) PXLW nearly doubled in size in just two years. The CRT transition enabled PXLW to nearly double in size from 2002-2004. During that period, the stock rose from a low of $12 to a high of $60.
- Revenues are expected to grow 35% next year, yielding 20-cents per share in earnings. Similar growth in 2015 would yield about 70-cents of EPS, giving it a P/E of 5 based on current levels. The shares are also cheap when compared to its R&D spending. Traditionally, 3x R&D has proven to be a bargain for investors. PXLW's valuation is even below that level. The company has invested over $100 million in R&D over the past 5 years and over $300 million over the past ten.
- The Pixelworks story remains unknown to most investors and Wall Street institutions. Like HIMX, PXLW has non-disclosure agreements that restrict it from telling investors the details of major customer wins and deal sizes. However, its most recent earnings call and investor presentation make it clear that it is working on several big (albeit undisclosed) projects.
- Insiders have been buying. Over the past year, 100% of PXLW's insider transactions have been purchases.
Further catalysts for the stock could come in the days/weeks ahead. COMPUTEX, the largest technology trade show in Asia (and second largest in the world) will take place from June 4 through June 8 in Taipei, Taiwan. On the aforementioned earnings call, PXLW said that key customers and partners will be "demoing our technology for improving the displays of all screens… I think we'll show robust results and demos at Computex".
Immediately following COMPUTEX, the InfoComm Show will kick off in Orlando and run from June 8-14. Then, Wall Street's attention will turn to Apple's Worldwide Developer Conference (WWDC) from June 10-14. There, possible clues could emerge regarding its future direction with iTV and other video-intensive products.
As was the case with HIMX, shares of PXLW should be considered speculative until the proof is in the pudding. The company needs to execute in order to ramp up growth beyond the 20-cents of EPS expected for 2014. That being said, positive evidence is piling up and the risk-to-reward is compelling. Looking at the company's operating model, it generates 50% gross margins and has plenty of capacity to grow with negligible increases in R&D or SG&A. It also has close to $200 million in tax credits, so we calculate that PXLW can drive 50-cents of EPS for every $20 million in incremental revenue.
In the TV market, revenue tends to come in larger increments. Recent market share data showed that Samsung owns about 30% of the TV market, followed by LG's 15% share, Sony's 8%, Panasonic's 7%, and Sharp's 5%. Most 4Kx2K TVs use 1 or 2 video processing chips (for 60Hz or 120Hz, though some models support up to 600Hz). PXLW sells these chips for $12-18 apiece. Thus, with a worldwide market of 66 million units, PXLW's Smart TV opportunity is currently in the range of $800 million and $2.4 billion. By 2016, those numbers will nearly triple to between $2 billion and $6 billion. Running the numbers, landing an exclusive with any one of the top 5 vendors would represent over $100 million in new annual revenue for PXLW, dropping over $2.00 of EPS to the bottom line.
|Pixelworks' 2016 Smart TV Market Opportunity ($M)|
|Revenue @ $12/TV||20.8||103.8||207.6||415.2||2,076.0|
|Revenue @ $18/TV||31.1||155.7||311.4||622.8||3,114.0|
|Revenue @ $36/TV||62.3||311.4||622.8||1245.6||6,228.0|
With more modest near-term expectations, we believe that a progression of annual EPS from 20-cents to 70-cents to $1.20 would justify a stock price of $20 over the next two years. This would be a big win from current levels, but just a modest rebound from PXLW's historical highs. During the 2002-2004 TV upgrade cycle, PXLW topped $50 per share. Its all-time high approached $150. With this level of potential upside juxtaposed against a modest level of risk (due to PXLW's cash, patents, and R&D foundation), we believe investors will be compelled to act as this story comes to light.
Executing against the opportunity will be crucial. Like HIMX, PXLW is a speculative investment that needs to be closely monitored. However, unlike HIMX, PXLW remains undiscovered. Accordingly, we are categorizing Pixelworks as a "Great Find" and believe its shares could be poised to triple.