Wedbush Morgan analyst Craig Berger recently sent a note to clients on International Rectifier's (IRF) last quarter. Wedbush maintained its HOLD rating for shares of IRF, who design, develop, and manufacture power discrete devices and analog and digital integrated circuits for the computing, communications, industrial, aerospace, and consumer markets. Excerpts follow:
• Checks suggest IR’s commodity chip supply remains very tight in the distribution channel, with recent double-digit price increases on FETs and leadtimes lengthening to 20-26 weeks on some parts. Recent double-digit price increases and lengthening commodity lead-times (20-26 weeks on some parts) do reflect strong demand from ramping gaming consoles and new Intel server platforms.
• IR’s supply tightness reflects robust demand from ramping gaming console and Intel server platforms, but also reflects less than stellar planning or execution in ramping its new fabrication facility. IR’s supply tightness is a direct result of several factors including 1) strong demand from ramping gaming console and Intel server platforms, and 2) less than stellar planning or execution in ramping its new fabrication facility.
• While IR’s recent gross margin performance has been disappointing, we wonder how much of the June ’06 bad news was driven by product cost spending versus non-recurring other cost of sales associated with ramping the fab. IR’s gross margin performance has been disappointing for several quarters. Nevertheless, we wonder how much of the gross margin bad news was driven by fab expenses that should ramp down over the next quarter or so, like fab-line start-up charges or underutilization charges for its new Wales facility, versus how much spending is recurring COS.
• While we respect International Rectifier’s server and gaming console design wins, we remain at a HOLD given: 1) the firm is not making sufficient progress towards its 50% gross margin target, 2) IR seems to have made material margin concessions on its new gaming and server platform wins, 3) the firm is ramping up its OpEx spending significantly, and 4) the stock’s valuation multiples are not compelling relative to peers or its growth rate. While some momentum players are likely interested in its ramping PlayStation3, Xbox360 and server businesses, we still are not seeing the firm grow its gross or operating margins as previously expected, making us wonder if the firm’s 50% gross margin target is realistically achievable before royalty income ceases in early 2008.
• No change to calendar 2006 EPS estimate of $1.90, calendar 2007 EPS estimate of $2.15, and maintaining price target of $40 and HOLD rating. Our price target is based on a 20x multiple of c’2007 EPS on the core product business, plus the present value of royalties expiring at the end of 2007.
• Risks to attainment of our share price target include: Greater than expected chip pricing pressure, weaker than expected seasonal demand in 2H’06, less than expected inventory reductions in the distributor channel, greater than expected internal inventory builds, and weaker than expected gross margins.
• Consensus revenue estimates seem modest relative to historical seasonality, a positive: Consensus revenue growth expectations are fairly modest given the firm’s historical seasonality, and given its ramping gaming console designs, possibly setting up IR to beat expectations in the future.
• Valuation multiple sensitivity shows that IR could command a $50 stock price again if EPS estimates are too low; otherwise the stock is likely range bound near-term: We ran a scenario in which we increased revenues by four points versus our model and increased gross margin percentage by one-point versus our model, which drove about $0.50 of annual EPS upside for c’2007. Applying a 22x forward multiple to this new, higher EPS forecast would justify a $50 target price for IRF.
• IR’s Key MOSFET Patents Expire in 2008, a $0.40 Negative Annual Impact: These patents generate royalty and licensing revenues for IR of roughly $40 million per year, and represent a $0.40 negative annual EPS impact when royalties fully cease.
• June Earnings Analysis — Positives: 1) June revenues of +9% beat prior guidance of +5-8%. 2) September revenue guidance of +5-7% QoQ is ahead of consensus revenues. 3) Backlog grew +12% QoQ, and bookings grew +27% QoQ with ramping console and server platforms.
4) Distribution weeks of inventory fell slightly to around 12 weeks on hand. Negatives: 1) Gross margins are not expanding despite big revenue growth in June and expected in September. 2) OpEx guided to grow +5% QoQ, almost as much as revenue growth guidance. 3) Management again delayed its non-focus divestiture, not meeting its previous divestiture timing goals.
• In Summary: While we respect International Rectifier’s server and gaming console design wins, we remain at a HOLD on the stock given: 1) The firm is not making sufficient progress towards its 50% gross margin target. 2) IR seems to have made material margin concessions on its new gaming and server platform wins. 3) The firm is ramping up its OpEx spending significantly. 4) The stock’s valuation multiples are not compelling relative to peers or its own growth rate. Our $40 price target is based on a 20x multiple of c’2007 EPS on the core product business, plus the present value of royalties expiring at the end of 2007 (adjusted for interest income of $0.07 and net cash per share of $6.50). Historically International Rectifier has traded within a range of 13x to 31x its forward 12-month EPS estimates, with a median forward multiple of 19x. Our $40 price target is also based on a 2.2x enterprise-value-to-sales multiple (2006).
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