Entropic Corporation (ENTR) shares rose 32% this week after announcing sales will be better than forecasted. In April The Street had gone running and dragged the price down to a five-month low after the company announced its recent Trident set-top box acquisition would take longer than expected to turn a profit. The recent news that some supply chain constraints have improved shot shares up to $5.49. This is still well below its 52-week high of $9.44.
There is no denying that the imagery of a family gathering around the living room in front of one television belongs in a museum. Home entertainment has gone through many transformations as advances in technology and family dynamics have changed throughout the decades. Many of us now rely on our DVRs and want to pick-up a show where we left off anywhere. That "anywhere" used to just mean the next room over, now it means on your computer at work or on your iPad. This demand for multi-screen home and IP entertainment requires advance systems from service providers. That is where the key to Entropic's growth is.
Headquartered in San Diego, Entropic provides silicon and software connectivity solutions that power the full home networking experience. Satellite and cable providers use these solutions to expand multimedia offerings at home and on the go. First quarter revenue came in at $59 mil up 5% sequentially but down 17% for the same period last year. This marks the second quarter of sequential growth in the past twelve months. With no debt on its balance sheet and the recent acquisition of Trident, Entropic has positioned itself as a scalable solution across the growing multi-screen environment.
The company recently acquired bankrupt Trident for $65 million and will start reporting combined financials on third quarter's 10Q. Trident's set-top box SoC products will help Entropic expand its home entertainment portfolio. The acquisition added 355 out of Trident's 365 employees to the payroll. It also expanded its patents and applications by over 2,200.
New product development timelines for this type of technology usually takes about 18 months to develop and another 12 before there are volume orders. This means that any new synergistic products developed would not see revenue streaming in until the second half of 2014. Until then, Entropic is able to bundle Trident and ENTR solutions together immediately.
MoCA technology is now being deployed by service providers covering about 90% of the premium television homes in the U.S. However Entropic's MoCA penetration is still less than 15%. The Law of Diffusion of Innovation states that between 15% and 18% is the tipping point. The rate of adoption cannot reach critical mass until market penetration reaches beyond this point.
The release of MoCA 2.0 to service providers later this year, should increase upgrade cycles. DIRECTV has 22 million subscribers, of which only 12 million use HD. This leaves growth of 10 million HD upgrades. Of the 12 million subscribers that already use HD, only 2 million are MoCA based. Leaving 10 million upgradeable subscribers. Considering the average US home has 3 boxes. That's another 30 million potential boxes. Totaling a potential 40 million new satellite boxes with MoCA. Using the same logic, cable providers would potentially add another 70 million MoCA boxes.
Thinking back to the Law of Diffusion of Innovation, MoCA penetration is very close to point where adoption accelerates quickly to fill this 110 million gap in satellite and cable devices. IMS Research shows the market for MoCA growing from 14mil devices in 2010 to over 100 mil devices in 2016, that's a 41% compounded rate.
At the end of 2010, 7 million subscribers were using ENTR's MoCA technology and annual revenue came in at $210. Assuming 100% adoption revenues would be $3.3 billion. Of course, 100% adoption is not likely but even 50% adoption over the course of the next four years would grow revenues to $1.8 billion.
These numbers do not include the growth in Asia which is starting to gain traction. The Korean cable market is starting to see some momentum building for the deployment of Android-based set-top boxes utilizing ENTR's chip. China is starting to increase bandwidth to homes using existing cable lines and Entropic's c.Link broadband access technology. India's government mandate to digitize in three years will boost pay-TV users. Currently 20% or 29 million of the market had digital televisions. This is expected to reach 50% or 69 million by 2016.
The recent $65M purchase of Trident and the disappointing ROI timeline had The Street concerned. The concern is warranted. Trident declared bankruptcy in January of this year. Unwilling to give up anymore assets, Trident's suppliers immediately halted shipments. This had led to a shortage of inventory and a loss of customers. 2011 revenue for Trident was $124 million (about $30M a quarter). However, with the current shortage in supply and a loss of customers; revenue guidance for Q2 is $21-$24M and is forecasted to stabilize late Q3. Gross margins are also expected to take a temporary hit down from 55% to the mid 40's. There is some room to tighten Trident's operating expenses because greater than 75% of the acquired employees held positions in R&D.
HD attachment rates and customer upgrades to advanced services have not increased as expected in 2011. This led to a steady decline in revenue in 2011. Although there has been an uptick in both these segments it is important to make note that consumer adoption is still under 15%.
When larger customers tighten their inventories, ENTR's revenue will adjust accordingly. For example in 2011 DIRECTV (DTV) averted a NFL lockout which affected seasonal promotions, also Verizon (VZ) cut back on promotions during the 2011 strike. Wistron NeWeb Corporation (6285.TW), which supplies DIRECTV, made up 22% of revenue in Q1. Motorola Mobility (MMI), a Verizon supplier, made up 18% of revenue.
A shake up in cable could be on its way and that could drastically throw a wrench in the attachment rates of set-top-boxes. In 2011 subscription-TV providers lost over one million subscribers. This loss can be attributed to a weak economy and new internet subscription services. Cities across the U.S., Boston being the latest, have or are considering ordinances to curb the clutter of satellite dishes on buildings. These ordinances push subscribers to cable or to pay for more costly dish installations.
The largest shake up in cable could be the release of an Apple (AAPL) television. When Apple releases its television it is more than likely going to jump to an a la carte subscription service. Although networks have been fighting it for decades, Apple shook up the music industry when it introduced the iPod and it shook up the publishing industry when it introduced the iPad. So it is very possible. On the other hand, a shift from set-top boxes would not ruin Entropic. The company's MoCA 2.0 chip and broadband technologies will be more vital than ever with the growth of streaming data.
ENTR has four basic product arms...
Home Networking- MoCA 2.0 chip enables multi-room DVR, video over-the-top video streaming, and extending Wi-Fi connections. Entropic's MoCA silicon has become the de facto connected home entertainment solution throughout the US.
DBS Outdoor Units- Consisting of its Band Translation Switch (BTS) and Channel Stacking Switch. These solutions support 12 tuners over a single cable compared to the traditional 1 tuner to 1 cable solution.
Broadband Access- c.Link broadband access technology has enabled robust broadband services in China for a few years. It upgrades existing cable networks to provide a cost-competitive solution for operators facing heavier bandwidth demands, more channels, and a need of IP-based applications.
Trident's Set-top SoC- A new generation of set-top boxes have enhanced performance to support the rise in HD interest and the innovations in video streaming across multi-screen broadcasts. Entropic's set-top box SoC reduces the manufacturer's and service provider's costs.
Not the only name in the game, Entropic holds about 35% market share. This is followed by Qualcomm Atheros (QCOM) at 33%, Sigma Designs (SIGM) at 14%, and Broadcom (BRCM) at 8%. ENTR's primary competitor for MoCA 1.1 is Broadcom's integrated SoC solutions. With the deployment of MoCA 2.0 and acquisition of Trident's SoC solutions this competition may decrease. Entropic has also partnered with Zenverge, which will support HD transcoding in the cloud.
When considering a valuation for Entropic, there are three scenarios that could play out.
1. After reviewing guidance and past growth patterns I have forecasted the more likely scenario to play out over the rest of 2012. Entropic's core business will pump out revenue of $243M. The Trident acquisition will bring in an additional $78M. With Gross Margins dropping to the mid 40's and operating margins hovering around 7.5%, EPS would be $.17. Adjusted net tangible assets (NTA) are $197 million. Using a conservative 1x multiple on forward twelve month revenue would yield an enterprise value of $321, giving ENTR a market cap of $492M or $5.63 per share.
2. The second scenario paints a rosier picture. Strong growth in the core business, as outlined in this article, would warrant a 2x forward multiple on revenue. With an adjusted NTA of $197 million and an enterprise value of $642M, ENTR's market cap would be $813M or $9.31 per share.
3. The third scenario reveals a grim outlook on Trident's revenue and illustrates no growth in the core business. Given this stagnant growth in the short-term, a 1x forward multiple seems quite reasonable. Entropic's core business revenue would likely see revenue stumble in at $217M and the Trident acquisition would bring in an additional $39M. With Gross margins dropping into the low 40's and operating margins remaining at 6%, EPS would be $.12. Adjusted NTA of $197M and an enterprise value of $256M would create a market cap of $427 million or $4.89 per share.
Considering the three scenarios listed above, with a current share price of $5.49 there is a good deal of upside to owning ENTR shares. From a risk reward standpoint, it is important to consider the break-up or liquidation price of Entropic. When considering the break-up value I use the adjusted net tangible assets of $197M as well a $30M value on patents and applications. Entropic would have a break-up value of $227M or $2.60 per share.
The company has positioned its product portfolio to take full advantage of the demand for multi-screen home entertainment. There is great buying opportunity ahead of new product ramp-up. The release of Q2 financials will give further insight to the true value of the company's acquisition. ENTR is an undervalued asset and contingent on the upcoming financials, I will be changing my position from "watch" to "buy."