Investors may have overlooked a good value and growth story from Silicom (NASDAQ:SILC). The company has nearly half its value in cash ($7.41 per share) and a newly patented technology that has the potential to drive the top-line to $100 million in annual revenue.
Silicom engages in the design, manufacture, marketing, and support of connectivity solutions for a range of servers and server-based systems. The company has several growth engines, including Information Technology's return to growth, the march to 10GB per second technology, a large and growing base of OEM customers that includes most of the market-leading players, staged launch of new products, and a strong OEM business model that limits operating expenses.
SETAC, Silicom's new Server to Appliance Converter, which combines the best of standard servers with hardware appliances, should allow the company to push its revenues to the $100 million run rate level in coming years (up from $39.6 million in 2011).
SETAC, the best of both worlds
SETAC, which is Silicon's newly patented product family, converts standard servers to network appliances and is designed for systems that require front I/O ports, I/O ports replaceable without opening the system chassis, high quantity of I/O ports and flexibility to provide high quantity of different configurations.
When network appliance providers design their network appliances, they can either use a general server or a specific appliance oriented hardware solution. The server with standard add-on adapters assures server-grade reliability and a stable state of the art technological environment but sacrifices flexibility. On the other hand, using specific appliance-oriented hardware solutions allows for superior flexibility and field-re-configurability, but lacks in server grade reliability and technological stability.
SETAC offers the benefits of these two options, enabling branded high technology servers to be configured as hardware appliances, and creating an ideal network appliance that combines server grade reliability, front- end access, field- replaceable architecture and a stable state-of-the-art technology environment.
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Silicom's Promising Growth Drivers
The strong trends in rising internet traffic, cloud computing and virtualization that are developing within the information technology market offer Silicom several unique opportunities to dramatically increase revenues. These external developments strongly escalate Silicom's customer's network appliances needs for WAN optimization, internet security and application delivery.
While total global monthly internet traffic is expected to be 4x greater in 2015 than it was in 2010, the company estimates that the WAN optimization, internet security and application delivery markets are growing at an average of 20 percent per year.
These solid external growth engines combined with internal growth engines such as the company's increasing sales of SETAC and SETAC based network appliance products, as well as the staged launch of additional new products, has the potential to push the company's revenues to a $100 million per year run rate in the long term.
What's more, the SETAC product family, not only permits Silicom to address new market segments, but also allows the company to obtain nearly unlimited potential with its existing customer base of 75 OEM businesses that include market leaders within target segments.
Silicom should outperform, given the IT market's bottomless need for faster response times and increased bandwidth against the backdrop of cloud computing, virtualization, and Internet-based applications.
I believe Silicom should be valued by its cash plus business operations. With cash and liquid assets of $7.41 per share, plus the company's business operations value based on 9.3x our 2012 EPS estimate, this gives us a $20.00 company value.
Looking at it another way. I see the SETAC technology driving the company's growth over the next several years. (Background for valuation models pages.stern.nyu.edu/~adamodar/)
Two Stage Free Cash Flow to Equity Model
FCFE = Net Income - Net Capital Expenditure - Change in Net Working Capital + New Debt - Debt Repayment
- The company is expected to grow at a higher growth rate in the first period.
- The growth rate will drop at the end of the first period to the stable growth rate.
Rationale for using the Model
As new products are introduced to new customers, we expect the company to grow at a higher overall rate than the industry. As these products mature and the company faces more competition, we expect the growth rate to level off.
Weakness of the Model
As you add more layers to the model, it is more sensitive to the assumptions you make. The growth may look more "lumpy" than we have in the model.
We used the following inputs:
- An 8-year period with an earnings growth rate of 13.5% ((average forecast)) and a discount rate of 13.8%.
- A continuing period assumed to go on forever, with earnings growing at 5% and a discount rate of 9.56%.
With these inputs we arrive at a target price of $20.00.