Silicom: Multi-Year Growth Cycle Retains Traction

Jan.27.12 | About: Silicom Ltd (SILC)

Silicom (NASDAQ:SILC) reported good Q4 results. The company is the leading provider of high performance networking systems for computer servers, enabling multiple units to work together more effectively. Silicom added a second product line ("SETAC") a few years ago that allows specialized appliance manufacturers to implement their technologies on industry standard computers. The latter segment grew 400% in 2011 and represented 9% of total sales. The core adapter line grew 21% and accounted for the balance. Total sales rose 30% last year to $39.6 million. Non-GAAP income, which excludes non cash stock option expense, advanced 50% to $1.23 a share. (Note - we tax adjust our non-GAAP figures, while the company does not in its presentations. So there is a slight difference between the two numbers.)

Sales growth moderated to a 12% pace in the December quarter. Economic factors may have contributed to the reduced level of incoming business. Silicom deals with more than 75 original equipment manufacturers and some probably deferred orders to spruce up their end of year balance sheets. Real final demand appeared to be unaffected, though. Silicom focuses on many of the strongest parts of the computer industry, cloud computing, virtualization and the mobile Internet among them. Industry trends remain robust despite the economic storm clouds. Silicom is gaining market share as customers shift away from commodity offerings to the company's high performance systems.

Margins remain above average. Proprietary features help the company keep pricing firm. And once a product is designed into a customer's system orders tend flow automatically, keeping selling costs in check. A lot of new business is generated by penetrating other divisions of existing customers. Most research and development is conducted in Israel, where engineering costs tend to be lower than in the U.S. or Europe. Our 2012 earnings estimate assumes gross margins will remain at current levels, at approximately 42%-43%. Pretax margins are likely to improve a shade as sales improve at a faster rate than overhead costs.

New markets are opening up. In 2011 North America represented 75% of sales. In the coming year China could start to make a more meaningful contribution. Silicom added a second major Japanese customer in 2011. It also has signed up several more SETAC users. We estimate that the high potential line will expand 50% or more in 2012 and top the $5.0 million mark in revenue.

We have reduced our 2012 sales estimate by 4% to $48 million. That caution may prove unwarranted. But it's possible the slower growth experienced in Q4 will persist if the macro-economic scene fails to improve. We've lifted our pretax margin estimate a notch, though, and lowered our predicted tax rate by a percentage point. So our earnings estimate is unchanged at $1.50 a share.

The long term outlook remains bright. The adapter segment is bound to undergo technology transitions as the industry develops. But Silicom appears well positioned to capitalize on those changes. The company is not tied to any legacy technologies in the adapter segment, so it has no marketing reason to eschew the leading edge. In addition, the SETAC line holds great potential. Direct competition has failed to develop in that segment. And new customers continue to sign up. Silicom also has more than $7.00 a share in cash which might be spent on complementary acquisitions. In two to three years earnings could reach $2.25 a share. Applying a P/E multiple of 16x suggests a target price of $35 a share, potential appreciation of 80% from the current quote.

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Disclosure: I am long SILC.