Silicom's Strong Upward Trajectory Should Last Several Years - At Least

Jun.12.11 | About: Silicom Ltd (SILC)

Silicom (NASDAQ:SILC) was founded over 20 years ago when Zohar Zisapel and Avi Eizenman, both working at the Israel Defense Force's Intellegence Department at the time, signed a piece of stationary paper and made it official. Not only did these two gentleman work together, they also both have strong mathematics skills with degrees from The Technion, the MIT equivalent in Israel.

Zohar is a serial Israeli entrepreneur starting dozens of successful technology companies over the last couple of decades, many of which were traded on the Nasdaq and bought by larger US companies over the years. He currently owns over 20% stake in Silicom and is still active on the Board.

Silicom has been traded on the US Nasdaq exchange for nearly a decade. It is a micro cap company with a total market cap of $125 million; $45 million of this is in cash and liquid securities. The company has no debt and has always been managed conservatively. The company's CEO, Shaike Orbach, also a Technion graduate, is an extremely talented steward of the company and has done a remarkable job positioning the company.

Silicom has been profitable from its onset as a tiny company with only one product, and it has morphed into a “Go To” OEM supplier of over 10 different product families of various adaptors and intelligent server products. In 2007, Silicom did a secondary offering to raise cash to help it qualify as a supplier to large Tier 1 technology players. In 2010, the floodgates opened, and Silicom’s strong and deep pipeline started to secure design wins for additional product lines with their existing customers and get planned into the current generation of products from many leading companies. Once designed, the product cycle usually lasts several years or more, and Silicom is poised to retain these customers in further product iterations. Primarily distributing its products in an OEM model, SILC stays well informed of upcoming product roadmaps and has an early glimpse into future products to help ensure its edge.

Silicom has recently begun its ascent on a strong upward trajectory that should last several years at the least and probably far longer, coming off a long base of success. With a well diversified base of about 80 customers, including the world's leaders such as EMC (NYSE:EMC), Dell (NASDAQ:DELL), Riverbed (NASDAQ:RVBD), Cisco (NASDAQ:CSCO), and F5 Networks (NASDAQ:FFIV), SILC has established itself as a key partner. SILC has a very diversified customer and revenue profile for such a small company with no single customer accounting for a significant part of its revenue. In fact, the company has never lost a customer and has earned the trust of today's technology leaders in fields including web infrastructure, data centers, cloud computing, WAN optimization, as well as security vendors and Tier 1 server vendors. To put it simply, Silicom's products make the pipe fatter, faster, more secure, and fail-safe.

Silicom operates out of Spartan industrial park, in the northern suburbs of Tel Aviv, with a no frills, energetic, lean operation. They have a brilliant R&D team and an inspired Test and Assembly staff. One of the key differentiators of Silicom, though, is in the software. Silicom's distinctiveness comes from the hardware being turbocharged by intelligent software, and within that software lays algorithmic magic that makes its products best in class. It also provides for a strong IP moat to keep its competitive position strong.

Silicom successfully combines its connectivity and operating system expertise to yield superior products. This combination of hardware coupled with strong software provides for a gross margin in the 40's % rather than in the 20's of just simple hardware providers. As the product mix moves forward with more intelligent cards, modules, and adaptors the margins should gradually increase to the 45% area in the next few years, with possible upside surprise.

This stew of assets has fueled Silicom's push into more product categories over the last few years. These are now crystallizing with an astounding force. That paired with SILC’s strong business model and disciplined management will likely result in highly levered EPS growth, expected to more than triple over the next few years along with its revenue growth.

A new transformative product for SILC is its innovative patent pending Server to Appliance converter (SETAC). Simply put, SETAC blends the best of Server class reliability and couples it with an Appliance look, feel, flexibility and scalability. This product alone has the potential to earn the company tens of millions of revenues. This is driven by recent design wins. For example, already one of the top 5 Tier 1 server vendors has agreed to sell SETAC through its OEM group. Talks with others are in progress.

Also, recently SILC announced a win with two companies just selling SETAC modules, as these companies designed their hardware platforms to accommodate SETAC modules. These modules are where the IP lies and thus is where the meat is for margins. The later provides a new market angle for the product that has only lately come into focus and is one possible catalyst to incremental margin improvement.

In terms of revenue and earnings, I'll keep away from the deep analytics to focus on being approximately right rather than trying to be precisely wrong, but between 2014 FYE and 2016 FYE, SILC has a very reasonable probability of reaching its stated goal of $100 Million revenue. We saw the company make a similar forecast in the early part of the last decade, and it not only reached its goals, it exceeded them by going from roughly $5 million to over $25 million annual revenues.

SILC’s management is not only highly skilled and disciplined, but has consistently delivered on its promises. Gross margin should reach 45% and operating margin should reach a 25-28% range. Net income will be similar to the operating income because the 14% Israeli tax rate will be mostly offset by interest income, especially if you assume higher interest rates going forward. This would yield roughly $3.50 in diluted EPS and a reasonable expectation for a 25 P/E yields a price target of $87.50.

For reference, in 2007, when SILC had far less going for it than it does in this cycle, it traded at about a 30 P/E. While nothing goes in perfect linearity, SILC should grow revenues by about a 40-50% clip over next few years on its pathway to $100 million revenue.

Let’s talk risk factors. The fact that Silicom is based in Israel is one commonly voiced concern, but SILC has a robust Disaster Recovery Plan (DRP) in place, which has been reviewed and accepted by large Tier 1 and other large and important customers. SILC has the ability to quickly move their operation to US and China locations if necessary. The value of the company lies in its executives, key personnel and IP, and as long as they exist. Even if the headquarter was destroyed during a catastrophic event, the company will survive and prosper. In my view, when looking at Israel’s history of wars, we see them consistently rise again and get things done, no matter what.

Competitive products are always a risk for any company, but Silicom is in the best position it has ever been in since it was founded. In fact, more and more of its customers are adopting SILC's solutions, and the company has more products than ever, even more than it had during the last peak in 2007.

There has been insider selling by Yehuda Zisapel, Zohar's brother, which may be seen to some as a negative sign. However, Yehuda is no longer a board member and has thus decided to disinvest. Zohar is a strong Board member and retains a robust, roughly 20% position in the company. Therefore, I view the selling by Yehuda as benign and not a negative signal.

The most realistic risk factor is a deterioration of the macroeconomic environment which would only slow the trajectory rather than reverse it. The mega trends of broadband infrastructure build out are strong tail winds.

Putting it all together, you have a seasoned, well managed company with innovative products just entering a strong upward trajectory fueled by solid secular drivers. Silicom is still and undiscovered gem given that it has few institutional investors and no analyst coverage. One can reasonably make some broad assumptions incorporating recent design wins coupled with longer term company projections. My opinion of a 3-5 year stock price target would be $87.50 based on the above discussion and using today's share count of 6.9 million shares outstanding.

Disclosure: I am long SILC. I reserve the right to trade in security within the next 72 hours.