Rebutting The Bear Case On Pixelworks

| About: Pixelworks, Inc. (PXLW)

(Editors' Note: This article covers a micro-cap stock. Please be aware of the risks associated with these stocks.)

In June, I released a SeekingAlpha article entitled Shares Of Pixelworks Could Be Poised To Triple. In it, I outlined the Pixelworks' (NASDAQ:PXLW) enviable prospects for growth in the emerging Internet TV market. On August 6, the company took the first step toward validating my thesis by reporting Q2 results, which included an exceptional outlook for Q3.

The shares leapt 40% on the news. However, on August 15, the company announced the public offering of common stock. This prompted the publication of a scathing article, condemning the move, along with the company's prospects.

This is not an uncommon occurrence for my picks. In fact, this spring I defended Himax (NASDAQ:HIMX) against a similarly short-sighted attack. Soon thereafter, my analysis was proven correct, resulting in public recognition and 150%+ returns for SeekingAlpha readers who heeded my analysis.

In this article, I will explain why the negative thesis on Pixelworks is misguided. I will also provide further insight into my original assertion that shares of PXLW may be poised to triple.

1) For starters, the author states his belief that PXLW should be valued at $2.60-3.20. Yet, institutional investors (a.k.a. smart money) just paid $3.50 per share for nearly 3 million shares of PXLW stock. Based on my research, the deal was only offered to a limited number of investors. Despite this, the offering was still quickly oversubscribed.

In other words, the demand for PXLW's shares outstripped the amount of shares the company was willing to sell. For proof of this, look for Roth Capital to exercise its overallotment allowance (to fulfill a portion of the excess demand for shares).

This evidence explains why the stock started moving up shortly after the deal was announced (not down toward the offering price). In fact, I know of at least one institution that was buying PXLW after the offering was announced because it couldn't obtain shares in the offering.

Sounds a bit like a hot IPO, no?

Of course, PXLW is not a hot IPO, but the demand for its shares is an important consideration that the author clearly neglected.

2) The author also discussed year over year growth being down, but failed to mention the fact that Pixelworks has just started rebounding from a revenue trough in Q2. Instead of discussing the past growth rate, he should have looked at the change in PXLW's growth rate, which is now moving back in the right direction (see chart below).

An acceleration in growth tends to increase a stock's value, not decrease it. To exemplify this, if someone had similarly condemned Apple in the 2003/2004 time frame, they would have been missing the fact that the iPod was about to have a profound impact on the company's future growth rate (and its stock). Indeed, a stock is valued based on the perception of its future cash flows.

Pixelworks Revenue Growth


Y/Y Growth















2014 est


* Based on midpoint of guidance

** Based on Street estimate

Which leads me to my next point …

3) The author states that PXLW's positive guidance is "likely due to a one-time bump thanks to a licensing deal that was pulled into the coming quarter" and that he "would expect that unless licensing momentum can be sustained (which is unlikely given how niche the firm's technology is and how long it took to find this single licensee), the company's gross margins will essentially see a spike in Q3 before coming back down to the low 50% range."

This statement causes me to question whether the author was on the last couple of PXLW conference calls (or at least spoke with management prior to writing / releasing his report). If he had, management would have surely repeated what CEO Walicek said on the Q1 call:

"We exited the quarter with the most robust licensing pipeline that we have seen to date for Pixelworks' technology, which now validates the growing importance of our portfolio, advanced video display processing techniques."

Walicek also reiterated that his licensing pipeline is robust on the Q2 call.

As I stated in my original analysis, tertiary vendors are looking to cut costs while remaining competitive at higher resolutions. This would explain why PXLW's licensing pipeline is "robust". By outsourcing their image processing to PXLW (which spends over $20 million per year on R&D), these TV manufacturers can cut millions of dollars out of their operating budgets.

In other words, PXLW's recent licensing deal is more likely to be the first of several.

4) When discussing PXLW's co-development project, the author describes it as a "blue-skies" opportunity before stating "I don't buy this for a second" without qualifying why. Based on discussions I've had with the company, I can confirm that the opportunity is not considered to be "blue-skies" by Pixelworks management. In fact, the opportunity is limited to a single (albeit very large) customer who is looking to replace its in-house technology with PXLW's expertise.

In other words, PXLW never claimed that this deal was going to open the gates of heaven. However, the company has stated (repeatedly, during the conference calls I reference above) that the deal should result in significant market share gains next year, helping to drive revenue growth. This growth driver will be enhanced by a new television upgrade cycle to UltraHD.

Consequently, you haven't seen an UltraHD set yet, I invite you to visit your local store and check it out. Then you can decide for yourself whether this is the future of TV. I believe it is.

5) Finally, the author says that the timing of PXLW's share offering was "deliberate", with a clearly negative connotation. However, he failed to recognize that none of the existing shareholder or insiders sold a share as part of the offering. In fact, PXLW insiders haven't reported a single sale to the SEC since 2006.

Further, in the offering prospectus, management stated that one of PXLW's largest shareholders was actually restricted from purchasing additional shares. I believe that shareholder was Becker Drapkin, a large activist shareholder, whose partner sits on PXLW's board.

So, instead of doubting the company's timing, investors should be asking themselves -- why would PXLW's executive management team and its largest shareholder / board member allow their personal shares of PXLW to be diluted with this offering?

6) The author does make some good points in his article. For one, it's true that management has been overly aggressive in its guidance. However, this is part of the reason why the stock has been knocked down. Stocks with a history of over-aggressive guidance do not get rewarded with excessive valuations -- quite the contrary. Personally, I would like to see the company become more conservative in its guidance-setting to unlock some "consistency-value" for shareholders.

7) It is also true that if Ultra resolutions fail to take off, it will be difficult for PXLW to take flight. However, newer resolutions have always been adopted in the TV industry. More importantly, the last major TV replacement cycle passed its peak in 2007. Meanwhile, the life expectancy of an LCD/LED TV is between 4 to 10 years.

In other words, the last wave of TVs is starting to outlive their usefulness. Thus, a new replacement cycle is beginning to ramp. This trend should accelerate for the next three to four years. The last time this happened, PXLW nearly doubled its revenues and its stock rose 5x from a low of $12 to a high of $60. A similar move would drive shares of PXLW to $10.55, a near triple from current levels.

I will personally be contributing to this trend. My last television was purchased in 2004. The picture has faded, so I plan to purchase one or two new ones before year-end.


All of this culminates in my final point -- PXLW is one of the few remaining pure plays in the image processing space. Most of its competitors have gone out of business or fallen behind the technology curve.

The recent dry spell has impacted the financial performance of all vendors, including PXLW. However, the world appears primed for an upgrade / replacement cycle and PXLW is one of the few independent vendors left who can serve the manufacturer's needs for UltraHD technology. Historically, when a dynamic like this unfolds, the result is positive for the last man standing, not negative.

Despite this, shares of PXLW are trading at less than 4x R&D, a level at which most technology vendors have subsequently experienced share gains, acquisition, or both. Accordingly, I invite investors to review all of extensive research I have done on this company.

Indeed, I continue to believe that shares of Pixelworks could be poised to triple.

Disclosure: I am long PXLW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.