MagnaChip: Very Attractive Risk-Reward - 58% Upside With Little Downside

Mar.14.14 | About: MagnaChip Semiconductor (MX)

Summary

The extreme market reaction to MagnaChip's short-term revenue shortfall and a non-cash accounting restatement has resulted in the stock pricing in almost all of the risk.

At the current valuation, risk-reward is very attractive, and under most scenarios, including a bad outcome from the internal review, upside is substantial.

Downside is reasonable (18%) and upside is very high (58%+).

Headquartered in South Korea, MagnaChip Semiconductor Corporation (NYSE:MX) is a Korea-based designer and manufacturer of analog and mixed-signal semiconductor products for high-volume consumer applications.

Market Overreaction - Multiple Looks Indicate That Almost All Risks Are Priced In

Valuation is cheap by most metrics:

  • From October 21, 2013 to March 13, 2014, the stock is down 41% compared to comps and the Russell 2000 that are both up 6%.
  • The stock is trading at an estimated P/E ratio of 6.4 (comps at 13x) and estimated EV/EBITDA ratio of 4.3x (comps at 6.8x).
  • The stock is at a 26% discount to the average analyst target and at a 19% discount to the lowest analyst target.

It is important to note that even after the revenue disappointment in October 2013 and the delay in reporting financial statements (announced on January 27, 2014), short sellers have concluded that the stock is not overvalued (short interest is just 0.6% of the float and has steadily declined from the low level it was at prior to the disappointing earnings).

The Company's balance sheet is healthy, with debt maturing in 2021 and net debt just 0.5x EBITDA. Operating margin has been improving with better utilization rates and growing higher margin revenue from the power segment. Free cash flow has averaged a healthy 7.6% of revenue over the last three years.

About The Company (10-K, Company presentation)

MX manufactures all of its products at three fabrication facilities in Korea.

The Company supplies products to the following end-markets: Smartphones, Smart TVs, Notebooks, Automotives, Tablet PCs, Consumer Electronics, Portable media & game consoles and Industrial applications. The Company's clients include global blue-chip companies: Samsung, LG, TCL, Compal, Flextronics, Cirrus Logic, Peregrine and others.

The Company operates in three segments:

  1. Foundry/Semiconductor Manufacturing Services (47% of revenue; low growth)

    Its Foundry customers use it to manufacture a wide range of products, including display drivers, LED drivers, audio encoding and decoding devices, microcontrollers, touchscreen controllers, RF switches, park distance control sensors for automotives, electronic tag memories and power management semiconductors.

  2. Display Solutions (34% of revenue; low growth)

    Its Display Solutions products include source and gate drivers and timing controllers that cover a wide range of flat-panel displays used in LCDs, light-emitting diodes, or LEDs, 3D and OLED televisions and displays, notebooks and mobile communication and entertainment devices.

  3. Power Solutions (19% of revenue; very high growth)

    The Company expanded into the Power Solutions business in late 2007. Products include discrete and integrated circuit solutions for power management in high-volume consumer applications. The solutions enable customers to increase system stability and reduce heat dissipation and energy use, resulting in cost savings for customers and consumers, as well as environmental benefits.

    This business has grown from 7% to 19% of revenue from 2010 to 2013 via global account penetration focused on emerging markets.

Brief history -- In 2004, Hynix Semiconductor spun off two South Korean semiconductor product lines to a group of venture capital firms under the name MagnaChip. Its new owners were unable to turn the struggling Company around, which made its high debt load unsustainable. It unsuccessfully tried to raise money in a 2007 IPO. On June 12, 2009, the Company filed for bankruptcy court protection. On November 9, 2009, MagnaChip's plan of reorganization became effective. In March 2011, the Company completed an initial public offering (IPO) at $14 per share.

Revenue Disappointment, Accounting Restatement and Share Overhang

Three issues (which, we believe, are almost fully priced into the stock)

  1. In October 2013, the Company reported disappointing revenue (past and guidance) primarily due to continued inventory correction by its customers in light of the slowdown in high-end smartphone and tablet demand. While high-end mobile devices are unlikely to resume their prior strong growth, this inventory correction is a short-term issue, since demand stabilization is all that is required for the Company. Further, during the conference call, the Company has said that it has won a number of new contracts which, along with the continued strong growth in its power segment will result in attractive revenue growth in 2014.
  2. On January 27, 2014, the Company announced that it is postponing its fourth-quarter 2013 earnings release to provide additional time for the Company to complete its review of its financial results. Subsequently, on March 11, 2014, MX announced that the Company incorrectly recognized revenue on certain transactions, and as a result, will restate its financial statements.

    Revenue on these transactions was recognized when products were shipped to a distributor, but should have been recognized when the distributor shipped the product to the customer. As a result, revenue on these transactions will be reversed and recognized in the period when the products were shipped by the distributor.

    The Company also stated that it does not anticipate that the restatement will cause any changes to the previously-reported cash and debt balances as of the end of each of the periods being restated. This is critical, since this means that the accounting issue is restricted to the timing of revenue recognition and not the validity of the sales.

    The Company also said that this correction is not expected to impact revenue generated from the Company's non-distributor customers. This is also critical, since the revenue in question is just 15% of total revenues, since only sales through distributors in the power and display segments have been found to have a revenue recognition timing issue.

  3. At the IPO and in subsequent secondary offerings, the Company's largest shareholder, Avenue Capital Management (currently owns 11.7% of the outstanding) has sold shares. Avenue was originally a debtholder during the bankruptcy, and got shares as part of the bankruptcy reorganization. We do not believe that the selling of shares by Avenue is anything more than normal behavior of a private equity fund that has received shares via their debt holding during the bankruptcy process. We also believe that the regular share sales by Avenue post IPO has been an overhang on the stock even prior to the October 2013 revenue disappointment. Now that Avenue owns just 11.7% of the equity, this overhang is likely to be lifted, and that should help improve the valuation of the stock.

Valuation - Upside: $21.86 (+58%); Downside: $11.31 (-18%)

Discounted Cash Flow (DCF)-based valuation: $25.76

  • DCF assumptions; based on Company long-term guidance and KL estimates: 1) 34% gross margins, 2) 15% operating margin, 3) 13x terminal PE, 4) 11% discount rate for 2 years.

    This assumes that the higher-margin power segment continues to grow and the foundry and display segments are flat. The PE ratio is reasonable, both absolutely and relative to comps. A 11% discount rate may be high, but is appropriate for this situation.

Relative valuation based on current numbers: $21.83

  • Based on a 11.1x PE ($24.02) and 5.8x EV/EBITDA ($19.66). These are a 15% discount to comparables due to lower current margins at MX.

Other looks: $18.04

  • $17.36 -- discount to average analyst targets
  • $18.73 - if the stock price had moved in line with comparables since prior to the recent issues

DCF-based downside: $11.31

  • DCF assumptions: 1) Relevant sales are overstated by 25%, 2) margins fall from 13.4% to 10%, 3) stock trades at an 8x PE on revised earnings.

Conclusion

The three issues detailed above are significant, and the internal review is ongoing and may lead to additional issues being identified. However, the extreme reaction by the market has resulted in the stock pricing in almost all of the risk. At the current valuation, risk-reward is very attractive, and under most scenarios, including a bad outcome from the internal review, the upside is substantial. Downside is reasonable (18%) and upside is very high (58%+).

Disclosure: I am long MX. 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.

Additional disclosure: I may change or exit my position without updating this article and without informing the Seeking Alpha community.