As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In LSI Corporation's (LSI) case, we think the firm is fairly valued at $8 per share, slightly lower than where it is currently trading. However, we think a relative valuation assessment is worth a look.
For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for more info on our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. In the spirit of transparency, we disclose the performance of our VBI:
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Source: Valuentum's July 2011 edition of its Best Ideas Newsletter
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. LSI Corporation posts a VBI score of 5 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, attractive relative valuation versus peers, and neutral techinicals. LSI Corp trails most of the peer group, but is the only company to have both an attractive relative valuation and a strong relative strength rating. Peers in this group include: Altera (ALTR), Linear Technology (LLTC), Nvidia (NVDA), and Xilinx (XLNX).
Our Report on LSI Corporation
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LSI Corporation's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. We think there are better quality firms out there.
The firm is trading at attractive valuation mulitples relative to peers, but our DCF process indicates a less compelling opportunity. We'd wait for a clearer signal on valuation before jumping into the firm's shares.
LSI Corporation's cash flow generation and financial leverage aren't much to speak of. The firm's free cash flow margin has averaged about 4.4% during the past three years, lower than the mid-single-digit range we'd expect for cash cows. The firm had no debt at the end of last quarter.
Although we think there may be a better time to dabble in the firm's shares based on our DCF process, the firm's stock has outperformed the market benchmark during the past quarter, indicating increased investor interest in the company.
The firm experienced a revenue CAGR of about -8.6% during the past 3 years. However, we expect its revenue growth to be better than its peer median during the next five years.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. LSI Corp's 3-year historical return on invested capital (without goodwill) is 1.8%, which is below the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. LSI Corporation's free cash flow margin has averaged about 4.4% during the past 3 years. As such, we think the firm's cash flow generation is relatively MEDIUM. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website here. At LSI Corporation, cash flow from operations decreased about 97% from levels registered two years ago, while capital expenditures fell about 32% over the same time period.
Our discounted cash flow model indicates that LSI Corporation's shares are worth between $5.00 - $11.00 each. The margin of safety around our fair value estimate is driven by the firm's HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $8 per share represents a price-to-earnings (P/E) ratio of about 53.4 times last year's earnings and an implied
EV/EBITDA multiple of about 14.2 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 7.9% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -8.6%. Our model reflects a 5-year projected average operating margin of 17.9%, which is above LSI Corporation's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.3% for the next 15 years and 3% in perpetuity. For LSI Corporation, we use a 10.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $8 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for LSI Corporation. We think the firm is attractive below $5 per share (the green line), but quite expensive above $11 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate LSI Corporation's fair value at this point in time to be about $8 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of LSI Corporation's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $11 per share in Year 3 represents our existing fair value per share of $8 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements