Dialog Semi: The Apple Derivative Worth Noticing Ahead of Earnings

| About: Dialog Semiconductor (DLGNF)

Dialog Semiconductor (OTC:DLGNF) is a high growth mixed-signal semiconductor company with strong management and several free options that could be blockbuster sources of additional earnings. Based in Kirchheim, Germany, Dialog trades on the German DAX. With a market cap of $900MM, it is a fairly liquid stock, trading around 300-800K shares/day. However, because of minimal coverage from US brokerages and being on a foreign exchange, most people outside of the tech world and/or hedge funds do not know the name. This may change in the coming 6-8 months as more U.S. investors are becoming aware of the Company's performance.

DLG has grown revenues at a 56% CAGR over the past 2 1/2 years and EPS has grown even faster. However, Dialog trades at only 25x current earnings and ~14x analyst's 2011 forecast. Though near fair value on this year's earnings, Dialog continues to announce customer wins on a frequent basis and has several additional growth platforms (discussed later) for which shares are not given credit. Over the next 12-18 months, growth in the existing business as well as new product developments should provide catalysts for upside performance.
Company Overview
Dialog operates in the niche area of power management (PM) chips and has extensive tier-1 OEM relationships. DLG operates in three business lines: mobile devices, lighting & display and automotive. They have exhibited phenomenal growth over the past several years, driven by top customer wins, improvements in efficiency and a focus shift from lower volume/margin chip solutions to high growth mobile platforms.
The Company has an interesting competitive moat in that it utilizes mixed-signal technology (meaning the chip can run both digital and analog functions), for which there are a very limited number of researchers and engineers; fortunately, Dialog has many of the most talented engineers in the business (example here). This has allowed Dialog to produce chips that have greater functionality and smaller footprints within their respective devices and is why they have become very important to the mobile device space, most notably being featured in the iPhone 3GS, iPhone 4, iPod and iPad. Because their chips work alongside device baseband chips, the Company is agnostic as to whom they partner with and have therefore made relationships with many of the major baseband and mobile device OEM players (Apple (NASDAQ:AAPL), Marvell (NASDAQ:MRVL), NVIDIA (NASDAQ:NVDA), LG (OTC:LGERF), etc.).
Dialog's top 5 customers make up about ~85% of sales. While this level of concentration may seem like a potential risk, Dialog has long relationships with each of its top customers. In the case of Apple, DLG chips have been placed in every new mobile device since the iPhone 3GS. Because Dialog chips provide high levels of functionality, along with space and power savings at a low cost, I believe replacement by any of its top customers is unlikely in the next several years.
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SonyEricsson is the only medium-term potential risk as Dialog provides power management to EMP (Ericsson Mobile Platform) phones. This particular piece of business will remain for 2-3 more years, at which point ST Ericsson (Sony (NYSE:SNE) JV with ST Micro (NYSE:STM)) will likely begin to encroach. In the interim, Dialog will continue to grow business with SonyEricsson via audio only and lower function PM chips.

Apple is Dialog's top customer and one with which it maintains a strong partnership. DLG has been in all of Apple's blockbuster launch mobile products since the iPhone 3GS. The below chart details estimates of Apple's contributions to Dialog revenue for the first half of 2010 as well as estimates on performance for the second half of the year. In the last couple of months, the iPad has been released to great fanfare in several foreign countries, including China, where reception has been very strong. With iPad projections of 25-30MM units next year, I believe my estimate of 10.1MM for 2H10 should be beatable.
For iPod, Apple does not break out the types sold. I've backed into an estimate based on Dialog's first half chip sales to AAPL, iPhones sales numbers and the price of the chips sold during 1H10. Given the rising product mix of the iPod touch as well as Dialog's new appearance in the 6th generation iPod nano (with a similar ~$1.30 chip to the old iPod touch), I have raised estimates on the back half of the year for sales of these chips. Given that the new iPod Touch is functionally similar to the iPhone 4, pricing for iPod chips is elevated in 2H10. Note: below projections are calendar quarters, AAPL fiscal year ends 9/30.
With Apple having just reported another blowout quarter on 10/18, we have a pretty good window into a large portion of Dialog's revenue.
Important to note for the upcoming iPhone 5 (rumored in development) is that because Dialog is agnostic as to the provider of base band chips, it will not matter whether Qualcomm (NASDAQ:QCOM) (rumored to be replacing Infineon (OTCQX:IFNNY)) or Infineon is featured in upcoming versions of the iPhone or other Apple mobile devices. Dialog's power management chip can work with both and is a very cheap (but important) piece of equipment in relation to Apple's total cost of their mobile products.
Free Options
In addition to their primary chip lines, which will continue to produce strong revenue growth, Dialog currently has free options not priced into shares that could be very important to future growth.
Class D Audio Codec - In March, Dialog announced the release of its latest audio chip (class D chip), a stand-alone that can be combined with a PM chip or stand by itself as a speaker driver for audio enabled devices. With a tiny footprint that allows it to be placed near the speaker, the chip will reduce heat buildup and be twice as power efficient as the alternative class AB driver technology. The Company is currently working with several tier 1 partners and will likely begin to deliver the chips to customers in 4Q10. This stand-alone chip should be attractive to OEMs that either don’t want or need a PM chip in their device and will help to diversify Dialog’s revenue sources.
DA6011/Intel (NASDAQ:INTC) partnership - In mid September, Dialog announced a new chip partnership with Intel's newest Atom processor that integrates power management and clock driver functions and was developed in partnership with Intel. The Atom chip primarily runs automotive computers.
PMOLED - DLG is developing a smart power management chip for a technology called PMOLED (passive matrix organic light-emitting diode). PMOLED is designed as a low cost display alternative to high-end AMOLED (active-matrix) screens like those offered on Android smartphones, for example. PMOLED is currently at a disadvantage as it uses significantly more power than its AM counterpart, but has the advantage of being significantly cheaper to produce.
However, Dialog has designed a smart chip that could change the smartphone game and help PMOLED offer competing quality and power usage at a fraction of the cost to manufacturers. This would allow much cheaper devices to offer touchscreens similar to those currently found in expensive smart phones. With lower end phones still dominating the emerging markets, the adoption of PMOLED by tier 1 OEM suppliers could help make smartphones significantly more economical. With a price point of $1.50-2.50/chip, analysts believe PMOLED could be a $100MM revenue opportunity in 2-4 years. Dialog has already formed an early partnership with TDK in Asia and expressed they are working on other tier 1 client partnerships to come later in the year and in 2011.
1) Maxim Integrated Technologies (NASDAQ:MXIM) is a competitor that has developed similar power management technologies, but it has not achieved Dialog's superior level of function integration (display, keyboard backlight, battery power, etc.).
2) Wolfson (OTC:WLFMF) is a UK based company that competes in audio semis specifically, but its quality and clarity is not near Dialog and it has been losing market share to DLG.
3) As mentioned earlier, Sony/STMicro JV has also developed power management technology that will likely take business from Dialog in the next 2-3 years, but Dialog has continued to win other business with Sony in other chips that should continue to grow over the next couple of years.
Over the past 5 years, Dialog’s management team has successfully disposed of or divested several low margin, high R&D products and helped the Company navigate from what was a loss producing business to one concentrated on high growth/demand mobile segments.
Much of this turnaround is due to leadership by Jalal Bagherli, who joined Dialog as CEO in 2006, leading the spinout of loss-generating Dialog Imaging Systems (which took Dialog's former CEO with it). Additionally, he dropped Sharp's LCD driver business which had high R&D costs, yet only produced around 10% gross margin. Finally, he helped change the product design process by subcontracting testing services to Malaysian and Taiwanese partners with oversight by Dialog employees. This squeezed savings and time from the development process. Since these initial steps, Bagherli has continued to focus the business on high growth opportunities in power management, as well as establishing partnerships with Apple and others. Under the leadership of Bagherli and other senior management, Dialog has now reported nine consecutive quarters of profitability and two full year profits after seven years of losses.
1) Customer concentration: approximately 85% of the company’s revenue comes from top five customers (Apple, RIMM/Marvell, Sony, TridonicAtco, Bosch). A loss of any of these could materially affect sales and earnings.
2) Dialog operates in competitive markets in which, while protected by patents and proprietary technology, it is always at risk of losing customers to competitors that have a better product. To this time, Dialog has protected itself with top-tier relationships and technology that offers superior solutions in power management, functionality and audio to its competitors.
3) DLG is marginally exposed to currency risk due to its global operations. This is largely mitigated by the fact that it sells to customers and buys from suppliers in $USD. Only employee pay is in Euros, which it hedges 6 months out typically.
4) Large non-US investor base can tend to react oddly to news, or lack thereof. Anecdotally, during early summer, shares tumbled for seemingly no reason. When I spoke to management, they had received feedback from some of their German institutional holders that they were selling simply because there had not been many recent press releases. A few press releases later in August and September and shares are flying high again.
Second Half 2010 Projections
While I believe that much of 3Q earnings has been priced into shares, if DLG is able to approach my top line projections (which are significantly above street estimates due to strong AAPL results) and keep margins steady, shares still have upside potential. It should be noted that taxes are always an unknown from quarter to quarter because Dialog has ~$37.5MM of off balance sheet net operating losses that can be applied to taxes.
Below, I have projected 3Q and 4Q top customer sales based on conversations with management and analysts about customer concentrations. Due to the success of the iPad and the iPhone 4, AAPL will likely become a larger percentage of total sales; other customers are projected to grow 10-15% based on Dialog's historical revenue growth characteristics:

I have projected what FY10 may look like based on historical margins, assumptions on taxes and utilization of NOLs. Due to a "one time buy" from an automotive customer last quarter, gross margins were higher than expected - I would not assume this for 3Q. Assuming continued strength of AAPL product offerings in 4Q, I think analyst estimates are low and will likely have to be revised upwards after 3Q is announced. This could also provide upside potential to the current share price.
Although 1H tends to be weakest for Dialog, 1H10 provided a strong start compared to years past due to strong sales from Apple and other top customers. The Company is also working successfully to further diversify its customer base and product offerings.
Having successfully navigated through the credit crisis with a large cash balance, no debt and a high growth product portfolio, Dialog should continue to grow at a healthy clip. The numerous free options currently in development and moving towards launch will also have a meaningful impact on Dialog's top line.
While I believe DLG shares are near fair value at these levels, there is certainly room for upside surprise. If the market provides an entry point at a lower price in the near term, I think Dialog's future prospects make the shares a worthwhile purchase.
Disclosure: Author is long DLG