Peregrine Semiconductor: Why I'm Buying... Before Someone Else Does

May.19.14 | About: Peregrine Semiconductor (PSMI)


Peregrine's current operating performance remains challenging due to its mobile division.

But it remains uniquely positioned for future growth in SOI-based RF devices.

The HPA division is a hidden gem - potentially worth more than the entire enterprise value (EV) at current prices.

Balance sheet remains strong with net cash of ~$60 mm.

Value of RF technology to the mobile market likely remains significant.

Let's get one thing out of the way first. Peregrine Semiconductor's (NASDAQ:PSMI) most recent quarterly results were not good. Shares have traded higher since then because results were significantly better than expected, but if we're talking in absolutes, the numbers were bad.

Revenue remains at a run-rate that is too low to generate sustainable profitability. Gross profit margins have compressed. The company needed to recognize charges related to restructuring and higher legal fees. Most importantly of all, it burned some cash.

In the short-term, performance should be able to remain stable, if not slightly improve. Management appeared to guide conservatively for the upcoming quarter and results may very well exceed analysts' muted expectations. But in the more intermediate term over the next 2-4 quarters, things may be about to get worse as it faces some clear headwinds.

From its past earnings calls, the company has clearly outlined that it will not be included in Apple's iPhone 6. Mobile represents roughly ~65%Est. of Peregrine's sales and given its estimated dollar-content within models of the iPhone 4 and iPhone 5 generations, Apple (NASDAQ:AAPL) likely represents ~40%E+ of that market vertical. Doing the math, that is equivalent to roughly $10mm-$15mmE of sales on a quarterly run-rate, the majority of which is likely to dry up rather quickly upon launch of the new flagship model. Legal costs are likely to continue at least at this pace through to the end of the year as the company nears its court date to defend its intellectual property (IP) against RF Micro (RFMD); and the business is already pushing up on scale challenges through under-absorption of relatively fixed R&D and SG&A. So not a very rosy picture and precisely the reasons why the company traded down to a lowly enterprise value of only ~$100mmE, prior to its recent pop.

So with all of those challenges still on full display, what is it about the long-term prospects for the business that make me so optimistic about Peregrine's future?

It all comes down to wireless radio transmission.

Wireless Radio Transmission -- What is it and why does it matter?

Indulge me for a moment as I dive deep into the inner workings of radio frequency (RF). It is the backbone of wireless systems, controlling the interaction between devices which are not electronically connected via physical wires.

What does that really mean though? Think back to the most basic high-school physics experiment on circuitry. It involves a battery, a switch, some connected wires and a light-bulb. When the switch clamps down to touch the contact-point and complete the circuit... the light turns on. The uninhibited flow of electrons is established and the power source can now provide energy throughout the closed-loop system.

But think about a similar circuit setup that is able to be controlled outside the loop via a remote control. Or perhaps a handheld device in the living room to dim the lights while never needing to get up from the couch. How is that system working without a wired connection?

In a wireless system the passage of critical information -- whether that information is to turn on/off or send back important missile coordinates or deliver a simple text message from mom -- all of that is referred to as data transmission. And the transmission is accomplished through energy waves.

Since I'm already traveling back in time to high-school physics, I am stopping to consider the electromagnetic spectrum.

Different bands of frequency are chosen to transmit the necessary data of various applications for different reasons. For example in certain health applications, we use x-ray waves to create radiation that allows us to see through the skin and gather data about bones and vital organs. For something like a TV set though, we interact using infra-red waves. This is because we don't want our device to interact with other electronic devices throughout the house that might go haywire, so we need to point infrared at the set-top box in order to change a channel. Similarly we use the wide band of frequency waves known as radio for just about everything else, including our all-important mobile data. Cell service. Text messages. Streaming music. Video chat. Downloads. Radio frequency happens to just be really great at transmitting all this data while still maintaining low output power and high signal integrity. So we choose that.

It is likely that you already know this about the vital role RF plays in our everyday lives though... you just know it under a different name. Nicknames like 2G, GSM, 3G, W-CDMA, Edge, 4G, LTE, WiFi and Bluetooth -- these monikers all refer to specific slices of radio frequency band which make up the standards of RF.

RF Devices

So with it established that wireless systems are critical to our everyday lives and that data transmission of many of the most important wireless networks is backed by RF technology, I'd like to dig even deeper on the component devices that enable RF itself.

Data traverses RF the same way it would any other type of wave. The signal within the desired spectrum frequency must first be detected by the device through an antenna. In layman's terms this would refer to having service on your phone. The incoming or outgoing encoded signal can then be interpreted using the baseband processor, also commonly known as a modem. These are the two general areas that make up a device's RF capability.

For the modem portion, while the word may not be used as often as it was in the days of 56k dial-up on AOL, it is an incredibly modern and critical piece of technology. It is a digital logic chip that is a darling in the eye's of some of the largest semiconductor companies like Intel (NASDAQ:INTC), Qualcomm (NASDAQ:QCOM), Samsung (OTC:SSNLF) and Broadcom (BRCM). And all of these companies are fighting tooth and nail to deliver the latest and greatest baseband chip with improved connective ability.

The antenna is part of an RF front-end (RFFE) module that serves as a catchall for the various small components and devices needed to establish an RF connection. In addition to the antenna, it includes a cluster of switches, filters, power amplifiers, tuners and sensors.

It is the latter of the two where I'd like to focus, the RFFE and its $5bnE annual market.

Not All Components are Created Equal

Each of the individual components of the RFFE have a meaningful influence on the overall signal integrity, download speed and battery life of a wireless device.

So how does this involve Peregrine?

The answer is SOI. And longer term the answer is convergence on monolithic integration.

The explanation involves understanding that most devices aren't just tasked with finding one RF protocol. Rather, devices are sifting through them in order to advantageously select the most efficient standard available. Telecom companies don't yet have all of their customers running on 4G all the time. If you are an AT&T user in the tri-state area for instance, you've seen your cell connection not-so-seamlessly transition between Edge, 3G and LTE. This constant switching and filtering helps to ensure a viable connection, but it is not easily accomplished and may be the reason your best friend's text from a crowded sporting event got delivered, while your own did not.

In order to lock-in on a standard, the RFFE must also take the signal and magnify it using a power amplifier in order to eliminate distortion. As its name implies, a PA requires energy. This is why a phone's battery will drain a lot faster when you are driving in a car or sitting on a train. And the power output for LTE is estimated at 2x that of 3G -- faster download capability coming at the expense of battery life.

Both of these tasks are altogether made harder by the fact that the standards of RF aren't actually standardized at all. They are de-facto standards built upon proprietary protocols. And a quick search through the market will tell you that everyone and their mother owns essential wireless patents. Each frequency band requires its own set of tuners, filters and PAs. The more sets, the more complex switches that are required. And because of the proprietary nature of the market, there are multiple bands across each standard. This band fragmentation only gets worse with 4G/LTE. It is estimated that a phone would need to handle up to 40 different frequency bands in order to fully cover the LTE spectrum.

So with LTE being rolled out rapidly by US operators; and with Europe & China not far behind in deployment, this issue is an absolute nightmare for hardware designers. RFFE components are indeed small, but added up together they are not insignificant, especially when considering that specs on overall form factor and performance including thickness, weight and battery life are dissected by the media. This is why the manufacturability of a "world-phone" is so difficult, despite being massively desired by business consumers. Designers desperately want to be able to devote less space and less power consumption to RF in order to allow more room for processing & graphics and a larger battery. But as we learned from "antenna-gate" a couple of years ago, it is wholly unacceptable to sell a phone that can't connect.

But why male models?

Are you serious? I just told you that a moment ago...

Movie reference aside, I am going to explore exactly what makes Peregrine so special in this balance of equations.

Mobile Devices - The Death of GaAs

Radio frequency devices fall into two categories: electromechanical and solid-state.

This is essentially a traditional analog vs. digital match-up. Roll-down window vs. power windows. Rotary phone vs. push button. Hard-disk drives vs. flash memory. Incandescent bulbs vs. LED. Over time, once the performance of the upstart digital technology has caught up with the incumbent analog technology, then the application will switch over. Digital always wins out in the long run. It creates integer 1s and 0s with no intermediary values. This binary can replicate on/off options, like a switch. It can then be strung together through large-scale integration to form complex logic, memory or other kinds of semiconductor devices.

RF technology switched to solid state in the 1950s with pin diodes. Pin diodes then moved whole-heartedly into gallium-arsenide devices during the 1970s and 80s.

Gallium-arsenide devices are better known as GaAs, a term derived from the concatenation of their elemental symbols. GaAs became the workhorse of RF and experienced a meteoric rise from the build-out of 2G/3G telecom networks and the ramp in global smartphone production.

GaAs is now transitioning to SOI though. Manufacturers of GaAs devices may say otherwise, but it is...

SOI is shorthand for silicon-on-insulator. The technical performance over GaAs has always been there, but now the cost has caught up too. The performance advantage is a reflection on the use of silicon as a wafer substrate, instead of another material like GaAs or gallium-nitride (GaN). Elemental silicon [Si] is a beautiful and abundant semi-metallic element that is able to take advantage of its four free electrons. Electrons form rings around an atom's nucleus, and these rings stabilize in groups of eight. So to become content with itself, silicon really wants to either gain or shed four electrons. This means it is really good at both conducting and resisting current; and it allows precise control over that process in the transistor circuit formation.

This is why silicon is used for nearly all major semiconductor applications, like processor chips or the baseband. And because of the intense usage of silicon, it also creates massive libraries of reuse design engineering. Components need to connect with one another. Devices also need to interact, especially between the baseband and the RFFE. But a device built on silicon, connecting with a device built on GaAs is like a person speaking English to someone that speaks back with a thick Irish brogue accent. It's not that far off, but its also not so understandable to maximize efficiency.

So the desirability to transition RF components to SOI is clear. The performance is better. And it can converge the RFFE and ultimately integrate it with the baseband in monolithic silicon.

Peregrine Specializes in SOI

Peregrine has been delivering that message to the industry for the better part of the past two decades as if it were your crazy uncle at a party.

For the most part, the industry has appeased it. "Damn, Peregrine, you're right. These switches based on SOI do provide improved technical performance... and I'm sure they'll be useful in niche high-end applications. But GaAs is king when it comes to scale and cost advantages. And the idea of monolithic integration is just ludicrous."

Then Steve Jobs said otherwise. At least I like to imagine it was Steve. In any case, someone at Apple made the decision to include Peregrine's SOI switches in the iPhone 4. And the industry immediately took notice. "Damn, Peregrine, you guys were right. SOI could provide technical improvement across a broad range of RF applications. GaAs isn't necessarily king when it comes to scale for switches, but it still dominates the other discrete component markets and your idea of monolithic integration is still crazy."

Then Qualcomm said otherwise. The company introduced the vision for its future platform known as RF360 in 2013. An integrated RFFE based on SOI. And one that also happens to be produced by the world's largest designer of modem chips. The industry likely had the same collective thought. "Damn. How did I not see this coming?" Monolithic integration is the holy grail of RF. Silicon hanging out with silicon, just talking about efficiency.

I only called it a vision for the future, though, because Qualcomm's RF360 product doesn't actually exist yet in full SOI technology. It turns out that the development and fabrication of these devices is not such a simple process.

We already know this though because Peregrine has been the world leader in SOI for decades. Companies partner to work with them because of a multi-year lead in R&D and probably closer to a decade long lead in technical knowledge. That is the carrot. The stick is that the company also owns foundational patents around SOI. And despite its relatively small scale, it isn't afraid to use it to defend its intellectual property. It has a court case set for November against RFMD which could set an interesting precedent, as Peregrine seeks a full injunction.

For every startup claiming in its latest PowerPoint to be developing a disruptive technology, Peregrine actually has one; and it has already proven it on the world's largest scale -- the mobile device market. It has literally shipped over 2bn devices in the form of switches and tuners. And it has been readying an SOI power-amplifier for some time.

Mobile Devices -- Valuing 65% of Revenue

This is the mobile market that makes up 65% of the company's revenue serving the roughly 1 billion smartphones produced annually. But that market is currently enduring some challenges related to volatility of a rapidly changing technology landscape. And at the present moment, it isn't making money in it after losing key sockets with Apple that appeared to be based on non-engineering, top-down decision making -- i.e.: sacrificing performance at the expense of supply chain management.

So how to value this business? Simply the fact that it isn't profitable today should not equate with being of limited value. Explore the list of public companies in the S&P 500 and you'll find plenty with valuations numbered in the billions that are not making a penny of profit... and that fact alone does not necessarily make those companies overvalued. Scalable, disruptive technology does not come cheap. So to measure valuation, qualitatively it is a balance with the technology's future potential. Quantitatively though it is discounted cash flow. Both of which are hard to determine with any degree of accuracy. It is hard to be confident in cash flow projections for a stable industrial company, let alone a technology company that is right on the leverage point of profitability.

And that is where Peregrine's mobile business sits at the moment. Huge upside from its UltraCMOS Global1 platform as a potential game-changer. Small cash burn in the interim. And whether investors are positive/negative on the eventual outcome of this platform, given all of the uncertainty for the future road map, the vision of potential value is indisputable. So it should be similar to a probabilistic outcome, and priced similar to a derivative call option based on the upside. Evaluating it from there we can look at all the operating metrics we want. Peak revenue performance. Trough revenue performance. Peak-to-Trough. Margin profile. R&D costs. Cash burn...

My head is spinning. For right now, I want to simplify it so I am going to do something that might sound silly. Just for the moment, I am going to assign zero value to the entire mobile business. No negative value for an investor focused on the near-term challenges with the business at its current ~$100mmE run-rate of annual revenue. And similarly no upside value for an investor willing to look through the short-term and at the future potential of a leading edge technology platform.

So I'll come back to mobile in a minute, but for right now, merely as a placeholder... let's assume it's worth absolutely nothing.

The Other 35% -- HPA as the Hidden Gem

I'm willing to place zero value on the mobile business because it is important to remember that the applications of wireless control, driven by the technical performance of RF devices are not all about phones. We are forgetting the HPA business, Peregrine's hidden gem.

High-performance analog (HPA) represents the other 35% of Peregrine's sales. The division is a catchall for all of the other niche applications the company's chips go into. The stuff Wall Street doesn't care about. The not-so-important-but-actually-really-important, non-mobile end markets. This covers everything from telecom base stations, satellites and other defense applications, to backhaul radio, network routing equipment, test & measurement instrumentation and home appliances.

And car-key fobs. Yes, the reason the beep-beep feature on a luxury car's key fob can work from a farther distance away than your beat-up Honda's beep-beep is because of RF technical performance. It's also why new cars can start without a key in the ignition.

In aggregate numbers, the HPA division is doing annual sales of ~$50mm and growing. Growth is primarily based on expansion of the existing customer base as well as product launches that help push the technology into new market applications.

Sadly, the focus on this business got off track. My guess is the company became distracted by its private-equity led IPO in 2012; and then even more distracted by the enormous ramp to deliver product to the mobile device industry. But focus on the non-sexy piece of the company appears to be back as it has launched a record number of new products over the past two years. And returning with it, has been the growth.

Also visibility. The HPA division is great business. A Buffett business. Moats on top of moats. Customer wins typically bring with them annuity-like revenue streams that can last multiple decades, allowing the company to harvest long tails of cash flow.

But don't take my word for it, look at valuations of related companies. While there is a limited number of public comps, the ones that do exist trade at massive premiums to the market. Look at companies like Intersil (NASDAQ:ISIL) and M/A-Com (NASDAQ:MTSI). On a pure-play basis though, if we really want to benchmark the HPA division, look at Hittite.

Hittite (NASDAQ:HITT) designs products for niche RF and millimeter-wave applications. (Millimeter is the next spectrum of frequency over, which you'd probably know better as microwave. And in addition to warming your burrito it is great for defense communication.) Hittite specializes in the everything-besides-mobile markets that I mentioned above. It generates gross margins in the 70%E range -- not likely a far cry from the margin profile in Peregrine's HPA division. This margin profile allows it to generate substantial cash conversion on revenue, garnering higher multiples. With an EV of $1.3bnE, it trades at roughly 4.5x revenue and 25x earnings on FY'14 projections.

From a revenue perspective, even with a 10% discount, this would place an implied value of approximately $200mmE on the HPA division as a standalone unit -- 35%E greater than the enterprise value of the entire company based on current trading levels in the $6 range.

But It's All About Scale

Ok, back to mobile. Back to the billion devices produced annually. It is very clearly the most scalable market in the history of the world. If you can win mobile, that equals big dollars.

How can I value that business? The company has products with technical advantages that could perhaps lead for the next decade, or more. Logically it is the company farthest along on the path to integration of the RFFE, and even eventual convergence with the baseband processor. But in the interim, it is losing a few million dollars per quarter.

So analyze the timeline. It is not a traditional DCF formula, but I start with the cash burn for that division from the most recent quarter. Adjust out for the completed restructuring. Maintain the legal fees at the current run-rate as the RFMD case ramps towards a conclusion and offsets the winding down of the ITAR case. Maintain one or two more solid quarters of iPhone 5s/5c contribution. Moderate increase in revenue from Samsung on the new flagship model and from domestic Chinese OEMs that are building in LTE capabilities. Continue to capture growth from HPA, offset by higher investment in Global1. Overall, it paints a picture that is not too bad a situation for the next 3-6 months. I am pegging the burn at another $5mm-$10mm.

H1'15 is a bit more suspect though. Apple revenue will likely fall out as the brunt of missing a product cycle is on full display. This could be partially offset by continued overall growth in LTE and Samsung. Additional upside from the HPA business, likely offset by a final push in R&D for Global1 down home stretch. I could hope for a windfall settlement from the RFMD infringement... but hope is not a safe investment strategy. So I'll assume another $10mm-$15mm cash burn.

Then by H2'15, it expects to reach commercialization of the Global1 platform. It is a game-changer product with tremendous potential; and I remain confident in that outlook based on all of the public commentary from Mobile World Congress. If this turns out to not be the case, then this is where the investment thesis will ultimately break down.

But looking forward there is already so much potential for Global1 in the module channel through its relationship with Murata. There is potential to partner directly with baseband producers like Intel or Broadcom. Or even go directly to an OEM like Apple or Samsung. In an attempt to remain conservative I am assuming another quarter of outflow in Q3'15. By the end of the year though, I expect it to be back to cash flow break-even... on a sustainable basis.

With $60mm of cash and equivalents on its balance sheet and zero debt, it should be able to make it through. There are no ticking convertible time bombs and there is no clear necessity for any equity dilution.

So back to the question of valuation. What is the mobile business worth? It is admittedly still very difficult to determine. Remember though that I'm looking at the other 35% of revenue from the HPA division as arguably being worth more than the entire market value of the company at current prices. So attempting to estimate the Mobile division down to a T doesn't really matter to me so much since the investment thesis can stand on its own without it.

But I'd venture to say that the mobile division is still worth a lot; and the true value may be more easily discovered in understanding what it could potentially be worth to someone else.

A Gentleman Caller

If Tennessee Williams were going to put on his investment banker hat for a minute, there are a number of companies that might find value in this technology.

Apple. With over $100bnE of net cash, there is no clearer example than the big Apple. Putting the Beats hoopla aside, the company's lifeblood has been off small technology acquisitions. Everyone knows about the acquisition of NeXT for $430mm in 1996 that brought Steve Jobs back to the company.

But lesser known is PA Semi. Acquired in 2008 for less than $300mm, it now makes up the backbone of Apple's system-on-chip (SoC) development. Apple makes hardware components. And while not as visually stimulating, the ability to not be reliant on merchant silicon is as big a differentiator for the company as its internal software developments. Competitors cannot license the A7 processor any more than they can touch iOS. Apple computers may still be powered by Intel, but Apple phones are powered by Apple. This shift was powered by PA Semi.

Then there was Anobit. Acquired in 2012 for under $400mm and now the basis for Apple's proprietary flash memory controller. It is not by coincidence that Apple has been able to move its entire line of mobile devices and laptops to solid-state flash memory. The controller is the gatekeeper, necessary to provide efficient access to the blocks of memory; and thereby making the blocks themselves commoditized.

I call it lifeblood because these types of technology acquisitions can extend Apple's lead in mobile devices. A little bit of technology here, a smidgen there and voila! You've bought yourself another generation of smartphone sales and the billions of profit that go with it.

RF performance is part of the next frontier. Otherwise the company will end up beholden to the Qualcomms, Samsungs and Intels of the world for that capability. Apple already maintains an unbelievable level of internal RF engineering talent and despite these engineers continually appearing to spec Peregrine, purchasing managers have won out. I don't need to hope that the ghost of Steve Jobs is still listening to his engineers though, because I have conviction in Tim Cook.

He is an elegant thinker with a clear understanding of the markets Apple is navigating. He is not swayed by the flashing lights of the moment; and there is no application more important to the long-term functionality of a mobile device than data transmission. Text messages. Downloads. Streaming video. Battery life.

There is no technology more integral to the future roadmap of RF than monolithic silicon between the baseband modem and the RFFE. That is the holy grail.

And there is no company farther along in that Arthurian quest than Peregrine.

Samsung. Peregrine would likely make sense to Samsung for all of the same reasons it would to Apple. While Apple is trying to stretch its lead in mobile devices, Samsung is vying to narrow it. But there are two factors that make Samsung a less likely suitor. One is culture. The second is engineering talent within RF. Alternatively though, Samsung unlike Apple is also fighting to remain a leader in LTE modems. And perhaps the vision of direct product integration from a company that makes baseband processors is more strategically apparent than a circumventive inversion of the RF supply chain.

Qualcomm. Announced to the world its RF360 platform in 2013, but since then has had little to show for it. Peregrine is the only clear significant long-term threat with a multi-year lead in development. With net cash of over $15bn and a team of lawyers that could defend its newly found IP against anybody, perhaps it's easier to simply buy them than compete.

Intel. Depending on how you look at it, Intel is either catching up to the lead or out of the race in LTE modem. Assuming Qualcomm does only have a lead in LTE, given the fact it is now also talking about integrating the RFFE for the future, where would that leave the Intel giant? Sure, Peregrine would likely be available as a partner with its technology, but with a few billion dollars of net cash on the balance sheet, perhaps Intel isn't interested in a scenario that still leaves room for the rest of herd.

Broadcom. MediaTek. Nvidia. There are other companies that are vying to be a leader in the market for LTE modems too...

Murata. It may not make modems, but it does make modules. It also makes great filters. And it already has a great relationship with Peregrine. It probably has little interest in ever letting that chain of command become inverted.

RF Micro Devices. It designs RF components that are similar to Peregrines. Unfortunately these devices were perhaps too similar in that it caused Peregrine to sue the company for IP infringement. But with over $150mm net cash, maybe the company would decide it is better served to end the pesky litigation without needing to risk an injunction.

Skyworks Solutions (NASDAQ:SWKS). Avago (NASDAQ:AVGO). Analog Devices (NYSE:ADI). NXP Semiconductors (NASDAQ:NXPI). TriQuint (TQNT). Xilinx (NASDAQ:XLNX). QLogic (NASDAQ:QLGC). Which of these companies are still players for the long term. Which have aspirations to consolidate the future module market vs. those that have already admitted defeat for the commoditized discrete market for mobile devices.

And of course Hittite. It already serves many similar non-mobile markets making RF and microwave devices.

So with Peregrine all but left for dead by its investor base, it is interesting to think about which companies might find its technology significantly more valuable that Wall Street gives credit. Interesting to think about which CEOs in the tech-world really have a grasp on the long-term roadmap and are playing for a sustainable competitive advantage to lead them for the next 5-10 years, rather than the short-term margin game for 10bps in the next quarter.

In either case though, I decided that I'm buying... before someone else does.

Disclosure: I am long PSMI, AAPL. 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: Long PSMI. Long PSMI calls. Long AAPL calls.