The move shouldn't have been that surprising. Shares of Entropic Communications (ENTR) fell nearly 20% in trading Thursday and Friday after reporting third quarter results after the market closed on Wednesday.
It was the direction of the move that was somewhat surprising -- as The Motley Fool noted, Q3 results beat analyst estimates -- but its magnitude shouldn't have been. Entropic has a beta of 2.60, according to finviz.com, and it has moved wildly in response to earnings news over the last six quarters:
* -- first trading date after news announced
** -- movement in response to raised Q2 guidance; stock fell 3% when Q2 results officially announced
*** -- two-day drop
That type of volatility might scare away some investors; certainly, a long-term investment in Entropic requires patience (and perhaps some prescription anti-nausea drugs). But the two-day drop after Wednesday's earnings report is particularly confusing. As noted, Q3 results came in ahead of analyst expectations. Q4 guidance was slightly disappointing, but a revenue range of $89-92 million and non-GAAP EPS guidance of 8 cents per share was only slightly shy of consensus expectations for profit of 9 cents on revenue of $92.8 million.
It does appear there were some worries about the company's commentary on its post-earnings conference call. CFO Dave Lyle noted that gross margin was expected to decrease to about 50% in 2013, with the possibility of dropping into the high 40's if the company's chips for cable boxes saw increased demand. Later in the call, Credit Suisse analyst Ryan Carver noted the potential for competitors (likely referring to Broadcom (BRCM)) to lower prices and undercut Entropic. But overall, analyst sentiment seemed rather complimentary, with two different analysts offering congratulations on what one called "a solid quarter."
In short, there was nothing in the quarterly results to justify a 20% drop in Entropic's share price. In fact, the quarter showed that Entropic's long-term story remains intact. The maker of chips for home networking bought the assets of bankrupt Trident Microsystems earlier this year. The idea was to combine Trident's SoC (system on a chip) products for cable boxes with Entropic's MoCA solutions for wireless home networking to provide a single solution for cable, satellite, and telecom companies. Entropic was clear from the start that the plan would require time, noting that Trident would not become accretive until the end of 2013 and estimating the entire integration process would take about three years.
And, so far, the integration has progressed relatively well. Early supply issues for Trident products have been resolved, as Entropic has re-started relationships with vendors unsettled by Trident's bankruptcy. CFO Lyle noted that the revenue for the SoC business was "at a new baseline for growth, with revenue stabilizing in the mid-20s in millions of dollars [quarterly]." Later in the call, CEO Patrick Henry argued the company could at least double that number going forward. It is in fact this growth that is expected to create the aforementioned margin pressure, as lower-margin SoC products lower gross margin but increase gross profit dollars. This should hardly have been a surprise -- or a disappointment -- to analysts. Meanwhile, the company expects to maintain 50% market share globally in its legacy MoCA segment, while maintaining its targets for the Trident business to become accretive late next year and for its integration to be completed by late 2014.
In short, Entropic is a company completing a smart, long-term restructuring, with dominant market share for one of its products, while serving an industry expected to see significant growth going forward. It is executing well on its strategy, seeing design wins, expanding globally, and just delivered a record quarter in terms of revenue. Nothing in the Q3 report changed those facts, and certainly nothing in that report warranted the sharp drop in the stock on Thursday and Friday.
At Friday's close of $4.57, Entropic trades at just 12.3x its 2012 non-GAAP earnings; backing out the company's expected $1.92 per share in cash, its non-GAAP P/E moves closer to 7. The company is generating cash -- the legacy MoCA business created $52 million in free cash in FY11, well over 20% of its current enterprise value -- and saw revenue increase 75% in the most recent quarter, thanks to both the Trident purchase and organic growth.
Looking forward, the company has guided for long-term operating margins of 18-20% once the Trident assets are completely integrated. Given the potential for the SoC segment to grow revenue to $50 million quarterly, even modest growth in the MoCA business should get Entropic's revenue to at least $400 million by 2014. Operating income on the low end of the range would be $72 million; net income would be in the range of $47 million. Ignoring any cash accumulated over the next two years, and giving the operating business a multiple of 10, Entropic would be worth about $645 million, a 57% increase over its current market capitalization of about $410 million.
That bull case should be attainable; Entropic simply needs to continue its execution in regards to Trident and keep market share and margin pressures modest, allowing its growing industry to overcome some of the competitive pressures. In short, it needs to keep doing what it has been doing -- and what it did in the third quarter. The sharp sell-off in the stock should allow patient long-term investors to profit, as long as they can endure a few more earnings reports.