Silicom Limited (SILC) engages in the design, manufacture, marketing, and support of connectivity solutions for a range of servers and server based systems. The firm has several growth engines including Information Technology's return to growth, the march to 10GB per second technology, a large and growing base of OEM customers includes most of the market-leading players, staged launch of new products, and a strong OEM business model which limits operating expenses. SETAC, the firm's newly patented Server to Appliance Converter, which combines the best of standard servers with hardware appliances, will propel the firm to push its revenues to the $100 million level and beyond in the near term.
I outlined my investment thesis in my last article here.
I expected $50 per share after the last quarter, and after the quarter four results came far ahead of my adjusted estimates, the stock soared to $60.00. Here is an update and a fresh look at the valuation.
Another Record Quarter/Year
On January 23, 2014, Silicom reported financial results for its fourth quarter and full year, ended December 31, 2013.
The company ended the year with concrete numbers, continuing its momentum of 50 percent quarter over quarter growth, which resulted in record revenue, operating and net income, and record-highs in operating and net margins. Even more impressive is the fact that this phenomenal growth is on the heels of three previous record years with a compound average growth rate of 33 percent. Here are the highlights.
Despite the very strong growth and balance sheet characteristics, the firm is not without risk. The firm is headquartered in Israel, and despite the fact that it has operations in all major parts of the world, some degree of political risk does exist. Also the very nature of the business is the firm must continually find new products and get "buy in" from its customers. This is mitigated by the firm's design win business model where Silicom will work with the customer for a long period of time before the product is designed and sold. Finally the size of the firm is important to consider. The Networking & Communication Devices industry ranges from $1 million in market capitalization to $130 billion. Silicom is on the lower end of the spectrum at $435 million. Many of the larger firms have great financial flexibility, and acquisitions in the space could hurt results. The firm has approximately 7 million shares outstanding and the float is 5 million shares.
I feel Silicom should be valued by its cash plus business operations. With cash and liquid assets of $7.74 per share, plus the company's business operations' value based on 21.8x our 2014 EPS estimate, this gives us a $70.00 company value. According to Zacks.com the average P/E in the peer group is 21.6x. Certainly the stock should trade at a premium given the growth and balance sheet position.
Looking at it another way, I see the SETAC and NICS technology driving the company's growth over the next several years. The discounted free cash flow to the firm model accounts for two periods of growth - one in which the firm outgrows the industry, and another in which the company's products mature and their growth looks more like the economy. We assume the top-line grows at 15.0% for ten years and then levels off at 5% per year. This may actually prove conservative as revenues have grown much faster than that over the past 10 years. I was also conservative when projecting future discount rates, net income margin, and tax rates.
1. The company is expected to grow at a higher growth rate in the first period.
2. The growth rate will drop at the end of the first period to the stable growth rate.
Rationale for using the Model
As new products are introduced to new customers, we expect the company to grow at a higher overall rate than the industry. As these products mature and the company faces more competition, we expect the growth rate to level off.
Weakness of the Model
As you add more layers to the model, it is more sensitive to the assumptions you make. The growth may look more "lumpy" than we have in the model.
I used the following inputs:
1. A 10-year period with a growth rate of 15.0% (average forecast) and a discount rate of 11.70%.
2. A continuing period assumed to go on forever, with earnings growing at 4% and a discount rate of 10.21%.
With these inputs we arrive at a target price of $80.00.
We average the two models to get to a target price of $75.00