Sigma Designs to Acquire CopperGate

Sigma Designs (SIGM) recently announced the acquisition of CopperGate for 160 million, to be paid with $92 million in cash plus the issuance of an estimated 4 million shares. Boards of both companies have approved the deal.

As has been happening lately, shares of the acquiring company traded down. Sigma closed Tuesday at 13.46, down about 6% on the day. After reviewing the slides that accompanied the company's conference call, I regard the acquisition as a favorable development, based on a good strategic fit and the ability to fund it without incurring debt.

I wrote SIGM up favorably on Sept. 14 at 15.67, with my case resting on the possibility of renewed growth by expanding its IPTV expertise from telcom into the cable area, together with margin of security due to the excess cash on the balance sheet. A number of commenters questioned the pick, and the discussion got to be about whether management would dissipate the cash trove by high price buybacks or by overpaying for a series of ill-conceived acquisitions. A recent article on Seeking Alpha suggested that SIGM would be a good target for an activist shakedown, adding a special dividend to the mix of possibilities. The acquisition of CopperGate answers these questions.

The Deal – from the press release:

Sigma Designs(R), Inc. (NASDAQ:SIGM) ("Sigma") and CopperGate Communications Ltd. ("CopperGate") today announced that the companies have entered into a definitive agreement for Sigma to acquire CopperGate in a cash and stock transaction with an agreed value of $160 million, net of CopperGate's cash at the closing of the transaction.

The estimated amount of cash to be paid by Sigma on the closing date is approximately $92 million, plus the amount of cash and cash equivalents estimated to be held by CopperGate at the closing, net of CopperGate transaction expenses and debt outstanding at the closing. In addition, Sigma will issue shares of its common stock to CopperGate shareholders estimated at the time of signing to equal approximately 4.0 million shares.

The combination of Sigma and CopperGate is also expected to yield several potential synergies including synergies from leveraging manufacturing know-how and combined wafer sourcing, further SoC integration and combined research and development.

Side by Side – from the presentation slides:

	Sigma Design	CopperGate
	TTM 8/1/09	TTM 6/30/09
Revenue	$197 million	$69 million
Gross Profit	$91 million	$39 million
Gross Margin	46%	56%
Income from Operations	$17 million	$10 million
Income from Operations - Margin	9%	15%
Net Cash	$229 million	$24

Doing the math, the combined entity has $266 million of sales and proforma TTM earnings, which I estimate at.$88 per share. Most of SIGM's excess cash has been spent on the deal, so valuation at this point is very much dependent on estimated future EPS growth. On the topic of synergies, R&D was 23% of SIGM's revenue during its most recent quarter. If Coppergate's expenses were comparable, any overlap of R&D that can be eliminated would result in substantial expense savings. Because R&D is closely related to the sales process and has an 18-month cycle, making changes in an orderly fashion would require about two years to implement. CopperGate is approximately 1/3 the size of Sigma, so the acquisition is large enough to be meaningful without being so big as to pose difficult integration problems.

According to the presentation, worldwide broadband households will have a CAGR of 11% from 2009 to 2013. CAGR for telco IPTV cumulative subscribers will be 36%, for worldwide home networks 15% and for worldwide network enabled video devices 65%. All of these estimates are double-digit, with some more impressive than others.

Assuming SIGM participates, double digit growth is implied.

Valuation - Using the .88 EPS estimate, and applying a P/E of 23 for a double digit growth situation, 20 is reasonable if and when SIGM demonstrates the ability to participate in the industry growth projected in their presentation. As discussed in the original writeup, rapid revenue increase in a fabless operation with high gross margins can generate increased EPS very rapidly, which in turn generates P/E expansion, with gratifying results.

SIGM has traded in a very broad range of price/sales, from .9 to 11.2 over the past 5 years. Ken Fisher did quite a bit of work on P/S for his 1984 book “Super Stocks,” noting at the time that higher price/sales ratios are common in growth stocks with lower market caps. From 2004 to 2008 SIGM traded at a price/sales over 7 at some point during every year. The combined entity will have TTM sales of about 9 per share, multiplying that by a historical midpoint price/sales ratio of 3.5 suggests a price of 31. Again, this depends on the resumption of robust revenue growth.

These recent ratios are consistent with Fisher's advice from the 80's: He suggested buying companies of this type at P/S ratios of less than 1.5, .75 would be better, and selling them somewhere between 3 and 6. At a recent price of 13.05, the proforma combination trades at a P/S of 1.4, falling within Fisher's guidelines, although cheaper would be better.

Noting that this is an acquisition involving companies that have been profitable in the difficult recessionary environment, with no long term debt, downside risk is moderate while the upside potential is large but indefinite.

Any acquisition raises the question of possible overpayment. However, my view is that if the acquiring entity is able to consummate the deal without incurring debt and if the strategic fit is good, then even a generous price will prove to be money well spent. Shareholders who contributed the funds which have been sitting idle on the balance sheet intended that the capital would be deployed in the IPTV/SoC business. After initially buying back some shares, then doing a small but strategically questionable acquisition, management has now put the money to its intended use, a positive development.

Some P/S math: During its fiscal 2008 year, SIGM issued 4.6 million shares at 43 per share, which valued the company at 7X sales. SIGM has used these same funds to acquire CopperGate at 2.3X sales.

PRR – Price to Research Ratio - Fisher had another rule of thumb, applicable to these cases where R&D is a substantial part of the mix. “The Price Research Ratio (PRR) is the market value of the company divided by the corporate research expenses for the last 12 months.” His rules: Do not pay more than a PRR of 15; preferably these types of companies should be bought somewhere between 5 and 10 on this metric.

Sigma's market cap is 349 million, divide by 2008 R&D of 43 million and you get a PRR of 8.1, within the suggested range. Guessing that CopperGate has R&D of 10 to 15 million, that would imply a PRR of 6 to 6.5 for the combined entity, right about where Fisher suggests is the sweet spot.

Short interest – As noted in the previous writeup, this company is heavily shorted. With the number of shares to be issued to pay for the deal an open item, short-sellers might try to force the price down ahead of the closing, thereby forcing the company to further dilute its shareholders. On the other hand, management has enough extra cash to increase shareholder value by buying some shares back if the situation gets out of hand.

Strategy – The October 15 calls I sold over my position will expire worthless. Noting the shares are declining on the acquisition, which I regard as a positive, I have been enlarging my position. I plan to monitor earnings and conference calls, looking for confirmation that Sigma will be able to penetrate the cable market for IPTV and triple play.

Disclosure: Long SIGM

Comments

[Ricard:]

Tom,

Thanks for the update - good on you for writing the calls.

I'd love to look into this in more detail, but something tells me I'll be very involved in ETFC in the foreseeable future. Cheers.

Oct 16 07:46 PM

[Tom Shohfi:]

Nice analysis, Tom. I had also considered writing a commentary piece on the transaction. As SIGM shareholders, we can take solace in the fact that management did not spend $200-$250M for CopperGate. That number had floated around before the deal was announced. SIGM had $192M of cash/equivalents and and short term investments as of Aug 1st (plus another $40M in long term auction rate securities), so there is still a nice a cash stockpile of $100M after the transaction. That's still probably too much working capital, but management may be less likely to do another repurchase after doing so last time at such a high price per share. I for one would like to see them announce a new buyback of around $30M (which is 10% of shares out prior to transaction, 30% of cash and 75% of 3 Year average FCF) to fight some of the short selling that has kept the stock down.

Frankly, I think the synergies are much more top line oriented than with costs. Geography will be one basic challenge to trimming R&D expense. Then there's the differences between the two technologies - they're complementary in use but not so much in development. The deal is structured to retain and provide incentives for CopperGate's existing talent - a plus for the new company but goes contrary to R&D expense reduction. SIGM's management must believe that the deal will offer a more complete IPTV suite that can keep Broadcom from taking a large percentage of market share, particularly with AT&T. Their offerings fit into AT&T's strategy more so than Verizon and its fibre to premises offerings.

I have a detailed model that I'm adjusting to the deal, but here's a back of the envelope calculation that I believe is fairly conservative:

Disc Rate 13.00%
FCF Addition (mm) $22
Pre Transaction Post Transaction
Long Term Yearly FCF $40 $62
FCF Perpetuity $307.69 473.0769231
Net Cash 192 100
Target Market Cap 499.6923077 573.0769231
Shares Out 26.8 30.8
Target Price 18.64523536 18.60639361

Basically, the new company would have to increase FCF by $22M (over 50%) to equal the prior valuation of SIGM. That's an aggressive assumption and a likely contributing factor to the stock's sell off. If the contribution is $15M in long term FCF, which is more realistic in my opinion ($10M in income is already there and it's bound to grow at a double digit rate), the estimate drops from $18.60 to $17.

We'll have to see how quickly they can integrate and provide the combined offering to customers. Broadcom has been looming, but, as many SIGM longs believe, it has already been priced into the equation.

Oct 17 10:47 AM

[pone:]

Except for two exceptional years in 2007 and 2008, SIGM rarely has a return on equity of more than about 8% average, looking back over the last seven years. Is this really the kind of growth against equity that anyone should get excited about?

Oct 17 08:37 PM

[wobatus:]

Hey, they could take on a pile of debt and have a higher ROE. :)


On Oct 17 08:37 PM pone wrote:

> Except for two exceptional years in 2007 and 2008, SIGM rarely has
> a return on equity of more than about 8% average, looking back over
> the last seven years. Is this really the kind of growth against
> equity that anyone should get excited about?

Oct 18 09:59 AM

[Tom Shohfi:]

The drop in ROE has been reflected with a 80% decrease in share price since the 2007 high (with 35% ROE). Furthermore, ROE is distorted because of the cash stockpile - take half the cash out and see what ROE looks like. I can't make the argument that management has made an effective use of that cash - the jury will be out for a while on the latest transaction. I care about cash flow, not ROE. Bank executives are often compensated on ROE... that's enough to demonstrate how misleading the metric is, and that's particularly true for the tech sector.


On Oct 17 08:37 PM pone wrote:

> Except for two exceptional years in 2007 and 2008, SIGM rarely has
> a return on equity of more than about 8% average, looking back over
> the last seven years. Is this really the kind of growth against
> equity that anyone should get excited about?

Oct 18 03:12 PM