Several years ago, Emcore (NASDAQ:EMKR) was a very diverse semiconductor company with very little focus and even less direction. Over the past couple of years, the company has righted the ship. The board laid out a clear vision for where the company should go, sold businesses that didn't fit that vision, and brought in a new CEO with a focus and experience to get the job done. One year into the job, CEO Jeffrey Rittichier finds himself in a very enviable position. He's running a profitable company with growing revenue and a boatload of cash.
After several quarters of focusing solely on the broadband fiber optics and specialty photonics businesses, the results have been very good. In December, the company reported their fourth quarter and full-year earnings. The fourth quarter provided the highest gross margin in over five years, and was the fourth consecutive quarter with sequential gross margin improvement.
On the conference call, they had many positive comments about specific business lines. The laser chip business doubled quarter over quarter, and the GPON upgrade cycle in China has been very strong for them, with two more years of anticipated strength. This strength should continue to drive growth higher as they leverage their operating model.
Some CATV revenue has been delayed recently, but management thinks that business has bottomed and will start to see a recovery following recent industry consolidation by some large customers. The growth in the CATV business should be driven by the growth of DOCSIS 3.1, which is starting in early 2016 with certain customers, and is expected to ramp over the next couple of years, providing 15% to 20% annual revenue growth.
The most notable of the asset sales made by EMKR were the solar division, which sold for $150 million, and the telecom division, which sold for $17.5 million. The company used $45 million from those sales to buy back 6.9 million shares, and still reported $112 million in cash as of September 30. The buyback left them with just 25.2 million shares outstanding, meaning the company has $4.44 per share in cash in addition to $1.20 per share in net working capital (receivables + inventory - payables). While future buybacks or strategic acquisitions are possible, the company has said that they intend to issue a one-time cash dividend in the next few months. This will likely take place as soon as the arbitration is complete. We would expect a one-time dividend to be at least $2 per share.
The NOLs on the balance sheet often go unnoticed by investors. The company has over $400 million in NOLs that will eliminate any taxes payable for years to come. From the perspective of a potential acquirer, roughly half of the NOLs are available for use at any time, while the other half have some restrictions. With immediate tax savings that could be used, these NOLs are worth at least $2 per share to an acquirer, and could be much more depending on the specific tax status of the potential acquirer.
EMKR is at the tail end of an arbitration process with Sumitomo, which has been an overhang on the stock. In March 2012, EMKR sold some assets related to their Fiber Optics segment to Sumitomo for $17 million. In September, 2014, Sumitomo filed for arbitration, seeking $40 million for claims relating to quality issues, and claims that EMKR make fraudulent misrepresentations prior to selling the company. EMKR called the claims egregious and vowed to fight them. Note that this lawsuit was filed by the corporate parent, based in Japan, after the U.S. branch of Sumitomo originally decided not to pursue a lawsuit. We view this lawsuit as saving face and being more of a scare tactic to others than a viable lawsuit where they believe fraud was really committed.
Of great importance regarding the arbitration is that the agreement from the asset sale limits any damages to 20% of $17 million purchase price, or $3.4 million, unless fraud is proven. Current management has been confident in the past that the previous management at the time of the sale did not commit fraud. On the company's most recent conference call, the company indicated that the hearings have all been completed, and we believe a decision should be coming in the next 60 days.
The market appears to be pricing the stock as though EMKR is going to lose the full $40 million, but this is highly unlikely for several reasons. First, Sumitomo made claims of fraud, which are very hard to prove. Second, the issue at hand is related to a $17 million asset sale. And third, as mentioned above, the asset sale agreement limits damages to $3.4 million. To suggest that an arbitrator will award them $40 million seems unlikely. We think the chances of a ruling involving fraud are less than 1%.
While this is a liability for the company that could result in a cash payment, it looks like the market has priced in a result that is very unlikely simply because Sumitomo has made claims that they have very little chance of collecting.
Currently trading around $5.80, EMKR has an enterprise value of $37 million, which is just 2.8x FY 2017 EBITDA and 0.3x sales. If you factor in EMKR's net working capital, the stock price is essentially the value of current assets. Consensus estimates have the company growing revenue 15% annually, with FY 2017 EPS of $0.34 on $106.9 million of revenue. This is a company with solid 15% growth, improving margins, positive cash flow and tons of cash. In addition, the company has $400 million in NOLs, so they won't pay any taxes for several years. The recent weakness in the market has pushed the stock price down nearly to its cash value and below its liquid asset value. We believe a very reasonable short-term price target is $11, or 1x sales plus cash and $2 per share for the NOL. We believe a 1x revenue estimate is very cheap, and could justify a 1.5-2.0x revenue multiple, but we will wait until EMKR approaches our $11 price target first. From here, there is virtually no downside, and as the company continues to prove it's on the right path and commands a multiple in-line with the peer group has the potential to double your investment. We also believe that EMKR is a very logical buyout possibility to a strategic buyer or a private equity investor given its large cash position, huge NOL, and soon to be completed lawsuit. If the stock stays close to this level, we expect that EMKR will not be a public company in a year's time.
Disclosure: I am/we are long EMKR.
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.