RF Micro Devices: A Return To Growth Set To Reward Shareholders

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RF Micro Devices (RFMD) has historically been a volatile stock. Shares approached $90 during the dot-com bubble, only to fall below 80 cents amidst the financial crisis. And over the past several fiscal years, RF Micro Devices (hereafter referred to as RF Micro) has seen inconsistent results, especially in fiscal 2012. But the RF Micro of today is not what it once was. The company has a clear path to further revenue growth, and with management aggressively expanding the company's gross margins, while keeping operating expenses in check, EPS growth is set to dramatically outpace revenue growth in both the current year and the year to come. However, little of this is reflected in RF Micro's present share price, and the company trades at a discount to both its semiconductor peer group and its own historical multiples. When a clean balance sheet is added on top of a material discount to fair value, we see upside of over 40% for RF Micro as the company moves to bring EPS back to historical records, and build its cash balances further. Unless otherwise noted, financial statistics and managerial commentary will be sourced from the following: RF Micro's Q3 2014 (the company's fiscal year ends in March) earnings release, the company's latest 10-Q, or its Q3 2014 earnings call.

Setting the Stage: Trading Revenues for Earnings

Over the past 12 months, amidst a rally for the NASDAQ, RF Micro has meaningfully underperformed the broader technology sector, as well as the semiconductor industry.

As the chart above shows, RF Micro's underperformance accelerated in late October, coinciding with its Q2 2014 results. While the results themselves beat estimates on both revenues and EPS, the company's guidance was less well received. RF Micro guided for revenues to be between flat and up 5% sequentially in Q3 (much more on RF Micro's Q3 results to follow), well below a consensus of 5% sequential growth. However, the company's EPS guidance of $0.13-$0.14 matched a consensus of $0.13. During the 2nd quarter, RF Micro continued its structural campaign to raise margins, and the company's ongoing restructuring underlined its confidence in EPS guidance. However, for many investors, that was not enough. Many investors worried that RF Micro would be unable to hold up EPS with anemic revenue growth, and the stock fell quickly in response as investors sold first and asked questions later. Moreover, RF Micro's Q3 results, on the surface, seemed to demonstrate more of the same concerns, as weaker than expected revenues, and weaker than expected revenue guidance, fueled by lower than expected device volumes at key customers Apple (NASDAQ:AAPL) and Samsung (OTC:SSNLF), seemed to reinforce the perception that RF Micro will be unable to navigate this period of uncertainty in the smartphone market.

We, however, do not see things this way. RF Micro's weaker than expected Q3 results are more than mitigated by strong margin expansion, and management outlined clear targets for further margin expansion, which will help drive EPS back to historical levels. And with increased EPS, RF Micro will add more cash to an already clean balance sheet, creating further opportunities to deploy capital.

Q3 2014 Results: Margin Expansion Carries the Day

For some investors, RF Micro's Q3 2014 results, released on January 28, served to feed the narrative that RF Micro is failing to turn itself around. Below, we present a consolidated overview of the company's results, with discussion to follow below.

RF Micro Q3 2014 Income Statement

Q3 2014

Q2 2014

Q3 2013

Sequential Change

Y/Y Change

Cellular Products (CPG) Revenue

$238,688,000

$255,476,000

$222,662,000

-6.57%

+7.20%

Multi-Market Products (MPG) Revenue

$49,831,000

$55,232,000

$48,551,000

-9.78%

+2.64%

Other Revenue

$1,000

$8,000

$0

-87.50%

N/A

Total Revenue

$288,520,000

$310,716,000

$271,213,000

-7.14%

+6.38%

Cost of Goods Sold

($173,935,000)

($198,381,000)

($175,013,000)

-12.32%

-0.62%

Gross Profit

$114,585,000

$112,335,000

$96,200,000

+2.00%

+19.11%

Gross Margin

39.71%

36.15%

35.47%

+356 bps

+424 bps

Research & Development Expenses

$48,035,000

$47,003,000

$44,536,000

+2.20%

+7.86%

R&D Expenses as a % of Revenue

16.65%

15.13%

16.42%

+152 bps

+23 bps

Marketing & Selling Expenses

$15,859,000

$16,175,000

$14,402,000

-1.95%

+10.12%

M&S Expenses as a % of Revenue

5.50%

5.21%

5.31%

+29 bps

-15 bps

General & Administrative expenses

$10,725,000

$11,969,000

$10,487,000

-10.39%

+2.27%

G&A Expenses as a % of Revenue

3.72%

3.85%

3.87%

-13 bps

-15 bps

Total Operating Expenses

$74,619,000

$75,147,000

$69,425,000

-0.70%

+7.48%

Operating Expenses as a % of Revenue

25.86%

24.19%

25.60%

+167 bps

+26 bps

Operating Income

$39,966,000

$37,188,000

$26,775,000

+7.47%

+49.27%

Operating Margin

13.85%

11.97%

9.87%

+188 bps

+398 bps

EPS

$0.13

$0.12

$0.08

+8.33%

+62.50%

Consolidated revenue fell by over 7% sequentially, well below the company's guidance for flat to 5% sequential growth, as revenue in both cellular products group (covering the company's mobile business) and multi-products group (covering sales to markets such as testing and measurement, aerospace, and cable television) declined sequentially, thereby causing RF Micro to miss revenue estimates by over $31 million. On top of this, the company's Q4 revenue guidance also missed consensus estimates, a sign of continued softness in several key customers. But, the company met its EPS guidance of $0.13, matching consensus estimates. How can a company miss revenue guidance by over $31 million and still meet its EPS forecasts? The answer lies in the company's margins.

For Q3 2014, RF Micro posted a pro forma gross margin of 39.71%, more than 4 percentage points higher than a year ago and over 350 basis points higher sequentially, as well as above the company's guidance of 38.4%. The result of this is that while revenues fell by over 7% sequentially, gross profit expanded by 2%, and when combined with a 70 basis point drop in operating expenses, RF Micro's EPS actually expanded sequentially. On a year-over-year basis, the comparison becomes even more favorable. Gross profit grew by over 19% year-over-year, on a 6.38% increase in revenue, helping grow EPS by over 60% year-over-year, due to relatively tight operating expense controls; we note that as a percentage of revenue, consolidated operating expenses rose just 26 basis points year-over-year, with the increase driven by both R&D and M&S expenses.

RF Micro's move to expand gross margins began in April 2013. On its Q4 2013 earnings call, the company outlined its strategy for driving material gross margin expansion, which consists of three key points. First, the company has now divested two of its United Kingdom fabs, moving to "externalize" a portion of its supply chain and strike a better balance between internal and external manufacturing capacity in order to better respond to changes in customer demand. Secondly, RF Micro has added capacity at its Beijing lift to bring more Chinese capacity in-house. As CFO William Priddy noted on the company's Q3 earnings call, "We're [RF Micro] seeing a margin lift today as we reduce our reliance on external suppliers, and we'll get an additional lift as our internal assets are fully loaded." And third, RF Micro's new ultra-low cost CMOS power amplifiers have boosted the company's emerging market performance, with many low and mid-tier customers having moved to the new power amplifier line. CFO Priddy has forecast that the commencement of shipments of these new CMOS power amplifiers to a "tier-one" customer will help boost gross margins further. RF Micro's management team has outlined 75 additional internal company initiatives to boost gross margins further, and on the Q3 call, management strongly telegraphed that it is moving to raise its gross margin expansion target. In October, on its Q2 2014 earnings call, CFO Priddy laid out a 40% gross margin target within calendar year 2014. However, on the company's Q3 earnings call, he stated the following: "At the beginning of this year we internally set a goal for ten points of margin improvement, and that was basically off of 35% gross margins. So that is our internal goal. We've already achieved half of that and we have initiatives in place that we believe will give us the additional five margin points. Now obviously some revenue growth and increased utilization of some of our facilities are going to help that, maybe even get us to that goal faster. But we're looking at the one- to two-year plan here in order to converge on that company-wide goal of 45%."

With gross margins for Q3 2014 now standing at almost 40%, the company has five more percentage points of gross margin growth left to achieve, and we are confident that the company will achieve this goal, given management's track record in boosting its margins throughout fiscal 2014. However, while margin expansion will help drive earnings growth, it is not the only component available to RF Micro. A gradual, but noticeable return to revenue growth will help provide further tailwinds to the company's EPS.

For the fourth quarter of 2014, RF Micro has forecast revenues of $255 million at the midpoint of guidance (within a range of $250-$260 million), and pro forma EPS of $0.09-$0.10. While that will represent a sequential increase in revenue, it would also represent a decline of over 9% relative to Q4 2013 at the midpoint of guidance. However, management attributed the sequential decline to weakness at one key customer, and noted that outside of that customer, the company expects revenues to grow in both its cellular and multi-market products group. In any case, weakness at the top-line is not flowing through to RF Micro's bottom line. EPS of $0.09 would represent a 50% increase in EPS year-over-year, as gross margins continue to expand. And as the global smartphone semiconductor market begins to recover, RF Micro stands to benefit. On the company's Q3 call, CEO Robert Bruggeworth noted that customer order patterns are strengthening, and that revenue will grow by double-digits in fiscal 2015 (revenue has grown by more than 21% in the first three quarters of fiscal 2014), driven in large part by continued migration to either LTE services in developed markets or 3G services in emerging markets. The United Kingdom serves as a prime example, where Three, one of the main U.K. carriers, began its 4G LTE rollout only in December 2013. RF Micro has specifically cited increasing penetration rates for LTE and the shift of LTE chips into "mid-tier" phones as a key driver of revenue.

As noted by Ericsson (NASDAQ:ERIC) in its November 2013 Mobility Report, globally, LTE remains in the minority relative to older networking technologies; even by 2019, 15% of mobile subscribers within North America will not be on LTE networks. In virtually every global mobile market, there remains ample room for LTE growth. Per figures from Ericsson, LTE accounted for around 20% of mobile subscriptions in North America in 2013, a figure that will rise to 85% by 2019. In Western Europe, LTE holds less than 5% share, but will rise to 55% by 2019. Full forecasts for key mobile markets regarding LTE penetration rates, per Ericsson's Mobility Report, are shown in the chart below.

The structural shift to LTE, in the United States, North America, and around the world will provide RF Micro with ample revenue opportunities in the long run. However, RF Micro remains keenly focused on the present, and the company's management spoke at length regarding the current revenue environment on the Q3 earnings call. Analysts questioned that company from multiple angles on its revenue, including the sizeable shortfall in Q3 revenue relative to expectations. Management attributed the shortfall to weakness in the low-end Chinese mobile market, where the company's new ultra-low cost CMOS amplifiers are resulting in revenue being traded for margin, something we believe in the end results in a more favorable profile for RF Micro. Within China, weakness is isolated to 2G demand, with management noting that the demand for 3G-related products remains healthy. The 2nd reason lies in the decline of 2G demand, which is declining at a faster rate than management had expected; but with the demand being caused by a shift to 3G services in emerging markets, the long-term picture at RF Micro remains bright. And with 2G-related products now accounting for less than 20% of consolidated revenue, the impact of the 2G market's continuing decline should become less and less meaningful in coming quarters. In addition to questions regarding its Q3 performance, management was questioned regarding its commitment to double-digit revenue growth in fiscal 2015; given the company's uneven revenue performance in fiscal 2014 (even if no such weakness exists in the company's EPS performance), analysts have shown themselves to be skeptical. CEO Bruggeworth and CFO Priddy steadfastly committed themselves to double-digit revenue growth in fiscal 2015, citing the impact of further LTE market growth, namely the increasing prevalence of multi-band LTE, which enables smartphones to utilize more LTE networks globally, but requires more advanced chips, thereby creating an opening for RF Micro. RF Micro's management team also specifically cited the rollout of TD-LTE in China as a key driver of growth; Eric Creviston, head of RF Micro's cellular division, stated that many of the company's smartphone customers within China are increasing the design and production of TD-LTE smartphones, which will help drive international demand for RF Micro's products. Of further note is the opportunity in tablet-based LTE; with a 25% penetration rate (per Eric Creviston), the company is forecasting that the demand for LTE-enabled tablets will increase substantially in the quarters and years to come. And as always, the launch of "marquee" phones, almost certainly a reference to the Galaxy S5 and the iPhone 6 (assuming Apple follows its present naming pattern). The company defended its growth target further, noting that while the growth in aggregate volumes of high-end smartphones may be slowing, the dollar amount of RF chips being utilized within those phones is not. As CEO Bruggeworth stated, "I'm not disagreeing with your [Merrill Lynch analyst Vivek Arya] comment that the number of handsets is slowing down but the RF dollars that are going into them continue to increase. LTE is also moving down into the mid-tier, which again is a lot of volume, so it's not always just the high-end phones. We also just talked about LTE growing in some of the other connected devices such as tablets. So we're seeing a lot of growth in other areas that maybe aren't just the top guys."

In our view, RF Micro's revenues will continue to grow in fiscal 2015 at a double-digit pace. However, it appears that the sell-side community does not see things that way. Currently, consensus estimates call for fiscal 2015 revenues of $1.25 billion, representing growth of less than 8% relative to fiscal 2014. However, consensus estimates are also calling for EPS growth of almost 35% in the coming fiscal year. Frankly, we believe that concerns about RF Micro's revenue growth are overblown, particularly given the potential for further margin expansion. If RF Micro's shares were trading at exuberant multiples, we would understand such concerns more fully. However, on both an absolute basis, and in relation to a collection of mobile chip peers, shares of RF Micro are inexpensive, providing further protection to the downside. We present a peer comparison of RF Micro in the table below.

Peer Comparison

Company

RF Micro Devices

Maxim Integrated Products

Cypress Semiconductor

Cirrus Logic

Synaptics

Fairchild Semiconductor

PMC-Sierra

Broadcom

Skyworks Solutions

OmniVision Technologies

Microchip Technology

Peer Average

Ticker

RFMD

(NASDAQ:MXIM)

(NASDAQ:CY)

(NASDAQ:CRUS)

(NASDAQ:SYNA)

(FCS)

(NASDAQ:PMCS)

(BRCM)

(NASDAQ:SWKS)

(NASDAQ:OVTI)

(NASDAQ:MCHP)

Share Price

$5.33

$30.26

$10.04

$17.51

$58.36

$12.76

$6.55

$29.76

$30.25

$15.39

$44.86

Shares Outstanding

282,535,754

282,664,000

148,558,000

62,318,377

33,990,000

126,600,000

201,615,000

581,000,000

188,930,302

55,957,863

218,371,000

Gross Cash & Investments

$210,050,000

$1,149,909,000

$119,257,000

$327,597,000

$387,684,000

$420,100,000

$225,073,000

$4,371,000,000

$648,600,000

$411,241,000

$2,031,327,000

Gross Debt

($85,902,000)

($1,003,836,000)

($227,000,000)

$0

($2,305,000)

($200,100,000)

($41,108,000)

($1,394,000,000)

$0

($39,395,000)

($1,019,471,000)

Net Cash & Investments (Debt)

$124,148,000

$146,073,000

($107,743,000)

$327,597,000

$385,379,000

$220,000,000

$183,965,000

$2,977,000,000

$648,600,000

$371,846,000

$1,011,856,000

Net Cash & Investments per Share

$0.44

$0.52

($0.73)

$5.26

$11.34

$1.74

$0.91

$5.12

$3.43

$6.65

$4.63

Stockholders' Equity

$660,062,000

$2,361,032,000

$183,109,000

$625,023,000

$624,999,000

$1,360,500,000

$584,462,000

$8,371,000,000

$2,212,200,000

$917,951,000

$2,075,108,000

Debt-to-Equity

13.01%

42.52%

123.97%

0.00%

0.37%

14.71%

7.03%

16.65%

0.00%

4.29%

49.13%

25.87%

Net Debt-to-Equity

0.00%

0.00%

58.84%

0.00%

0.00%

0.00%

0.00%

0.00%

0.00%

0.00%

0.00%

5.88%

Non-Controlling Interests

$0

$0

($4,474,000)

$0

$0

$0

$0

$0

$0

$0

$0

Enterprise Value

$1,381,767,569

$8,407,339,640

$1,594,791,320

$763,597,781

$1,598,277,400

$1,395,416,000

$1,136,613,250

$14,313,560,000

$5,066,541,636

$489,345,512

$8,784,267,060

Adjusted Share Price

$4.89

$29.74

$10.77

$12.25

$47.02

$11.02

$5.64

$24.64

$26.82

$8.74

$40.23

Fiscal 2013 Sales

$964,147,000

$2,441,959,000

$722,693,000

$809,786,000

$663,588,000

$1,405,400,000

$508,028,000

$8,219,000,000

$1,792,000,000

$1,407,929,000

$1,606,371,000

Fiscal 2014 Sales

$1,160,000,000

$2,390,000,000

$736,450,000

$707,420,000

$841,880,000

$1,460,000,000

$529,510,000

$8,580,000,000

$1,990,000,000

$1,510,000,000

$1,920,000,000

Fiscal 2015 Sales

$1,250,000,000

$2,620,000,000

$790,800,000

$677,990,000

$976,430,000

$1,540,000,000

$566,150,000

$9,160,000,000

$2,170,000,000

$1,580,000,000

$2,080,000,000

2-Year Revenue Growth

29.65%

7.29%

9.42%

-16.28%

47.14%

9.58%

11.44%

11.45%

21.09%

12.22%

29.48%

14.29%

Fiscal 2013 EPS

$0.18

$1.77

$0.39

$3.25

$3.11

$0.27

$0.33

$2.72

$2.20

$1.41

$1.89

Fiscal 2014 EPS

$0.43

$1.69

$0.50

$2.63

$3.71

$0.58

$0.40

$2.49

$2.60

$1.69

$2.42

Fiscal 2015 EPS

$0.58

$1.99

$0.65

$1.61

$4.13

$0.99

$0.47

$2.67

$2.88

$1.68

$2.68

2-Year EPS Growth

222.22%

12.43%

66.67%

-50.46%

32.80%

266.67%

42.42%

-1.84%

30.91%

19.15%

41.80%

46.05%

Fiscal 2014 EV/Sales

1.19

3.52

2.17

1.08

1.90

0.96

2.15

1.67

2.55

0.32

4.58

2.09

Fiscal 2015 EV/Sales

1.11

3.21

2.02

1.13

1.64

0.91

2.01

1.56

2.33

0.31

4.22

1.93

Fiscal 2014 P/E

11.37

17.60

21.53

4.66

12.67

19.00

14.09

9.89

10.31

5.17

16.62

13.16

Fiscal 2015 P/E

8.43

14.95

16.56

7.61

11.39

11.13

11.99

9.23

9.31

5.21

15.01

11.24

With fiscal 2014 and fiscal 2015 EV/sales ratios of 1.19x and 1.11x, and fiscal 2014 and 2015 P/E ratios of 11.37x and 8.43x, shares of RF Micro are inexpensive on both an absolute basis and in relation to its peer group. Relative to fiscal 2013, RF Micro is set to grow its revenues by almost 30% in the next two fiscal years, well ahead of a peer average of 14.29% (or 17.68% when Cirrus Logic is excluded). The same is true of earnings, which are projected to rise over 200% and back to RF Micro's historical performance. We note 2-year EPS growth (combining fiscal 2014 and fiscal 2015) is not due to a collapse of EPS in fiscal 2013 relative to fiscal 2012 (which would inflate EPS growth as earnings quickly rebound) and we present RF Micro's results from fiscal 2009 in the table below (relevant earnings releases can be found at RF Micro's website).

RF Micro Devices Historical Results

Fiscal 2009

Fiscal 2010

Fiscal 2011

Fiscal 2012

Fiscal 2013

Fiscal 2014

Fiscal 2015

Revenue

$886,506,000

$978,393,000

$1,051,756,000

$871,352,000

$964,147,000

$1,160,000,000

$1,250,000,000

EPS

($0.04)

$0.50

$0.62

$0.19

$0.18

$0.43

$0.58

At $1.25 billion, fiscal 2015 revenues are projected to reach a new record for the company, and pro forma EPS of $0.58 is less than 7% away from the company's fiscal 2011 record. RF Micro's weakness in 2012 in both revenue and EPS was caused by weak results at Nokia (NYSE:NOK), which accounted for 14% of the company's sales during that fiscal year. However, over the past several years, RF Micro has moved to diversify its customer base, and in fiscal 2013, Samsung was the only noted customer in the company's 10-K, accounting for 22% of total sales, with no other customer accounting for more than 10% of consolidated sales. RF Micro's management has highlighted further diversification of its revenue base as a top priority for the company, and we expect that when RF Micro's fiscal 2014 10-K is filed (sometime in May, assuming historical trends hold), it will show further declines in the percentage of revenue derived from Samsung, helping RF Micro generate more stable revenue growth. However, continued revenue growth is not the only avenue available to the company to grow earnings.

RF Micro has the potential to grow EPS further via the cash on its balance sheet, as well as the impending increases in cash flow to come from further profit growth. RF Micro ended Q3 2014 with over $124 million in net cash & investments, representing $0.44 in net cash per share, and while the company has been buying back stock, there is room to do more. During the first three quarters of fiscal 2014, RF Micro has repurchased $12.78 million of shares (inclusive of almost $1 million in buybacks in Q3 2014), versus $39.639 million in free cash flow. We note that in the first three quarters of fiscal 2013, RF Micro has boosted free cash flow by 46.85% increase relative to the first three quarters of fiscal 2013, even after accounting for a 76% increase in capital expenditures. We believe that as RF Micro continues its EPS recovery to historical levels, cash flow will rise as well, thereby positioning the company to be more aggressive in its deployment of capital.

We turn now to deriving a price target for RF Micro. In our view, the company's sharply rebounding EPS, as well as sustained revenue growth warrant EV/Sales and P/E multiples that are, at a minimum, in line with its semiconductor peers, and we present our valuation below.

RF Micro Devices Valuation Matrix

RF Micro Input

Peer Multiple

Implied Price Target

Fiscal 2014 EV/Sales

$1,160,000,000

2.09

$9.01

Fiscal 2015 EV/Sales

$1,250,000,000

1.93

$8.99

Fiscal 2014 P/E

$0.43

13.16

$5.66

Fiscal 2015 P/E

$0.58

11.24

$6.52

Taking the average of these four valuation yields a pro forma price target of $7.54 for shares of RF Micro, which represents upside of over 41% relative to the company's January 31, 2014 closing price of $5.33. RF Micro has put the weakness of Nokia behind it, and the company's various gross margin expansion initiatives, combined with operating expense discipline will help increase the stability of the company's earnings, thereby helping it close the valuation gap that shares trade at in relation to peers.

Conclusions

Although RF Micro has a clear path to further revenue and earnings growth, the company's stock price has yet to match its fundamentals. On both an absolute basis and in relation to peers, shares of RF Micro are undervalued, and we believe that this has created an opportunity for investors to add to or initiate positions in RF Micro at a meaningful discount to its fair value. With revenue growth and a sharp rebound in earnings set for fiscal 2014 and fiscal 2015, and with a clean balance sheet and the possibility of increases in the company's return of capital, we believe that RF Micro is well positioned in 2014 to both capture the various opportunities that lie in front of it, as well as create meaningful value for its shareholders.

Disclosure: I am long RFMD, AAPL, NOK, ERIC. 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.