Synaptics Boasts A Near-Perfect 9 On Our Buying Index

| About: Synaptics Incorporated (SYNA)

Investors know that to generate alpha one must constantly seek out new opportunities and new ways of looking at the same things. Alpha can be created by capitalizing on public information that other investors can't easily process (think footnotes of an 8-k), building a better mousetrap (think a better valuation model), achieving a better understanding of how the market works (an in-depth understanding of the company and its drivers), or exploiting structural impediments of the market (think cross-methodological work and post-earnings drift).

Exploiting Structural Impediments

If you ever ask value investors what they think of technical/momentum investors, you probably won't hear a lot of support for their process. Likewise, technical/momentum investors won't be paying too much attention to valuation, dismissing it as being too subjective. That leaves a tremendous possibility for investors to generate alpha by exploiting this structural impediment, particularly given the perceived distaste that momentum investors have for value investors and vice versa. Investors are leaving alpha on the table.

Combining Value and Momentum

So, what do you think might happen if investors combine value and momentum processes successfully? The answer: alpha. That's what we generate in our Best Ideas portfolio, and that's what has been shown academically to occur in a combined value-momentum process. Value and momentum investors, individually, are leaving a huge chunk of alpha out there ready to be exploited. And that's where we come in.

When value and momentum investors like the same stock, it explodes - think Apple (NASDAQ:AAPL) as the most recent example. If value investors don't combine the two, they could be left holding the bag - think Radio Shack (NYSE:RSH), or Hewlett Packard (NYSE:HPQ). And if momentum investors don't respect valuation, they can find themselves holding Netflix (NASDAQ:NFLX) at more than $200 per share.

Introducing the Valuentum Style of Investing

Valuentum may be our corporate name, but it is much more than that. It is a new style of investing - not value, not growth, not GARP, not momentum, but Valuentum. We combine an extensive three-stage discounted cash flow process (creating complete pro-forma financial statements) with a relative value assessment (price-to-earnings, PEG) and then add on a technical and momentum overlay to identify the best entry and exit points on the most attractive stocks on the market today.

We think earnings and free cash flow drive the valuations of stocks, and we use a tried-and-true margin of safety concept to determine which firms are undervalued. We embrace Warren Buffett and Benjamin Graham. Our technical and momentum process is also very simple and straightforward-we're not reading the stars for our next great alpha-generator. We love to find stocks that are undervalued and that are just starting to exhibit strong technical and momentum indicators - these tend to be home runs.

We want to capture alpha, and the higher the rating on our Valuentum Buying Index (our stock-selection methodology), the higher probability a company will deliver alpha in our Best Ideas portfolio.

But let's see if Synaptics (NASDAQ:SYNA) is set to deliver alpha.

Our Report on Synaptics

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Investment Considerations

Investment Highlights

Synaptics' business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.

The firm's shares are trading at an attractive level at this time, both from a DCF and relative value basis. The company also posts a rare 9 on our Valuentum Buying Index. Given the company's track record of solid business performance, we'd take a closer look at picking up some of the firm's shares in the portfolio of our Best Ideas Newsletter.

Synaptics has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 13% in coming years. Total debt-to-EBITDA was 0 last year, while debt-to-book capitalization stood at 0.7%.

The firm's share price performance has been roughly in line with that of the market during the past quarter. We'd expect the firm's stock price to converge to our fair value estimate within the next three years, if our forecasts prove accurate.

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 (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Synaptics's 3-year historical return on invested capital (without goodwill) is 158.5%, which is above the estimate of its cost of capital of 10.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. 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 estimate.

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. Synaptics's free cash flow margin has averaged about 16.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. 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 at At Synaptics, cash flow from operations increased about 10% from levels registered two years ago, while capital expenditures expanded about 24% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Synaptics's shares are worth between $34.00 - $52.00 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $43 per share represents a price-to-earnings (P/E) ratio of about 23.9 times last year's earnings and an implied EV/EBITDA multiple of about 15.1 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 8% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 18.4%. Our model reflects a 5-year projected average operating margin of 14.4%, which is above Synaptics's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.9% for the next 15 years and 3% in perpetuity. For Synaptics, 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 $43 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 Synaptics. We think the firm is attractive below $34 per share (the green line), but quite expensive above $52 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 Synaptics's fair value at this point in time to be about $43 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 Synaptics'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 $59 per share in Year 3 represents our existing fair value per share of $43 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

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.