In case you haven't heard, the world is becoming increasingly connected. According to a note from Morgan Stanley (MS), by 2016 we'll see 4 billion to 5 billion connected hubs (smartphones or tablets), and by 2020 they'll connect to up to 75 billion objects in the "Internet of Things," or the "Internet of Everything" as Cisco (CSCO) likes to call it. This is the next phase of the information age, and the enabling technology is the radio frequency micro device made by companies such as RF Micro Devices (RFMD). I believe that RFMD's position in an exploding field, combined with its cost cutting initiatives and deep value share price make it a unique opportunity.
The RF device field includes Qualcomm (QCOM) and Broadcom (BRCM), as well as smaller specialty companies such as Skyworks (SWKS), TriQuint (TQNT), and RFMD. At $1.16 billion in revenue RFMD is not one of the larger players, but thanks to the diverse needs of the industry its Cellular Products Group creates 100 new products per year, while its Multi-Market Products Group has a new product every day. These products include power amplifiers, filters, antenna chips and modules, and more, and RFMD ships about a billion of them a year.
The Internet of Things
The bulk of these products go in mobile devices or the base stations they connect to, but also in Wi-Fi hotspots, radar, satellites, wireless utility meter reading, gaming, and much more. Wi-Fi hotspots are undergoing rapid growth, with 5.2 million in 2012, and a predicted 10.5 million in 2018 (not including automobiles.) This will spur further tablet growth as the utility of mobile devices grows. More interestingly, the world is becoming connected in nontraditional ways. Google (GOOG) just paid $3.2 billion for home automation company Nest, maker of a remotely controllable thermostat and a carbon monoxide and smoke detector that alarms you via a mobile app. The Chevy Cruze can be remotely monitored and unlocked by satellite, and most 2014 North American GM (GM) cars will have in-car Wi-Fi, as will Audi and others. Millions of shipping containers are now tracked via satellite. A year ago, my city retrofitted every house with wireless water meter reading as a cost saving measure. These are just a few of the countless ways in which our world is becoming connected.
Evolving Cellular Technology
As cellular technology evolves, so too does the complexity and dollar content of RF devices in smartphones. A 2G phone has around $2 - $3 of RF content, while a 4G phone has up to $10 - $12 of content. New technologies such as envelope tracking provide appealing benefits that will spur upgrades, such as up to 25% less power usage. The new envelope tracking devices carry a 15% - 20% price premium. Over the next few years carrier aggregation is expected to become increasingly common, which will allow higher data speeds and more efficient use of costly spectrum, and further multiply RF dollar content per mobile device.
RFMD has two customers that contribute more than 10% of revenue, Samsung (OTC:SSNLF) and Apple (AAPL). Apple has doled out the RF content in a pretty even-handed fashion to keep a number of suppliers in the field healthy. Samsung relies rather heavily on RFMD and has given them a large share of the content in the flagship Galaxy S4. More importantly, RFMD will be making even more revenue from the upcoming Samsung Galaxy S5.
At the beginning of the fiscal year RFMD CFO Dean Priddy began a crusade to raise gross margins. The company identified 80 cost cutting initiatives, and committed to 300 to 400 basis points of margin improvement by the end of the fiscal year, with the goal of 40% GM sometime in 2014. They delivered 180 basis points last quarter, and expect another 120 bps improvement in the quarter that concluded in December. They expect to be able to deliver another 100 bps improvement in March, and another 50 bps per quarter until they reach 40%. A few of the major initiatives responsible include closure of a UK fab, a move to ultra low cost CMOS power amplifiers for emerging markets, and the installation of more assembly capacity in their Beijing facility. They've managed to reduce the cost of their gallium arsenide wafers from an already low level by 20% - 25%. They're now working on replacing gold in the wafers, and will have completely replaced the gold in the backside metallization within a few months, and will work on the frontside metallization next. RFMD is also working on cheaper sourcing of silicon wafers, as well as capacitors and inductors. These initiatives have lead to RFMD having the lowest production cost for many products.
On January 10th, BlackRock disclosed a 10.2% stake in the company, a significant vote of confidence.
RFMD repurchased 2.4 million shares last quarter at an average price of $5.03. $138.1 million remains in the share repurchase program representing 10.6% of the market capitalization of the company at the current price of $4.62.
As of December 31st, 2013, 17.56 million shares were short, giving a rather high short ratio of 4.50. On any good news, the stock could move significantly.
RFMD is very attractively valued by any metric. For instance, Price / Sales vs. competitors:
- RFMD: 1.14
- TQNT: 1.66
- BRCM: 2.06
- SWKS: 3.17
- QCOM: 5.15
The consensus estimate for RFMD's next 4 reported quarters is $.51, which I believe to be a bit low due to margin expansion and revenue growth (last quarter was the highest quarter ever.) That gives a forward PE of 9.06. I think a realistic forward PE is closer to 7.
Free cash flow is also pretty attractive. Here's a great quote from CFO Dean Priddy:
"And one other bullet that is actually not on the slide that I want to address is I think this is going to be a breakout quarter for free cash flow for RFMD. So look for a significant step-function in our free cash flow. I would expect something greater than $20 million, or probably greater than $25 million for the quarter and I think that's just a starting point for what the company is capable of generating."
RFMD reports earnings after hours on Tuesday, January 28th. My outlook is neutral for the quarter, but here are a couple of interesting data points. Samsung shipped only 9 million units of the Galaxy S4, vs. 13 million expected. Apple started selling iPhones to China Mobile on January 17th, and Foxconn (OTC:FXCOF) reportedly boosted production of the iPhone 5s by 75% in October, while decreasing production of the iPhone 5c by 35%.
The upcoming quarter is often seasonally weaker by 10% - 15%, but may buck the trend depending on the timing of product introductions such as the Samsung Galaxy S5 which should be released in the early or mid-spring.
For the long term, I am very bullish. I expect an increasing number of devices with RF content combined with an increasing dollar content per device. Couple that with decreasing costs, and both profits and free cash flow should be impressive. I expect to see a price in excess of $7 within a year which would give it a PE under 12 and P/S that would still be the lowest among its competitors.