Imagine that there was a company whose net cash & marketable securities balance exceeds its market capitalization. Though this company has been unprofitable for several quarters, it posts consistent positive operating cash flow, due to the nature of its cost structure. As a result, its cash & marketable securities balance grows each quarter, and yet the stock does not rise in tandem. Doesn't this company sound like a great value proposition? Well, what if we told you that the company in question is Actions Semiconductor (ACTS), a fabless Chinese semiconductor company? Would it remain a value proposition then, or would it lose its appeal? After researching the matter, we believe that in the long-term, Actions Semiconductor has a good deal of value, and we delve into this issue below.
If you are a believer in the theory of efficient markets, no company should trade below its net cash balance. Trading below book value (as in the case of many banks), is one thing, because book values can be inflated with intangible assets and goodwill. But cash is cash. Its value is supposed to be definitive.
Actions Semiconductor serves as proof that this theory is not always true. We delve into this mystery below.
Net Cash: Show Me the Money
Actions reported its first quarter 2012 results Tuesday, May 8. The company posted revenues of $10.735 million, up 14.61% from the previous year, but down 12.67% sequentially, due to the seasonality of the business. On the income side, Actions reported a net loss of $653,000, or $0.00941 per ADS, worse than the previous year's $5,000 net income. However, income tax expense, at $538,000, was far above usual levels, and had it been normalized, Actions would have reported a profit. These results, on their own say little. What exactly does Actions do?
Actions is a fabless semiconductor company that designs chips for portable media players, MP3 players, and now, Android tablets, which are the company's next growth engine. As the MP3 market ages, Actions' profitability has dropped. As recently as 2008, the company was posting revenues of well over $95 million, and net income of 31 cents a share. In fiscal 2011, however, revenue sagged to under $47 million, with the company posting EPS of just over 4 cents. And the company's stock price has reflected this trend, falling from nearly $12 in 2006, to just $1.67 as of this writing.
(click to enlarge) Even as Actions has reported narrowing profits and revenues, its cash balance has been growing. Actions currently has net cash & marketable securities of $221.563 million, per its most recent quarterly results. That works out to $3.21 per ADS in cash & securities. We should note that this figure does not include equity investments and other investments reported in the long-term assets section of the balance sheet. If those Before we answer the question of how can Actions trade so deeply below its net cash balance, we must first answer this question. How can Actions keep growing its cash balance if its revenue and income are dropping? The answer lies in the company's cost structure.
Actions' statement of cash flows yields a number on insights into where cash is coming from. In the last quarter alone, Actions had $1.769 million in depreciation, amortization, and stock-based compensation expense, which more than accounts for the company's net loss of $653,000. While operating cash flow may have fallen this quarter to $717,000, down from the $2.774 million level seen a year ago, the decline is due to Actions' accelerated paydown of accrued expenses. It is important to note that even with this elevated level of accrued expense reduction, Actions still posted positive operating cash flow. And in the quarters to come, Actions is set to streamline its cost structure, which should provide boosts to both net income and operating cash flow, according to CEO Zhenyu Zhou. We will delve into the operational aspects of Actions later in the article.
Actions posts consistent operating cash flow, and is growing its cash & securities balance. Yet the stock trades at deep discounts to its intrinsic value. Why is this happening? We delve into that issue below.
Mirror Mirror on the Wall, Which Chinese Company is the Most Honest of Them All?
Actions' stock has been weakened not only by its business issues, but by the sentiment surrounding Chinese companies listed in the United States. No one wants to be left holding the next Sino-Forest or Longtop Financial. Therefore, investors have taken to simply selling all Chinese stocks that are not blue-chip in nature, such as Baidu (BIDU). We, however, think that there is no fraud going on at Actions. Our reasons for this start with the company's declining performance, both in terms of revenue and net income. If executives wished to enrich themselves and defraud unsuspecting retail investors, it is likely that they would have simply chosen to manipulate results and state that revenue and profits were higher than they actually were. That being said, we believe that there are several other reasons why Actions is not a fraud.
- Lack of Reverse Merger Issues: Many of the frauds that have been exposed in Chinese stocks come from companies that began trading in the U.S. via reverse mergers. For those unfamiliar with the process, reverse mergers are when a private company buys a publicly traded shell company to gain access to the public markets without having to go through the scrutiny of an IPO. Actions, however, began trading on the NASDAQ via a traditional IPO. The company went public in 2005, with Credit Suisse First Boston acting as the underwriter. It is unlikely that the company could have survived the scrutiny of an IPO while committing fraud. Here, critics can point to Longtop, which went public in 2007 via a traditional IPO, led by Goldman Sachs and Deutsche Bank, only to have its auditor, Deloitte Touche Tohmatsu resign via a letter that reads more like a tale of a crime novel than that of an auditor's relationship with its client. Deloitte alleged massive fraud at the software company, and the stock has been suspended from trading since 2011. If Longtop can survive the scrutiny of an IPO and go on to defraud investors, won't Actions turn out to be the same way. We think not. Longtop's fraud stemmed from its reporting of non-existent cash and assets, which were supposed to be the result of the company's rapid growth. Actions, however, has no rapid growth (at the moment), and its cash pile is growing slowly but surely as a result of its positive operating cash flows. If Actions truly wished to commit fraud, wouldn't the company simply report whatever numbers it wished, rather than the numbers it has been posting?
- Audit Issues?: Many of the frauds in the Chinese stock sector were exposed when auditors resigned, as was the case with Longtop. Actions' auditor, Deloitte Touche Tohmatsu, has been with the company since it became public in 2005, and remains with the company to this day, having just audited Actions' 2011 20-F filing. We will concede, however, that this is the weakest point in the argument against fraud at Actions. After all, Deloitte audited Longtop for 6 years and reported no issues. It was only in 2011 that Deloitte resigned, the details of which are still not crystal clear. Much of the issue stems from the fact that the PCAOB does not have investigative authority over accounting firms based in China, such as Deloitte Touche Tohmatsu, even if the end clients of those firms trade in the United States. Deloitte has been sued by the SEC over its role in the Longtop case, with the SEC alleging that Deloitte deliberately withheld documents, in violation of the Sarbanes-Oxley Act, which requires that foreign accounting firms hand over documents regarding companies that trade in the United States when the SEC requests them. This episode does not demonstrated malfeasance on the part of Deloitte. Though this is a unit of Deloitte, Deloitte Touche Tohmatsu is required to comply with Chinese law regarding accounting firms, since it is based in Shanghai. And under Chinese law, Deloitte Touche Tohmatsu is barred from handing over documents to foreign regulators without explicit approval from the Chinese government, which is something that has not occurred. The auditing issues this raises do not reflect weakness with Deloitte. Rather, it is an issue that affects the entire accounting industry. Is there audit risk at Actions? Yes, but no more than at any other public company. It is likely that in the 7 or so years that Deloitte has been involved with Actions, it would have found fraud by now, in our opinion.
- SEC Filing Concerns: Unlike public companies based in the U.S, Actions does not file quarterly filings with the SEC. Only annual reports, reported on Form 20-F, are filed. Is this a sign that Actions is hiding something, and allowing itself more time to cook the books since it only has to file them once per year? The answer is no. Under U.S. law, foreign companies that trade in the United States are only required to file annual reports, not quarterly ones. Not even Baidu, considered the bellwether Chinese company trading in the United States, files quarterly reports with the SEC. Under U.S. law, foreign companies instead file 6-K's, which include any materials that companies file in their home countries or with the native stock exchanges.
- Actions Cannot Deploy Cash All at Once: Critics may argue that if Actions is trading deep below its net cash balance, the company should immediately begin buying back huge quantities of its stock. The fact that it has not done so must mean that the cash does not exist. Actions has in fact been buying back stock. Since 2007, the company has bought back over $42 million in stock, representing 18.5 million ADS'. And in the last quarter alone, Actions bought back $1.025 million in shares. Per the company's first quarter earnings results, Actions has reduced its share count by 4,391,616 shares in the past year, representing a 5.98% reduction in shares outstanding. While this is no small amount, Actions' growing cash & securities balance, as well as its depressed share price imply that the company should be aggressively ramp up its repurchase activity. At current market prices, were Actions to spend $100 million buying back its ADS', it would reduce its share count to just 9,106,596 shares ($100 million / $1.67 = 59,880,239 shares bought back). Even with the corresponding $100 million reduction in cash & securities, Actions' net cash & securities per share would jump to $13.34 per share, more than 315% above today's rate. So why isn't Actions pouring money into its buyback? The reason is that it is currently unable to. This issue was brought up on the company's first quarter earnings call. CEO Zhenyu Zhou said that the company is carefully evaluating what it can do ramp up its buyback activity, given the obvious benefits of dong so. Actions, however, cannot simply jump into the market and begin buying back shares. Part of the difficulty stems from the company's inability to rapidly convert its yuan denominated cash into U.S. dollars, as well as low trading volumes. Actions' average daily trading volume during the last 3 months is just under 45,000 shares. Were the company to step in and begin buying millions of shares of stock, it would overwhelm the markets. Therefore, the company must tread more slowly, buying back shares in small increments. However, Actions has seen a pickup in trading volume. Per Finviz, May has been the busiest month in terms of volume since the start of 2011, with many days seeing volume of over 100,000 shares. Should this volume rise be sustained, it is likely that Actions can accelerate its repurchase activity (it is also possible that the rise in volume is due to Actions itself; we will have to wait till the next earnings release to see how many shares are outstanding). Alternatively, the company could announce a tender offer for a large portion of its stock; we expect more color on this front when second quarter 2012 results are released.
- Interest Income: Actions' large cash & securities pile generates millions for the company in interest income (over $12.6 million in 2011 alone). As revenue has sagged, due to changes in its end business, Actions' interest income has risen, providing a cushion for the company as it transitions to new product lines. Interest income at Actions has grown by an average of 12.08% annually over the past 5 years, as the company expanded its cash & securities pile. Were Actions to begin deploying that cash, interest income would fall, thus likely pushing Actions consistently into the red. Until the company can return to sustainable revenue growth, we think it is unlikely that Actions will initiate a massive buyback that would deplete the capital on which it can earn interest.
We believe that the points cited above provide a reasonable level of certainty that Actions is not a fraudulent company. Now that we have established that, we can delve into where Actions will go from here.
The Road Ahead: Transitioning to A Tablet World
Since its IPO, Actions' profits and revenue have fallen, due in large part to the fading relevance of MP3 players not made by Apple (AAPL). However, we, in addition to Actions, see 2012 as being the year that the company finally turns its business around. For the second quarter of 2012, Actions has guided for revenues of $12-$13 million, and a gross margin of 36%. At the midpoint of revenue guidance, that implies a gross profit of $4.5 million, which would represent sequential gross profit growth of 20.1%, and 22.75% over previous year levels. For the past several quarters, R&D expense has been above average, due to the development of ATM701x chip line, which we will discuss a bit later. In 2011, R&D expense was $22.086 million, per Actions' 20-F filing. That represents a 27.48% jump over 2010 levels, indicating the company's confidence in its future, for companies that are withering away do not usually boost R&D expenses (it should be noted that Actions was profitable in 2011, posting a profit of $3.005 million, but that was due to the company's interest income)
Over the past 5 years, Actions has posted average revenue declines of 16.45%. Although revenue rebounded in 2011 to $47.485 million from 2010 levels of $37.585 million, it is a far cry from 2007 levels of $116.628 million in revenue. Furthermore, 2008 was Actions' last full year of operating profitability. Since then, the company's growing cash hoard has been supporting results, due to the non-cash nature of many of the company's expenses (as discussed in the cash flow section).
So what is Actions planning to do to return to revenue growth? The company is moving away from MP3 players and into the tablet market. Its newest chip line, the ATM701x, which was the product behind its jump in R&D expense, was released in April, and Actions is ramping up production starting this month. The chip line supports the latest Android operating system (Ice Cream Sandwich), has a 1.2 GHz core, 3D graphics, and 1080P video encoding. The company is targeting the low-end tablet segment, primarily in emerging countries. According to CEO Zhenyu Zhou (on the conference call) within a year there will be 3-5 million units sold each month with chips from this product line, at an average selling price of $5-$10. At the midpoint of those two figures, the ATM701x line alone will be pulling in $30 million of revenue each quarter. That represents a more than doubling of revenues from this most recent quarter's $10.735 million in revenue. Here, criticism may emerge once again. Actions does not supply chips for the iPad, so how can it succeed in the tablet market?
The simple answer is that consumers who can afford an iPad are not in Actions' target end markets. While the iPad may be the market leader in the United States and other developed nations, with overall global market share of 68% in the first quarter of 2012, the story is different in emerging markets. In 2011, 2 out of every 3 tablets sold in Southeast Asia were Android tablets. In addition, Actions has a great deal of potential in China as well. While the iPad may be in great demand in that nation, it is seen not just as a media device, but as a status symbol, similar to how a Coach (COH) purse or Hermes scarf might be seen. There are many consumers in China, however, that simply want a tablet device, for they cannot afford an iPad.
(click to enlarge)Actions estimates that on a worldwide basis, its total addressable market will expand to $920 million by 2013, from just $410 million in 2011. MP3 players, once Actions' core business, are set to become just a slim portion of its total market by 2013.
(click to enlarge)Actions is the market leader in non-Apple audio products, with global market share of 40% overall, and a 60% share at the OEM level. In addition, Actions is set to capture a good deal of share in the Personal Media Player sector, which is growing rapidly in emerging markets. It is important to remember that this is not an iPad vs. non-iPad story. There are simply customers in many emerging economies that cannot afford an iPad. For them, tablets with Actions' chips inside them are the answer to their computing and media consumption needs. Actions has a clear roadmap for 2012 and beyond.
Production of the ATM701x line will headline 2012, and so long as Actions' results are consistent with the estimates of its management, the company will stage a dramatic turnaround by 2013. And in 2013, the company will move towards more powerful chips, under the 40LP and 28LP processes. Critics may scoff, and say that while this is all well and good, Actions' customers are small companies with no chance of ever selling product. We do not see it that way. Actions' downstream customers include LG, Disney (DIS), iRiver, Coby, Aigo, and hundreds of Chinese brands. We see 2012 and 2013 as the years that Actions will turn around its business, and believe that as the company reports its quarterly results, the progress will be clearly evident.
We believe that Actions Semiconductor is a company whose best days are ahead of it, and believe that for investors comfortable with owning a Chinese-based company, now is an ideal time to add to or initiate a position in Actions Semiconductor. We see no evidence of fraud at the company. Actions results would have demonstrated consistent growth in both revenue and profitability if fraud was occurring. We have never seen a case where a company defrauds investors by manipulating its results in order to post lower revenue and operating profits. To us, Actions is a legitimate company that has been dramatically oversold, due to worries about its business and the general attitude towards Chinese companies trading in the United States. Our analysis, however, leads us to believe that Actions will turn itself around in 2012 and 2013, leading to growth in both revenues and operating profits. Add in the fact that the company is trading at a deep discount to its net cash & securities balance, and will likely accelerate its share buyback, and Actions Semiconductor has a great deal of value to offer long-term investors.
Additional disclosure: We plan on initiating a long position in ACTS this week. We own shares of BIDU via a mutual fund that gives it a weighting of 0.84%. We own shares of DIS via the SPDR Dow Jones Industrial Average ETF.