Authentec: Downgraded to Hold on Lower Outlook

They say that good things come in small packages.

While that might be true of AuthenTec’s fingerprint sensors, it sure wasn’t true with the nice little “Business Update” that AuthenTec provided on Sunday evening or their nice little share price after the close of today’s market.

AuthenTec (NASDAQ: AUTH), the world’s leading provider of fingerprint sensors and solutions to the PC, Wireless and Access Control markets, dropped a bombshell on all of us late Sunday night in announcing that they were lowering Q3/2008 and full year revenue and earnings forecasts, as well as announcing the loss of a customer that will represent over 35% of their revenue in 2008 and 2009.

In addition, AuthenTec held a conference all with analysts on Monday morning before the market opened to discuss the lowered forecast as well as the customer loss, in what is a highly unusual occurrence, which shows the severity of the situation.

Needless to say, Wall Street was none too pleased (sending shares down over 60%) and frankly, neither am I.

What this calls into question now is our investment thesis.

Has it changed such that an investment in AuthenTec is no longer warranted?

What follows is a summary of AuthenTec’s “Business Update”, conference call highlights, and my take on the company’s future prospects, and my investing thesis.

New to the AuthenTec story?

AuthenTec, Inc., is a fabless mixed-signal semiconductor company that provides fingerprint authentication sensors and solutions to the high-volume personal computer [PC], wireless device, and access control markets.

AuthenTec’s sensors use a patented technology called TruePrint that reads beneath the surface of the skin to the “live” layer where the true fingerprint resides.

Hit Me With Some Numbers

AuthenTec Lowers Revenue, Profit Guidance

Here are some of AuthenTec’s revised estimates for the remainder of 2008 (compared to analyst’s estimates):

• Q3/2008 revenue of $18.2 million to $18.5 million, down from a previously estimated $19 million to $20 million (vs. $19.75 million projected by analysts)
• Full-year 2008 revenue of between $69 million and $71 million, down from $72 million to $78 million (vs. $76.20 million projected by analysts)
• Q3/2008 Non-GAAP earnings per share of $.03 - $.04 down from $.04 to $.05 per share (vs. $.05 projected by analysts)

My Take: These numbers by themselves aren’t that big of a deal, but its the context with which they came that is troubling. I’ll explain more below.

Conference Call Highlights

CEO Discusses Future Business Prospects, Customer Loss

The following are highlights from AuthenTec’s analyst conference call:

• 2 Major Forces Affecting AuthenTec Going Forward: On the analyst conference call, CEO Scott Moody explained why AuthenTec was lowering guidance for Q3/2008 and full-year 2008, and talked about the significant customer loss in more detail.

First off the CEO explained, in prepared remarks, that their business is being affected by two separate events:

1) The first relating to the near-term forecast by their customers,
2) The second relates to a design-in loss that they expect will affect them in late 2009

Regarding the first issue, AuthenTec stated that they have recently experienced a number of order cancellations and changes affecting their 3rd quarter.

The CEO then stated that he had previously expressed concerns about the overall economy, even though it had yet to affect AuthenTec directly on any material level.

In fact, he stated, during the Q and A on the last conference call, one of the callers commented that AuthenTec seemed to be immune to the current economic downturn.

As it turns out, that is not indeed the case, but was masked because one of their customers overbought in the 2nd quarter and even into the beginning of Q3.

They are still working to understand the extent of the overbuy, but they believe it will take at least one quarter to work through, thus their slightly lowered guidance for Q3/2008, and full-year 2008.

The second issue is much more severe as far as AuthenTec is concerned.

It appears that AuthenTec lost a huge customer that will stop using AuthenTec’s sensors in the 3rd and 4th quarters of 2009, and switch to a competitor’s fingerprint sensor chips.

Speaking about that customer loss, the CEO stated that they are still not sure how this will impact them going forward and are still evaluating the situation, although one can assume, and Wall Street did assume, that AuthenTec is going to have trouble operating as an ongoing concern and remaining profitable.

In fact, when pressed by analysts on the call, AuthenTec basically stated that they will be losing about $20-25 million in revenue from this one customer in 2009, weighted towards the back half of the year.

More disturbing to me was when an analyst asked if, going forward, are they going to be able to sustain the business model and remain profitable, to which the CEO stated that they “are still looking at that”.

On the call, the CEO would not say who their competitor was that received the design-win, or who the customer was that pulled out, but did state that HP and Fujitsu, accounted for 10%+ of their overall sales, so we can infer our own assumptions there that it was obviously one of these customers.

He further stated that they are anticipating and modeling that the revenue from this customer would go to $0 in Q3/Q4 of next year.

Further, the CEO stated that outside of the inventory situation, the other segments are still performing well, and although they are still seeing incremental growth, they are not seeing the growth building in the sub-$1000 notebook market, where their attach rates are not as high.

So while their growth rates are still good, they are not seeing the incremental growth that would be associated with this market that is growig faster than the overall PC market.

Finally, the CEO stated that although the 35% year-over-year growth rate was not what they had expected, it is still higher than the overall PC market as a whole and higher than other electronic and semiconductor sectors as well.

What he didn’t say was that with this customer loss next year, sales would be lucky to climb 10-15% from this year by my calculations.

My Take: Huge bombshell!

Lowering guidance for next quarter and by extension the remainder of 2008 is one thing, and not unreasonable, but losing one of your largest, if not the largest, customer that you have because of problems that we’ll discuss below is absolutely unacceptable, and a huge shock to not only investors, but I’m sure AuthenTec’s management team.

The conference call was mighty somber, and while CEO Scott Moody did have his story straight, and was entirely honest with us from the beginning (what choice did he have), it doesn’t change the fundamental outlook for the company.

Can AuthenTec gain the revenue that they are losing from this customer in other segments or through other customers?

Even if the answer to that is a slight and incremental yes, that in and of itself would change the investing thesis from bleak to potentially lucrative in light of the stock price decline today.

Let’s get to some more conference call highlights.

• Business Outlook:The CEO spoke about what the company would need to do and was going to do, to try and bridge the revenue shortfall and touched on the future outlook for AuthenTec.

He then outlined 5 items that AuthenTec was going to address in order to remain solvent, potentially expand their market share at the same time, and get their sensors into more and more PC’s and to newer customers:

1) While they will be prudent with their expenses, they will still continue to invest in new fingerprint products, technologies, and capabilities.

2) With respect to the design loss, they continue to have a very good relationship with this customer, and for confidentiality and competitive reasons, they do not want to go into the reasons as to why this customer decided not to select them as their fingerprint supplier.

That said, the CEO stated that they believe they fully understand the issues and reasons why they were not selected by this customer, and are taking immediate action to remedy the situation.

3) With respect to the lower-end laptop PC market, they believe that they have a new sensor that will be competitive in this market and launch soon in order to take advantage of the recent uptick in sales in this segment.

4) Consistent with previous plans and discussions, they are working aggressively to produce applications tailored for this segment of the market, such as their TrueSuite application that they recently integrated this year via their EzValidation acquisition.

5) They are working aggressively to secure new business that can help compensate for the loss of revenue in the back half of 2009.

While they have some things to work on, the CEO believes that they are still in a great position to take advantage of this growing market, but of course, what else would he say?

In addition, the CEO also stated that Atmel Corp. (NASDAQ: ATML), which was perceived to be one of the few publicly traded companies that competed with AuthenTec, was pulling out of the fingerprint sensor market.

Along those same lines, there have been other competitors that have either withdrawn or gone out of business in the fingerprint sensor market within the last few quarters according to the CEO.

Finally, going forward, the CEO stated that AuthenTec wants to be not just cost competitive, but the lowest-cost leader as well.

In turn, the CEO came clean and said that “I’ll be frank” in stating that gross margins were likely to come down in the future as a result of the higher competition and other business related issues.

My Take: There is a disturbing trend that is recently coming to light with AuthenTec and it would appear, the entire fingerprint sensor market.

The CEO tried to paint a picture that some of AuthenTec’s competitors going out of business would be a good thing and that it would result in a tightening of the market, but the problem with that is that it doesn’t allow AuthenTec’s products to be differentiated enough from other company’s sensors.

But forgetting all of the rhetoric, let’s deal with the huge elephant in the room: that of the loss of a huge customer.

It takes a lot to lose a customer in this space because it can take up to 3 years to design-in a fingerprint sensor into new products and account for the sensors both in the product design, testing and manufacturing cycle.

The good news was supposed to be that as a result of this large lead time, as well as the difficulties and costs associated with the ramp-up, once you were designed-in to a product, odds were you would be the only provider for that product for a long time to come.

This was a purported competitive advantage, and one of the primary reasons for investing in AuthenTec.

Not only are their fingerprint sensors patented and the only ones on the market that read beneath the skin to the live layer, but their market leading position was supposed to establish AuthenTec as the de facto leader in this space and build upon their reputation and track record to then allow them to further penetrate the market.

How do you lose a customer that represents 35% of your sales?

You did something very wrong, and didn’t help that customer to achieve their desired goals for delivering to their end-users what they expected.

AuthenTec says that they “learned” from this experience and are working hard to change things, but the question then becomes, is it too late?

Can the business be saved?

Why didn’t AuthenTec do anything and everything in their power to make sure that one of their largest customers was getting exactly what they needed and foster a good working relationship with them?

What’s going on in the cutthroat fingerprint sensor market that all these companies are falling by the wayside, or abandoning the fingerprint sensor divisions within their companies?

Is this market already stabilizing, or worse, declining?

Could it also be that with the economy declining, manufacturers are looking for the lowest cost fingerprint sensors, regardless of their patents, or whiz-bang features?

Maybe customers don’t give a hoot about the cool Radio Frequency (RF) sensors that AuthenTec produces that read below their skin so that no one could ever steal their data…heck, we’ve all gotten along just fine for 20 years using computers without fingerprint sensors, maybe most people out there just don’t see the value in spending a few extra bucks for the confusing little sensor that comes with their computer that they don’t know what to do with.

In fact, one of AuthenTec’s reasons for purchasing EzValidation was exactly that: to make sure that their Graphical User Interface (GUI) was easily understandable and that their sensors were used more by the end-customer.

The CEO talked about how some companies liked fingerprint sensor technology and the software that came with it and wanted to implement that into their products, while some customers wanted the rock-solid dependability that other sensors offered, but then would look for the software to go with it.

It appears that AuthenTec may have acted to little too late in securing and trying to integrate EzValidation’s software into their own systems for customers to make their lives easier when integrating their chips and allowing the end-user to use the sensors easily and without hassle.

I don’t know exactly what went wrong, and AuthenTec wasn’t saying for “competitive and confidentiality” reasons, but you could glean from the conference call and Q and A that it was obvious that AuthenTec was not servicing this customer the way they needed to be serviced.

Bottom Line

Hold for now…

So far my track record around these parts is not very good.

That being said, I am downgrading AuthenTec to a hold.

Why not sell the damn thing and be done with it?

That’s a good question.

There’s a saying that I heard the other day that really caught my attention because of it’s truth: ignore deteriorating business fundamentals at your own risk.

What this means basically is that once a business shows cracks in the armor, and any sort of decline in business fundamentals, like losing a large customer and pretty much saying that margins and perhaps profitability will be hard to come by in the future, you are best served to cut-bait and get out.

As evidenced by the decline in AuthenTec’s stock price today, it looks like the market has heeded that sage advice to a tee.

But, as a result of that precipitous decline, we are presented with some interesting things to think about, and I need more time to think about them before pulling the trigger one way or another.

Here’s my thinking:

• AuthenTec now has about $2.14 per share in cash on the balance sheet with no debt. Shares closed today at $2.55. You are essentially getting the company and all its assets for $.40 per share.

This is the kind of low-ball value you give to a company about to file for chapter 11.

On top of this, even if we take down earnings this year to about $.15 per share from the current estimates of $.18 per share, we get a P/E ratio for 2008 of 17.

Even if we assume that AuthenTec’s growth will come to a screeching halt next year and decline from the 35% projected in 2008, to only 10-15% for 2009, down from a projection of 35%, a very real scenario inclusive of the lost business, we can see that the stock is now at the very least, “fairly” valued, with a lot of upside potential based on any good news whatsoever.

• I need more time to analyze the situation. Can AuthenTec recover? Are they being too grim and dire in their forecast so that they can “under promise and over deliver”?

Is there a significant flaw in their business model?

Is competition heating up so much so that AuthenTec won’t be able to survive, or is AuthenTec, with their large cash position, the one that will survive the shakeout and come out better and stronger on the other side?

Is the economy going to pick up next year and cause demand to rise for smart phones with fingerprint sensors, and higher end laptops that also contain these sensors, thus propelling AuthenTec to higher revenues and earnings despite losing their largest customer?

There’s still lots yet to learn about what’s going on, and how this will play out.

• The market tends to overreact. We know this to be true on many fronts, and I believe that a 60% haircut was unwarranted in one day.

I think that we’ll see the smart money come back into this stock and realize that the risk/reward scenario is worth looking into.

AuthenTec may have scared away the momentum and growth guys, but now we’ll see the real business fundamentals kick in.

So What Should You Do?

No one should tell you how to run your investment portfolio, because the ultimate decision is yours to make, but I believe that if you feel that AuthenTec is done, and is unlikely to recover, or if they do it would take so long as to render your investment dead in the water, then you should sell immediately and never look back.

If however, you feel as I do, that there’s something here that deserves to be looked at further, then hold your shares, and let’s see how this plays out, and get more information before being too hasty with our decision-making, especially in light of a huge decline which would leave us selling after the fact.

The final scenario for the very risk-tolerant, would be to get into AuthenTec at these levels knowing full well the dangers involved, and the very real possibility that the company could be at the beginning of a very real downward spiral from which it will never recover, but also seeing the dirt-cheap valuation as a low risk, possibly high risk/high reward scenario for a small portion of your portfolio.

An argument can be made for each and every one of these scenarios, which is why I simply need more time on my end, but wanted to give you guys all the information possible to make a decision as to how you want to proceed with your investment.

The absolute bottom line is that we are on tenuous and shaky ground here.

There was no sugar coating losing a customer that represents 35% of your total business revenue (40% in 2008).

It looks like AuthenTec might not be running as tight and smooth a ship as I first initially thought, and they have some serious customer retention initiatives that they need to get on ASAP.

I’ll be monitoring the situation, but suffice it to say, I do not take buying or selling companies in my portfolio lightly, and don’t plan on rushing this decision either.

Please feel free and leave your comments and thoughts below.

New to the AuthenTec story?

Click here to read my complete AuthenTec research report and buy recommendation

Comments

[BreakoutInv...:]

Good article Chris. Thanks for your analysis and commentary

2008 Sep 09 11:09 AM

[bschu:]

AUTH has now entered the relm of "High Risk, High Reward"
So, if you wish to speculate a bit and compare it to other potentials out there, they actually look pretty good.

A mature product (Verses a start-up), Mistakes made but identified and corrective action taken, Honest answers rather than hide bad news. I could name a few more but you get the picture. I bought some shares today.

2008 Sep 10 06:28 PM

[wisewhiskers:]

So who do you think the competitor is? Is it some Taiwanese company that will always be able to undercut Authentec's price? Or some competitor with superior technology? In either case, then it's easy to predict the future for this company. On the other hand if just a fierce rival competitor, then you win some and you lose some, but your still in the game. Does it mean that this second layer skin technology isn't really that special? I'll go ask my Taiwan friends to see if they have more insight what's going on.

2008 Sep 12 04:17 AM

[Blackeye:]

I'm not expert, but if Authentec is the leading company in selling fingerprint sensor (or maybe it was), something good should be there!!

Is it possible that other big companies will be now interested in acquiring Authentec due to the cheap price of shares and the know how of Auth? Something like this would push upward the shares.
What do you think about?

2008 Sep 12 06:15 AM