Around seven months ago, I wondered whether GSI Technology (NASDAQ:GSIT) was an undervalued tech turnaround candidate or a value trap stuck in a fading market. The story isn't over yet, but the latter option seems like the more likely one at this point. Not only do companies appear to be replacing static RAM with DRAM, pseudo-static RAM technologies like 1T-SRAM, and other memory options, but Cypress Semiconductor (NASDAQ:CY) would appear to be faring better in this fading market. A cash-rich balance sheet (the company's enterprise value is half of market cap at around $79 million) guards the downside risk, but it's hard for me to see how the company prospers outside of success in its antitrust litigation, and that will likely take years to resolve.
Revenue Is Eroding At A Troubling Rate
From almost $100 million in revenue in fiscal 2011, GSI's revenue has shrunk to less than $59 million in the recently-announced fiscal 2014. Just within the past year, quarterly revenue has shrunk from $16.4 million to $15.5 million to $13.8 million to $12.8 million.
While it is true that major customers like Cisco (NASDAQ:CSCO) and Alcatel-Lucent (ALU) aren't delivering rousing performances in networking equipment, their end markets haven't been performing badly enough to explain all of that. In the fourth quarter, for instance, GSI's sales to Cisco dropped 44% and that tells me that there is more going on than just an end market slowdown.
Along those lines, Cypress hasn't been struggling as badly as GSI Technology. In the last quarter (the March quarter), for instance, GSI Technology's revenue declined 18%, while Cypress reported a 1% yoy decline in its memory products business. Integrated Silicon Solution (NASDAQ:ISSI) is faring even better, with fiscal second quarter (also the March quarter) SRAM sales up 9% to more than $21 million, the highest level in over 10 years.
Gross margins improved back into the mid-40%'s in the March quarter and GSI Technology continues to generate cash, but there is a point below which that cash generation will cease.
Can GSI Technology Still Hold Its Own?
GSI Technology has focused on the high end of the SRAM market, where performance issues like speed and power consumption really matter. Unfortunately, high-end networking equipment demand has slowed as companies evaluate alternatives like software-defined networking.
Again, though, I don't think stagnant end markets are the only problem. It may not be as hard to incorporate a different company's SRAM into an existing design than it would be for a product like a microcontroller, but I nevertheless wonder if GSI Technology is getting to a point where potential customers question its staying power and elect to go with Cypress or Integrated Silicon instead.
GSI Technology's balance sheet is clean and there's no near-term risk of bankruptcy, but Cypress and ISSI are able to outspend GSI Technology on R&D and GSI Technology may have shrunk to a point where potential customers don't really consider it as a viable long-term partner. Likewise, successive developments in SRAM technology are getting more expensive to achieve, which may hurt GSI Technology's position even further.
Litigation A Long-Term Option
GSI Technology is spending considerable sums on litigation. For fiscal 2014, the bill totaled almost $9 million against a full-year operating loss of around $6 million. As a reminder, GSI Technology is suing both Cypress and Integrated Silicon for patent infringement and antitrust violations. Damages would be determined after a finding of guilt, but readers should remember that antitrust violations can carry treble damages.
This is purely speculation on my part, but I would assume that GSI Technology will try to argue that its revenue declines are tied in large part to those antitrust behaviors. Now, Cypress has seen its Memory Products division revenue fall about 14% from 2011 to 2013, but if GSI Technology can prove that the "extra" declines they saw are the result of antitrust actions, I suppose the awards could be in excess of $50 million just from Cypress and that may be still be too low of an estimate.
The problem with litigation, though, is that it is expensive, time-consuming, and uncertain. There are no guarantees that GSI Technology will prevail and if Cypress/ISSI lose in court, I'm sure they will appeal it as long/far as possible and financially prudent.
It Won't Take Much Growth … But Can GSI Generate Even That?
If GSI Technology can free cash flow at a scant 2% a year, a fair value of over $7 today seems pretty reasonable. Even 2% growth may be too much to ask, though. Both Cypress and Integrated Silicon acknowledge that significant parts of the SRAM market are in decline and that decline is likely to continue (if not accelerate). With that, the former estimate of $900 million in addressable market for SRAM is probably out of date and too bullish, particularly as SRAM alternatives and substitutes gain more share.
It is of course worth noting that GSI Technology has close to $4 per share in net cash on the balance sheet and continues to generate cash. There will be a breakpoint with revenue and operating leverage below which the company will not continue to generate free cash flow (and it's not likely to be a linear function), but GSI Technology can stabilize at these recent revenue run-rates, it can likely continue to generate cash.
The Bottom Line
It may be a long shot for GSI Technology to get close to $100 million in annual revenue again, but the stock offers a combination of $4 in cash, some turnaround potential, and potential upside from that litigation (whether awards or settlements). I don't see much in the operating performance to attract fundamentals-oriented investors but I can see the appeal of potentially meaningful upside with a downside protected by that cash. It could take a while for that all to work itself out, though, so readers considering these shares will need patience to see it through to the end.
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.