When I last wrote about Cavium (NASDAQ:CAVM), I was enthusiastic about the product launch and growth potential of this small(ish) semiconductor company, but very conflicted about the valuation and expectations. Since then, the company has offered up underwhelming guidance, a slower-than-expected launch of key new products, and a large acquisition that offers questionable value and a definite risk in how Cavium is perceived and valued.
The shares are only down about 12% from the time of that last article, but that's due in part to a strong rally off June/July lows. At the worst, the shares were down about a third in the intervening period. Looking ahead, I still have a lot of mixed feelings about this stock. I do genuinely believe that there is strong revenue growth potential in Octeon, Thunder, XPliant, LiquidIO, and LiquidSecurity and that Cavium delivers very good products for enterprise data center and service provider customers with high-end needs.
While I expect less from Cavium than I did before, the expectations are still robust, with near-term revenue growth above 20% and healthy long-term FCF margins. My new fair value(s) in the $50s offers upside, and there could still be a "disappointment discount" in the share price, but Cavium definitely needs to get back onto a "beat and raise" path.
Where's The Growth?
Allowing that the last few quarters have been less than ideal for enterprise and service provider hardware spending, Cavium was supposed to be beyond those concerns. With new products addressing the highest demands of companies like Cisco (NASDAQ:CSCO), Samsung (OTC:SSNLF), Amazon (NASDAQ:AMZN) and so on, Cavium was supposed to be looking forward to strong growth in the core Octeon business and a relatively quick acceleration in the contribution of new products like ThunderX and LiquidIO.
That hasn't happened. Since my last write-up, Cavium has logged low-single-digit year-over-year growth, with sequential growth accelerating from 1% in the first quarter to 5% in the recent second quarter. Although management did raise guidance for the third quarter, with the sequential growth rate set to accelerate to 6% to 8%, the overall trend has not been positive.
Since late 2015, analyst expectations for 2016 revenue have fallen by 8% while expectations for 2017 revenue are now 11% lower. Sure, this may be a bump along the road - Cavium has shown cyclicality in the past, particularly around product launch cycles. Still, given the very high level of growth (and sustained growth) that was underpinning expectations, the failure to exceed expectations has been disappointing.
On a more positive note, Octeon seems to be performing reasonably well relative to the industry, and management has talked of its expectation that this cycle/generation will do what past generations have done and achieve 2x the prior gen's peak sales. Management has also ramped ThunderX with a customer, and while I think the expected addition of one other customer this year is disappointing, there's still the potential for a bigger launch in 2017 and beyond, and particularly with the ThunderX2 about to go into sampling.
LiquidIO should ramp at a couple of customers in Q3, and XPliant is going into more general availability in the coming months. All told, then, it still seems plausible that these important new products could represent a mid-teens or higher percentage of revenue in the fourth quarter.
Why Would Anyone Care?
What is it again that makes Cavium worth paying attention to at all? It's all about supporting high-performance applications in the data center. Cavium's multicore processors are better able to handle very demanding tasks, and do so with good power/performance and cost of ownership trade-offs. With that, Octeon chips find their way into LTE gateways, control planes, routers, base stations, ADCs, security appliances, cloud installations and so on, with a customer list that includes Cisco, Samsung, F5 (NASDAQ:FFIV), Amazon, and Palo Alto (NYSE:PANW).
Going beyond Octeon, Cavium is counting on growth of its multicore ThunderX ARM processors in storage, networking, security, and hyperscale applications in clouds and "Big Data". Cavium believes it offers a strong alternative to Intel (NASDAQ:INTC), particularly when it's used in applications designed to maximize its advantages. Keep in mind, though, that Cavium has no aspirations toward being an Intel-killer; Thunder's core addressable market is probably around 20% of the total, but it's a segment that is willing to pay a premium for exceptional performance.
XPliant, LiquidIO, and LiquidSecurity are all very different products - XPliant is a line of programmable Ethernet switch chips, LiquidIO covers server adapters, and LiquidSecurity involves hardware security modules - but they share a common DNA so to speak. All of these products are high-end solutions for demanding applications. By their nature, they're new and unproven, but they do address well over $1 billion in potential revenue with relatively limited competition (at least in terms of similar features and price/performance).
Does QLogic Really Help?
Cavium really threw the market for a loop when it announced in June that it is acquiring QLogic (NASDAQ:QLGC) at an equity value of over $1.3 billion. QLogic brings a strong position in connectivity, with both fibre channel and Ethernet assets. On the Ethernet side, buying QLogic will allow Cavium to add software into its stack, and management believes that there are significant cross-selling opportunities as the two companies overlap about 60% on customers, but only about 10% on revenue. Cavium also believes that it can run the QLogic business for profitable growth, with operating cost synergies and improved sales growth in the future.
I'm skeptical. QLogic has unattractive margins and lackluster growth relative to Cavium and growth companies rarely see the market reward deals like this (or, at a minimum, there is a prolonged period of having to prove the value of the deal). Offering a more complete set of solutions is a competitive plus for Cavium and maybe there was a risk of someone else bidding for the company, but Mellanox (NASDAQ:MLNX), Intel, and Broadcom (NASDAQ:AVGO) all have QLogic on their radar. What's more, I wonder about the philosophical fit - QLogic has just never struck me as a "bleeding edge" technology type of company.
Reassessing The Value
Between the slower-than-expected revenue ramp in 2016 and the QLogic deal, I think Cavium is going to grow slower than I'd previously expected. I don't think Cavium will be able to grow QLogic at a double-digit rate for a sustained period of time, and so I think this deal reduces the long-term revenue growth potential from around 20% to the mid-teens. I do think that Cavium will wring a lot of costs out of the business, so I don't expect a horrible dilution to the long-term FCF margin potential. I still believe that Cavium can get adjusted FCF margins into the 20%s over time, supporting a 20%-plus internal long-term cash flow growth rate.
Discounted back, those cash flows give me a fair value of about $56 today (versus $65 before). While I think Cavium will wring costs out of QLogic and drive operating synergies, I do think the deal dilutes margins long-term, and so my "fair" EV/revenue moves down a half-point (to around 4.3x) and my fair value here moves to $59. The biggest positive driver I see at this point is an acceleration of new product adoption (the newest Octeon chips, the Thunder series and so on) such that the old revenue growth trajectory comes back into play, but I think the results of this year are a lesson in getting ahead of yourself with giving companies like Cavium too much benefit of the doubt.
The Bottom Line
Even though Cavium has already come back from the worst of the pullback, the shares could still be around 20% to 25% undervalued. That's not a bad return, particularly if the company can regain the trust of growth investors with beat-and-raise quarters. All told, while I question the QLogic deal, I don't think that this is a broken growth story and it's worth a closer look now from aggressive investors.
Disclosure: I am/we are long AVGO.
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.