Semiconductor producer Cirrus Logic (CRUS) is flush with 'apples' - that is, computer products made by its single most important customer, Apple Computer (GM:APPL). Cirrus supplies the audio chips used in Apple branded mobile devices like the iPhone and iPad. Because sales to Apple represent the majority of Cirrus' revenue, as goes Apple's mobile device sales volume so goes Cirrus' fortunes. For every analyst and media pundit who advances a convincing bull case for Cirrus based on market expansion for smart phones and tablets, there is at least one more who bemoans Cirrus' vulnerability in relying on a single customer.
It seems as though the pessimistic crowd had prevailed in recent months as CRUS had slid from a three-year high of $45.49 at the beginning of 2013 to the present price level near $22.00. Over 10 million shares had been sold short by traders expecting the stock to topple.
Now CRUS trades at a discount to its peers in the semiconductor industry - across several metrics. At the average price multiples of the semiconductor industry, Cirrus Logic would be valued at $30.90 per share. This market approach to valuing Cirrus Logic suggests investors scramble to buy shares and build long positions.
Semiconductor Industry Average
Price to Sales
Price to Cash Flow
Price to Earnings
Price to Book Value
Before taking advantage of the seemingly compelling opportunity, it might be worthwhile to explore whether Cirrus merits the same valuation as its peers. Is Cirrus as profitable or as efficient or as financially secure as its peers?
In the most recently reported twelve months Cirrus drew a gross profit margin of 48.7% off sales. This compares to an average of 47% its semiconductor industry peer group. That is impressive enough, but where Cirrus really stands out is in utilization of assets. Cirrus asset turnover (total sales divided by total assets) was 1.30 times compared to an industry average of 0.70 times. The semiconductor industry is capital intensive, but for the most part, uses equity capital to finance growth. Thus the peer group has a relatively low debt-to-equity ratio of 0.33. Cirrus has no long-term debt.
The foregoing is the conventional approach to determine if market-based valuation multiples can be applied directly to a particular stock - or if these averages need adjustment. Indeed, Cirrus compares so favorably to its peer group that some investors might argue its stock merits HIGHER valuation metrics than the group.
This is where we must rock the 'apple cart' on which Cirrus is riding.
To apply the market valuation method fairly, the analysis must be extended beyond the convention profitability, efficiency and leverage measures to consider the business model and the specter of customer risk that drives the bear case against Cirrus Logic. Are its peers as dependent upon a single end-user as Cirrus has become?
Cirrus Logic disclosed in its last annual report that ten customers accounted for 89% of its sales in fiscal year 2013. That does not seem so bad, except that 82% of its sales by value ended up in Apple products. The next nine customers accounted for a paltry 7% of Cirrus sales. That is some 'customer concentration' and is not equaled by any of the other major semiconductor producers.
Thus a strong case could be made that Cirrus does not deserve to trade on par with its peers at all because of the risk embedded in its portfolio of business. Granted Cirrus operates through a wide mix of distributors, several of which source components on behalf of Apple or its manufacturers. However, if Apple decided to use an alternative audio chipset for its products, those intermediaries would simply march on to the next supplier.
Applying a discount to the peer group average multiples is easier contemplated that done. Is a 10% discount enough to account for the added risk in Cirrus' customer relationships? Would a 30% reduction be too much? The answers are entirely subjective and that never is the basis for a reliable valuation.
Worst Case Scenario
An alternative approach is equally tentative as the forgoing market approach. In the worst case scenario, Cirrus Logic loses its key end-user Apple and nearly all its sales. Although draconian, one alternative in this scenario is to go out of business. Here is where the very pristine condition of the Cirrus Logic balance sheet proves helpful. Book value was $575.4 million at the end of June 2013, and after eliminating intangible assets such as goodwill that has no resale value, we can conclude that in a fire sale Cirrus assets could be put on the block for at least $486.4 million. That is $7.70 per basic share (option holders lose out in a situation like this).
The probability of the present day fire sale is next to zero since it would take Apple some time to change audio chip suppliers. That reality would forestall the worst case scenario two to three years. If we use the consensus estimates of cash flows over the next two years and assume going out of business at the end of the second year, we end up with an intrinsic value of $9.00 per share. (I borrowed the consensus estimate for the five-year annual compound annual growth rate of 19% for the discount rate.)
While this is a bit more realistic in terms of timing, going out of business outright is still not a likely outcome for Cirrus Logic. This scenario assumes there is no value in any of the company's intellectual property and that its other customer relationships would be eliminated along with that of Apple. Neither eventually is likely, underscoring the $9.00 as the absolute rock bottom share price for CRUS.
Now we have one possible fair value and a worst-case value for CRUS. All our efforts to put a fine point on CRUS value may be not much more than busy work judging by recent trading in CRUS. Even if its 'apple cart' is a bit shaky, investors have shown a clear willingness to support Cirrus Logic. Indeed, the stock moved nearly 10% higher in the day this article was being prepared, lengthening an upward trend that began in early June 2013. The dramatic move shifted the upside potential to the fair value from 50% to 40% and the downside risk to the worst case scenario from 50% to 60%. It is fueled largely by 'Apple' mania as investors anticipate a new 'refresh' cycle and large sales volumes if Apple introduces an upgraded iPhone.
That does not mean the smart trader is left out of the Cirrus Logic story. The battle between the bulls and bears have created some volatility in CRUS trading that portends a pull back at some point.
Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.