Sigma Designs (SIGM) closed Friday at $15.67, with a TTM P/E of $23.2 and a P/B of $1.32. It is well above its 52 week low of $6.93, dating back to late last year. This chipmaker has further upside potential, with the possibility of dramatic improvements, dependent on the successful development and marketing of its products into the cable industry. I picked up the idea from a screen by Marc Gerstein here on Seeking Alpha. The basic attraction is the combination of excess cash with a real business in a tech stock.
Overview – the company describes itself as follows:
We are a leading fabless provider of highly integrated system-on-chip, or SoC, solutions that are used to deliver multimedia entertainment throughout the home. We currently offer four distinct technologies that we market as separate product lines: media processors, VXP video image processing, Ultra-wideband devices and Z-Wave devices. Each of these technologies also contributes to our fully integrated SoC offerings.
We believe we are the leading provider of digital media processor SoCs for set-top boxes in the IPTV market in terms of units shipped. For set-top boxes in the IPTV market, we believe we are currently the only provider qualified to ship digital media processor SoCs based on the Microsoft (MSFT) IPTV platform. Our SoC solutions are used by leading IPTV set-top box providers, such as Cisco Systems (CSCO)/Scientific Atlanta (SFA), Motorola (MOT), Netgem and UTStarcom (UTSI).
IPTV set-top boxes incorporating our SoC solutions are deployed by telecommunications carriers globally including carriers in Asia, Europe and North America such as AT&T (T), British Telecom, Deutsche Telekom (DT) and Freebox. We work closely with these carriers and set-top box providers as well as with systems software providers, such as Microsoft, to design solutions that address the carriers' specific requirements regarding features and performance. Our media processor products are also used by consumer electronics providers, such as D-Link, Linksys, Netgear, Panasonic (PC), Pioneer (PNCOF.PK), Sharp (SHCAY.PK) and Sony (SNE), in applications such as Blu-ray DVD players, digital media adaptors (DMAs), HDTVs and other connected media player devices. Our VXP products are one of the leading solutions for studio-quality video image processing and are used by leading industry participants such as Polycom, Sony and Panasonic. Our UWB and Z-Wave devices target our connected home technologies market. We expect to commence shipping a limited quantity of UWB devices in the second half of our fiscal 2010.
I see a fabless chip company, a former high flyer, that is now in a low growth mode. Most of their revenue is derived from IPTV (Internet Protocol TV), used by Telcos to provide digital video to the home. There is room to debate the future growth potential of this market. Revenues for the 3rd and 4th quarters of fiscal 2009 (1/31/09) were off a staggering 30% and 40% respectively. Nevertheless, the company earned a profit during those quarters. The 1st and 2nd quarters of 2010 have shown a rebound, but not to prior levels. On the plus side, efforts to develop a presence in IPTV for cable may result in the robust resumption of revenue growth.
R&D – the company incurs heavy R&D expense, primarily directed at design in: that is, engineers engage the customers during the product development process to get Sigma's products incorporated into the design. This can be a time consuming and uncertain process. Where this situation prevails, R&D expense is sometimes a tell for future revenues – with a sales cycle of 18 months or longer the expenses are incurred before the resulting orders and revenue are booked.
R&D has been increasing both in absolute numbers and as a percentage of revenues:
6 months ending
R&D expense$ (millions)
% of revenue
This is a sign of strength. SIGM has the resources to increase the R&D efforts necessary to win future orders, while still making a profit on reduced revenues. R&D built substantial value in the past: it may do so in the future. This may be a situation to take the entrepreneurial interpretation, think of the R&D as an investment.
IPTV for Cable – while IPTV for telcos should not be expected to produce the kind of rapid growth the company experienced in 2007 and 2008, the technology has not yet been adopted by the cable industry. If SIGM is able to leverage their expertise into this adjacent and undeveloped market, there is a possibility of renewed rapid growth, similar to what propelled the shares into the 70's a few years back.
This came up for discussion during the last conference call.
Turning to the cable segment, certain providers are in the process of planning a careful transition to IPTV technology for future video delivery; a transition that requires new areas of expertise. To take advantage of this, Sigma is offering its vast depth of IPTV expertise and technology leadership to the cable industry to help drive the adoption of 3.0 to two-way and delivering the first generation of hybrid IPTV cable Set-Top boxes.
This transitional opportunity represents a market potential much larger than the current Telco based IPTV deployments. To address this market, we're investing heavily into cable gateway platforms, thin clients and associated software to provide a complete solution to drive this transition. Each quarter we are increasing the number of cable companies that we are engaging with for continued evaluation and potential deployment.
It's a competitive world and this opportunity is by no means a slam dunk.
Fabless operation – SIGM subs out the manufacturing of its chips. The advantage of this is that there are no expenses for maintaining factory operations during times when business may be slow. It also allows production to be ramped up quickly. In my experience, an operation of this type can rapidly increase revenues with strong margins. With both revenues and margins increasing, EPS and multiples increase and share price appreciation can be rapid.
The implication is that if SIGM is able to develop a market for IPTV in the cable industry it will be able to ramp up production quickly, with dramatic effects.
Valuation – SIGM has cash and equivalents substantially in excess of what is required to operate the business in an orderly manner. To quantify, I compare current assets to current liabilities – $249 million to $19.7 million. Using a three to one current ratio to define cash needs, I see $190 million of excess current assets. Cash and marketable securities is $229 million, so the excess assets consist of cash and marketable securities, $7.11 per share. Some of the money is frozen in ARS (auction rate securities) where the auctions failed. The company does not expect to realize losses. Otherwise, I would have evaluated excess cash using a two to one current ratio.
A P/E of 12 (slow/no growth) applied to projected recovery EPS of $0.93 works out to $11.20, add $7.11 of excess cash and a conservative valuation is $18 per share.
The upside beyond that is very indistinct. However, if the IPTV for cable comes in, revenue could double. Working with historical P/S ratios, a midpoint share price would be 57 under those conditions. The shares have traded as high as 73 in the past. The risk reward here is attractive: there is margin of security from tangible book value, backed by cash, with substantial if indistinct upside potential.
Short interest – a curious reservation here is the huge short interest, 36.07%. Shlomi Cohen has written a recent article on the subject. I am mystified. The company has a real business and excess cash, makes money under adverse conditions, and has been trading under what I consider a conservative valuation. My experience in the past with heavily shorted shares has been mixed: Some serious losers, but a few that made large and rapid upward moves.
Buybacks and capital deployment – During their fiscal 2009 (ending 1/31/09) SIGM bought back 4.2 million shares at a cost of $85.9 million, or an average cost of $20.45 per share, well above where they have traded this year. Matthew Rafat attended the most recent shareholder meeting and shared his notes. During the meeting the CFO, Thomas Gay, expressed regret at the buyback plan, a rare instance of a frank admission by any company's management of the potential waste of high priced buybacks. On the plus side, the buybacks were not done with borrowed money.
A recent small acquistion, Zensys, completed in December 2008, seems like a better use of capital resources. R&D, at 23% of revenue, demonstrates management's commitment to enhance shareholder value by developing new business opportunities, rather than financial engineering.
Strategy and tactics – Patient accumulation may be in order here. From the last conference call we know that the coming quarter will not be impressive and that progress on the cable IPTV front is still slow and may not show visible results until next year. Further, the large short interest may manifest in more short-selling at unpredictable intervals.
Monitoring conference calls and press releases for progress on the cable front, and keeping an eye on share prices, it may be possible to build a good size low cost position while achieving increasing clarity on future prospects.
I took up a starter position back in March, picking up shares at prices in the $11 area and later selling Oct09 $15 calls over them. My shares may be called away from me next month. In the meantime, I plan to bring my position up to 40% of my max this week, and after that I will add the rest of the exposure in smaller increments depending on my impressions of the earnings and conference calls.
Disclosure – Net long SIGM as described in the article.