How Long Will Investors Have To Wait For NVE?

| About: NVE Corporation (NVEC)
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While a good idea can be the starting point for a good investment candidate, investors who lose sight of the importance of execution and market development can set themselves up for a nasty shock down the line. NVE (NASDAQ:NVEC) would seem to be on to something potentially big with its spintronics technology, but the company's product sales have gone nowhere fast for the last five years and the stock has been largely stuck between $40 and $60 since May of 2009.

There are certainly intriguing applications and potential markets for spintronics - electronic devices are getting ever-smaller and that process requires more and more advanced technologies (and/or materials). NVE's technology could certainly find key positions in markets like factory automation, healthcare, automobiles, and telecom, but the markets have been frustratingly slow to develop. NVE doesn't look notably cheap today unless you are willing to make some bullish estimates that the spintronics market will accelerate notably (and relatively quickly), but NVE is a cash-rich, high-margin company with almost a decade of free cash flow generation behind it. NVE may end up as a company with a great future in its past, but today's shareholders aren't exactly suffering while the company tries to develop a commercial market for this technology.

Spintronics May Play A Key Role In Smaller Devices

There are plenty of articles and papers on the internet that go into the details of spintronics, so I will not attempt to reinvent the wheel here. What I will say is that the basic idea of spintronics is to use not just the charge of an electron but also its spin (and by extension its magnetic moment) to store or transmit data and essentially control magnetic movements in a device.

What this means in real world terms will sound familiar to most investors. Spintronics should lead to devices that are much smaller, much faster, and much more power efficient (and/or some combination of the above). The applications of spintronics could ultimately be extremely far-reaching (effectively any device with memory, sensors, or digital couplers), but real-world commercial usage today is largely limited to markets like healthcare (including pacemakers/ICDs, neurostim devices, and hearing aids/cochlear implants) and factory automation.

Translating Opportunity Into Sales Is Still Challenging

For all of the potential of what spintronics could become, it doesn't amount to all that much today for NVE. The company's annual product revenue has been pretty much stuck in the $20 million to $26 million range for the last six years, though the most recent quarter (the company's fiscal second quarter) did see product sales pick up to a point where they would annualize out to almost $29 million.

Regrettably, the company doesn't quantify the contributors of its largest customers, other than to say that medical technology companies St. Jude Medical (NYSE:STJ) and Phonak and chip company Avago (NASDAQ:AVGO) make up a "significant" percentage of revenue. The company's relationship with St. Jude goes back more than a decade, with NVE's spintronic sensors enabling telemetry for cardiac rhythm management devices and neurostimulators. With Avago, the two companies have a long-standing distribution agreement for NVE's coupler products, with the agreement having recently been extended out to 2016.

Is NVE Setting The Table For Somebody Else's Dinner?

My primary concern with NVE is that the company is not large enough and does not spend enough on marketing to really impact the pace of maturation in the spintronics market. At less than $1 million per quarter, NVE's marketing spend is a drop in the bucket and less than what the company spends on R&D.

There's nothing wrong with NVE prioritizing R&D, but the company isn't the only game in town. Companies like Fairchild (FCS), Analog Devices (NASDAQ:ADI), and Avago are quite a bit larger and have put not-insignificant amounts of money into other types of sensor and coupler technology. Speaking more specifically to spintronics, large companies like IBM (NYSE:IBM) have put their own R&D stakes into the ground and names like Texas Instruments (NYSE:TXN) and Intel (NASDAQ:INTC) are tied to various research initiatives researching potential spintronics applications.

My fear is that initial ground gained by NVE in areas like healthcare and automation gets swallowed up by larger, better-funded rivals when spintronics is finally ready for primetime. NVE does own patents and IP in this field and the company may emerge as more of a technology licensing entity (as opposed to a traditional fabless or integrated chip company), but the thing to remember about David-versus-Goliath battles is that that story resonates because the outcome was so improbable (more often, Goliath squashes David into a greasy spot without working up a sweat).

Modeling Is Still Mostly Guesswork

I thought NVE had a solid fiscal second quarter, with revenue growth rebounding to the tune of 25% year-on-year growth and 38% growth in product sales. Margins were also strong, as gross margin improved more than seven points (to nearly 80%) and most of that fell through to the operating line (where the margin is more than 58%).

NVE is a very tricky company to model. There's minimal sell-side coverage (just one analyst) and the company is so small (and the market is so new) that I still think you can argue as to what the business model will look like in 2017 or 2022.

Looking at the problem from the opposite point of view can sometimes help in these situations. If you accept the premise that NVE deserves a discount rate in keeping with being a risky tech stock, today's price would seem to incorporate a 10-year free cash flow growth assumption of 10%. For a company with less than $30 million in revenue and about $11 million in free cash flow, addressing a potentially huge market in its very early years, that doesn't sound like a particularly bold assumption to me.

The Bottom Line

Although it doesn't seem as though the stock's current price assumes that this will become a great growth story, that's not to say it's a slam-dunk buy. There is a long list of things that could go wrong here - NVE's IP may not hold up (or may not be worth much), the spintronics market may never develop, and/or large rivals like IBM may just blow past NVE.

All that said, NVE has more than $18 per share in net cash and a good history of free cash flow generation, though not much growth over the past five years. For investors with real conviction that spintronics can become a real market opportunity over the next three to five years, this is an interesting speculation. For investors who demand more certainty and more modeling rigor, though, this is probably a name that will prove to difficult and frustrating to own until well past the point where the early gains are made.

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.