Sigma Designs: Appealing At 2x Cash With Catalysts Impending

| About: Sigma Designs, (SIGM)
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BACKGROUND

Sigma Designs (NASDAQ:SIGM) is a provider of system-on-chip (SoC) solutions to four markets: Digital Television (DTV), Set-top Box (STB), Home Networking, and Home Control/Automation. The underlying theme driving these markets is the connected home experience - any room, any screen. The primary end-market being the everyday consumer (with ever-increasing expectations) results in a highly competitive industry distinguished by rapid technology change, evolving standards, and decreasing ASPs. Winning in this area requires scale or differentiation; where main competitor Broadcom (BRCM) dominates at both. These competitive forces and industry dynamics have created havoc on Sigma's operations; coupled with poor execution, are also reasons for the stock's 5-year scrape along the bottom, losing over 75% of value.

In early 2012, SIGM's characteristics of poor execution, zero debt, market value to cash equivalents of only 1.2x, and MV to net current assets of 1.1x, attracted the attention of activist investor, Eric Singer of Potomac Capital. The operating expense line was extremely bloated (3yr average R&D >40% of revenue, SG&A 25% of revenue) and in dire need of alignment with revenues. At the same time Sigma Designs acquired Trident Microsystem's DTV business out of bankruptcy for ~$40 million with intention of countering a declining top-line by entering a new addressable market. Singer deemed this decision unappealing and contrary to shareholders' best interest. After dealing with an uncooperative Board, Potomac instituted a proxy battle and gained three seats (including Chair) while displacing two entrenched directors. By that November, a restructuring plan to cut $45 million from op. expenses was adopted with emphasis on reduced headcount, including the CFO. But, that was insufficient according to another activist, Raging Capital, filing a 13D stating:

On March 28, 2013, Raging Capital delivered a letter to the Chairman of the Board of Directors of the Issuer (the "Board") expressing its concern with the pace of the Board's efforts to reduce expenses and improve operational focus and execution. Raging Capital also emphasized the need for the Board to take decisive and expedient action to effect a turnaround of the Issuer, including focusing on further cost rationalizations, making changes to the composition of the Board and management, returning capital to stockholders and exploring consolidation opportunities.

To date, Sigma has: regained non-gaap profitability through cutting ~$39 million of expenses; seen a revolving door of Director seats, including just recently Chairman Singer resigning and Potomac Capital dumping it's position; announced a $20 million repurchase program; and witnessed a 10-year low in share price.

CATALYSTS

Further reduction in operating expenses. The November 2012 restructure plan originally called for $45 million in operating expense cuts, to which management has executed ~$39 million. Recent CEO commentary during the Q3 press release, "Our current cash balance combined with the early results of our ongoing restructuring efforts allows us to be confident in returning value to shareholders…," and during the appointment of Director Pete Thompson, "… to help drive our growth strategy in parallel with our continuing restructuring efforts…" suggests management is planning to further reduce op. expenses.

By using Broadcom's operations as a benchmark, due to dominancy in the space, we can show Sigma's magnitude of misalignment:

(calendar years, GAAP basis)

2011

2012

2013E

3yr Avg.

BRCM

R&D expense as % of revenue

26.84%

28.95%

29.50%

28.43%

SIGM

R&D expense as % of revenue

47.38%

47.77%

36.20%

43.78%

BRCM

SG&A expense as % of revenue

9.23%

8.69%

8.50%

8.81%

SIGM

SG&A expense as % of revenue

30.28%

28.83%

20.00%

26.37%

The majority of increase in R&D arose from the revenue grabs of Coppergate and Trident that added 141 and 320 employees, respectively, a ~100% increase in headcount. The larger base of engineers and a new addressable market caused Sigma to beef up the SG&A headcount as well, which is now an area where we see opportunity. By aligning expenses with revenue in a similar fashion to Broadcom through focusing on further reductions in headcount, we calculate that SIGM should be able to cut an additional $35 million in op. expenses, based on our FY2014 (ends this Jan.) revenue estimate of $201.7 million:

BRCM 3yr Avg.

If SIGM was:

Expense would be:

COST SAVINGS

R&D

28.43%

30%

~$60 million

~$13 million

SG&A

8.81%

10%

~$20 million

~$22 million

Attractiveness remains for greater activism. At Friday's close of $5.10, SIGM has roughly 50% of its market value in cash equivalents ($2.50/share), zero debt, and an EV/sales ratio of only .45, all of which should garner attention for possibly increasing the $20 million repurchase program, especially if FCF turns up. Plus, the turnaround started by Potomac Capital and subsequent involvement of Raging Capital (though trimming its position) may have just got the ball rolling towards right-sizing the business. We believe an opportunity is still open for an aggressive investor to exert pressure and extract the possible $35 million from operating expenses. Such a move could be viewed as easy to accomplish with a Board already open to creating value; and the addition of passive Ariel Investments, (now claiming 10.1% of shares) known to support activists, could make the buy-in that much more appealing. Adding to the incentive of further cost rationalizations is what it would mean for Sigma to return to GAAP profit: the ability to use loss carry forwards that are currently off-balance sheet. We estimate the value of loss carry forwards at ~$17.5 million or $.50/share.

(thousands)

Amount

Expires

Value

Federal NOLs

33,934

2019-2032

$8.7 mil

State NOLs

25,407

2014-2033

$1.8 mil

Foreign NOLs

29,669

Indefinite

$2 mil

Federal research tax credits

15,693

2019-2033

$4 mil

State research tax credits

15,689

Indefinite

$1 mil

Potential new design wins in growing DTV and STB markets. Last week at CES, Sigma announced several new next generation products with improved differentiation that has the capability of attracting large OEMs and service providers. A glaring problem over the past few years was SIGM's inability to compete with the likes of Mediatek or Broadcom, but a first-to-market FRCX chip for 120-Hz UltraHD TVs finally puts Sigma ahead of BRCM's product for 30-Hz UHD TVs. Also, announced at CES: a new ARM-based HEVC chipset for Hybrid IPTV STB platforms that allows providers to benefit from bandwidth savings and improved video quality; first-to-market coexisting HomePNA and next gen G.hn technology that allows providers an easy evolution from legacy systems to upgrades; and another ARM-based chip for UltraHD and 4k TV video processing.

As we mentioned in our report on Orbotech, flat-panel display and printed-circuit board makers are building new plants in China ahead of rising demand for large screen TVs. NPD Display Search predicts sales of screens over 50 inches growing 18.5%, from 27 million units in 2013, to 32 million in 2014. Of the expected 241 million total TVs sold in 2014, IHS forecasts 10 million to be UHD/4k, up from 1.5 million in 2013. The acceleration of the upgrade cycle (in developed countries) to larger TVs, higher resolutions and faster refresh rates; and vastly greater penetration of the Chinese home; plays to favor SIGM as it seems SIGM's products have long-awaited an industry shift to larger, more complex TVs. For the STB market, AT&T's U-Verse (a large customer of SIGM) reported a near record quarter of 265,000 new TV subscribers, and y-o-y growth of 21%. According to the IHS Set-Top Box Market Monitor global STB shipments should grow 6% to 286 million units in 2014. This market is highly concentrated (Broadcom 34% share, STMicroelectronics (NYSE:STM) 34%, Taiwan's Ali Tech 26%) and though demand may be present, it is difficult to foresee Sigma succeeding other than to slow the bleeding. Also, the smaller, but promising home automation segment is expected to see a 16.9% CAGR through 2018. Here Sigma has a quasi-monopoly on Z-wave technology inserted into >1000 products, and an additional option to license out. Overall, we believe the combination of new product launches into larger core markets may benefit SIGM in the form of increased volume shipments that could outweigh the inherent declining ASPs.

Segment Revenue

FY13

FY14E

FY15E

Digital Television

66.6

52.4

62.0

Home Networking/STB

131.4

112.1

95.0

Home Control/License

18.6

37.1

47.0

VALUATION

We estimate the top-line to grow ~2% to $206 million and for non-GAAP gross margin to inch forward at 58%, due to continuing traction in margin-rich licenses. Out of the possible $35 million in cuts to op. expense, we conservatively estimate $12 million in cuts resulting in non-GAAP EBITDA of $26 million. We also conservatively assume management to only use $10 million of the $20 million for repurchases and for FCF to at least refill the cash used, hence a remaining $2.50 cash/share.

FY13

FY14E

FY15E

Net revenue

$216,613

$201,696

$206,000

GAAP Gross profit

91,025

108,232

112,300

+Stock Compensation

487

274

285

+ Amortization

6,327

5,644

5,612

+ One-Timers

8,488

1,436

1,303

non-GAAP Gross profit

106,327

115,597

119,500

Expenses

Research and development

103,478

73,028

69,000

Sales and marketing

34,550

22,417

17,400

General and administrative

27,899

19,911

14,400

One-time items

7,958

3,332

2,700

+Stock Compensation

10,109

6,773

5,100

+Amortization

1,604

1,518

1,518

+One-timers

17,842

4,939

3,382

non-GAAP Op. Expense

144,330

105,458

93,500

non-GAAP EBITDA

-38,003

10,139

26,000

On a comparables basis, we again choose Broadcom as an industry benchmark. BRCM is trading at EV/pro forma forward Ebitda of ~9x; we believe it appropriate to assign SIGM a much lower multiple of 6x EV/forward non-GAAP Ebitda. Also, the expected return to sustainable GAAP profit should allow the loss carry forwards to be recognized:

(FY'15 = 34 million diluted shares)

Value

Per Share

Enterprise Value

$156 mil

$4.59

Cash equivalents

$85 mil

$2.50

Loss carry forwards

$17.5 mil

$0.51

Total

$258.5 mil

$7.60

Our FY2015 fair value target of $7.60 suggests shares are currently ~50% undervalued.

RISKS TO THESIS

Poor management execution results in lower-than-expected operating expense cuts. This would negatively impact our Ebitda estimate and possibly defer the ability to recognize the loss carry forwards. We believe we accounted for such risk by applying a well-below average multiple. The required R&D in absolute terms may be above the proposed right-sizing. This could result in a lack differentiation and lower designs wins that would result in rapidly declining revenue. Large customer concentration inherent to the SoC industry could create a volatile top-line upon losing a large account. SIGM's new product launches may fail to achieve a healthy level of design wins and volume shipments may not outweigh declining ASPs. Activist investors may choose to overlook SIGM and a lesser degree of outside pressure could result in poor management execution.

CONCLUSION

SIGM shares are appealing at 2x cash, suggesting limited downside. Impending catalysts surrounding on-going cost restructure and activist involvement to right-size the business are indications of further unlocking value to return capital to shareholders. Therefore, we believe shares are currently undervalued by ~50% and represent an attractive risk/reward opportunity.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SIGM over 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.