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Silicom (NASDAQ:SILC) engages in the design, manufacture, marketing, and support of connectivity solutions for a range of servers and server based systems. The firm 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 includes most of the market-leading players, staged launch of new products, and a strong OEM business model which limits operating expenses. SETAC, the firms newly patented Server to Appliance Converter, which combines the best of standard servers with hardware appliances should allow the firm to push its revenues to the 50 million run rate level in coming years.

On October 22, 2012, Silicom Ltd, reported financial results for its fiscal 2012 third quarter and nine months, ended September 30, 2012. The company's strong momentum continued with third quarter revenues, operating income, net income and earnings per share, each breaking all of Silicom's previous records.

Growth for the quarter was driven by Silicom's increasingly diversified product line and customer base in all of its target markets. Likewise, the company saw an increasing contribution from its newer product lines as well as its recent design wins.

The company's third quarter revenues improved year over year by 15 percent to $11.522 million, which compares to revenues of $10.019 million for the three months ended September 30, 2011. Sequentially, revenues improved by $1.109 million from $10.413 million for the quarter ended June 30, 2012.

Operating income for the third quarter increased year over year by over 19.5 percent to $2.678 million, mainly as a result of the record revenues and lower total operating expenses as a percentage of revenues. Sequentially, operating income improved by $422,000 from $2.256 million for the quarter ended June 30, 2012.

Although total operating expenses increased year over year by $201,000, they fell to 20.2 percent of revenues from 21.2 percent of revenues during the third quarter of 2011. Likewise, operating expenses as a percent of revenues improved sequentially from 20.8 percent of revenues for the quarter ended June 30 2012.

Gross margin for the three months ended September 30, 2012, was steady at 43.5 percent compared to 43.6 percent for the third quarter, ended September 30, 2011. Still, sequentially, gross margin improved from the 42.5 percent for the three months ended June 30, 2012.

On a GAAP basis, the company's third quarter net income increased year over year by 22.7 percent or $477,000 to a record $2.581 million from net income of $2.104 million for the comparable quarter of 2011. Sequentially, GAAP net income improved by $299,000 from $2.282 million for the quarter ended June 30, 2012.

The increase in net income was a result of record revenues and lower total operating expenses as a percentage of revenues.

Based on a weighted average number of diluted shares of 7.020 million shares, diluted net income per share resulted in net income of $0.37 per diluted share during the third quarter of fiscal 2012. This compared to a diluted net income per share of $0.30 on a weighted average number of diluted shares of 7.012 million shares during the three months ended September 30, 2011.

On a non-GAAP basis, which excludes non-cash share-based compensation, the company reported third quarter net income of $2.705 million or $0.39 per diluted share. This compares to non-GAAP net income of $2.380 million or $0.32 per diluted share for the quarter ended June 30, 2012 and $2.214 million or $0.30 per diluted share for the quarter ended September 30, 2011.

For the period ended September 30, 2012, Silicom's cash, cash equivalents, bank deposits and marketable securities totaled $54.8 million or $7.91 per outstanding share, which is a sequential improvement of nearly $2 million from the $52.9 million, or $7.63 per outstanding share as of June 30, 2012. This quarter's balance represents Silicom's highest ever cash level which demonstrates to both its existing customers as well as new potential customers that the company can meet all their needs and provide them with support over the long term. The firm intends to internally leverage its cash position for continued investment in research and development and market leadership to build future growth potential.

The industry's fundamentals remain strong as a result of continued acceleration of worldwide growth of the internet and data traffic and the corresponding desire for bandwidth. All these add up to a dramatic increase in the rate in which data is generated, stored, processed and provided with a corresponding drive for increased capacity and bandwidth. Given that Silicom's products are core and critical building blocks for these next generation servers and appliances, the company continues to see strong demand.

With the company being sought out by the market's top server and appliance manufacturers, as a result of its reputation for out-of-the-box technologies, rapid response time and world-class service, Silicom is receiving a steady stream of new opportunities, design wins and ongoing orders.

In particular, Silicom's SETAC product family, which achieved four design wins in the third quarter, continues to gain ever increasing market traction which is leading to a worthy cycle of increasing customer acceptance of this technology.

Silicom's cost competitive SETAC (Server To Appliance Converter) product family, offers a distinctive growth opportunity that enables the company to offer a full network appliance platform solution. This new product line permits Silicom to address new market segments as well as obtain nearly unlimited potential with the its existing customer base.

These recent SETAC design wins will further accelerate the momentum that has been building for Silicom's SETAC product family, further boosting its importance as a significant driver for the company's sales and profits.

Furthermore, it is important to note that while SETAC was primarily accepted in the security market segment in the past, it recently has been moving into the acceleration optimization market, which is very important to the company.

During the quarter, Silicom achieved a design win with a Chinese networking giant and already has initial purchase orders for multiport adaptors in place. The short term forecast of revenues for this win are for a run rate of approximately $1 million per year with the potential for the annual purchase orders of several times this amount. This strategic win positions Silicom to benefit significantly from the rapid growth in China.

With China's population of over 1.3 billion and its quick uptick in smart phones, there is an enormous escalating demand for cloud services, mobility and big data networks. As such, China has become a huge opportunity for all the major networking equipment manufacturing and therefore for Silicom, as a strategic supplier to many of these companies. As a result management feels very optimistic about China as a growth driver for Company sales for years to come.

Along the same lines, it is also important to note that as the company's customer base continues to grow and diversify, the company's pool of design wins expands, which brings Silicom a growing platform of recurring orders as well as a broader range of new opportunities, often from different divisions within a large corporation.

As a result of these trends, management feels more confident than ever about its ability to continue its growth over the short and long term and believes that the company is ideally positioned to continue its progress in step with its fast-growth target markets.

With strong demand for all of the company's product line, exciting strategic wins with some of the industry's most important players, productive discussions in process, and an extensive pipeline of potential sales, management believes that Silicom has never been better positioned and remains very optimistic with regard to the company's future potential.

Valuation

I believe Silicom should be valued by its cash plus business operations. With cash and liquid assets of $7.91 per share, plus the company's business operations value based on 11.9x our 2012 EPS estimate, this gives us a $25.00 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

Assumptions

  1. The company is expected to grow at a higher growth rate in the first period.
  2. 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.

Output

We used the following inputs:

  1. An 8-year period with an earnings growth rate of 15.0% ((average forecast)) and a discount rate of 13.8%.
  2. 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 $25.00.

Source: Record Breaking Quarter At Silicom; Outlook Remains Solid