- Organic revenue has been falling for three quarters now. Total revenue growth was saved by the acquisition of Integrated Memory Logic. EPS was negative again.
- I reiterate my long thesis, but I am lowering my target price to $10, offering a ~8% upside. The downside should be fully protected at 10% below the current price.
- The long thesis has worked well for a year, with EXAR trading in line with the small-cap category which showed weakness. Last month, EXAR started underperforming.
Exar Corporation (NYSE:EXAR) reported disappointing second quarter 2014 results (SEC filing, press release, earnings call, presentation). Non-GAAP revenue was $32.6M, up 17% sequentially from $28.0M in the prior quarter. Including the deferred revenue write-down associated with an acquisition, GAAP revenue was $30.7M. GAAP gross margin was 36% and GAAP loss reached $0.26 per share. The results include the impact of consolidation of Integrated Memory Logic Limited. The company has been focusing on restructuring for the past 24 months and diversification and growth through acquisitions.
However, markets and I have become disappointed with the recent lack of progress as the company now hasn't reported a positive GAAP earnings in three quarters, after a promising streak of several quarters of gains. Organic sales have been falling for three quarters in a row now, with total sales being bumped up only by an acquisition. The turnaround seems to be evaporating and constant acquisitions keep generating one-time costs which are not really one time but return with high frequency to damage the balance sheet and income statement. Future growth is based on great megatrends that promise high growth. However, all high-growth areas attract competitors and EXAR does not have a lasting competitive advantage, nor adequate size yet. 72% of revenues come from Asia, a continent famous for low margins and low costs, For Q3, EXAR expects revenue in the range of $40M to $43M and non-GAAP gross margin between 47% to 50% and a non-GAAP EPS of $0.02 to $0.06.
My thesis based on a turnaround and subsequent growth worked relatively well for a year. EXAR traded in line with other small-cap stocks. But as soon as it became obvious that the revenue fall is not a one-off irregularity but a sustained downtrend, EXAR stock started losing ground and significantly underperformed in the last four weeks as organic sales growth kept falling and EPS turned negative. I reiterate my long thesis based on a premise that EXAR can grow through acquisitions, and perhaps even that the recently acquired Integrated Memory Logic could win back Apple (NASDAQ:AAPL) as its customer. However, my conviction dropped significantly for this stock's long-term prospects as organic sales keep falling and the future growth is too dependent on acquisitions. I am lowering my target price to $10 for the next twelve months. In the long run, I think EXAR will have a hard time to outperform the broad market due to high growth rates already priced in. Of course, if EXAR announces another acquisition - which is very plausible - the stock could get a lift from expected higher sales.
Key lessons taken from the thesis not playing out well
My thesis correctly stated as part of the valuation that the stock has high growth expectations priced in, and an up to 50% downside, and could be trading as low as $6 per share if growth doesn't materialize. Unfortunately, sales growth turned into an outright (organic) decline. Judging my analysis in retrospect, there are several lessons to take from this thesis not working out according to the plan:
1. If high future growth rate is priced in, always have a downside protection (10% to 20% below the purchase price) because when the growth falters, the stock can have a long way to fall.
2. I was probably too optimistic, lured in by the fact that EXAR was one of George Soros' favorite stocks and George Soros is one of my favorite investors. So this investment showed signs of being done with my heart and emotions instead of my brain and rational expectations. George Soros made large gains early into the turnaround, whereas I picked the thesis up in the phase where most quick turnaround benefits have been already priced in and the stock's continued gains depended on the continued growth. I clearly stated this in the thesis, though.
3. A turnaround thesis has inherently higher risk of not working out than a regular growth thesis, as the company attempting a turnaround usually has some troubles in the first place. The turnaround is especially risky if the company has not been able to be consistently profitable in the past, such as was the case with EXAR. For a turnaround thesis, a full downside protection 10% to 20% below the purchase price is a must, unless the stock is extremely undervalued to the tune of trading close to cash value or below tangible book value.
4. Semiconductors are cyclical and volatile, and operate in a very competitive environment. Downside protection should be used.