Cirrus Logic: Digging Deeper And Wider Moats

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About: Cirrus Logic, Inc. (CRUS), Includes: AAPL, NXPI, QCOM
by: OmniScience Capital

Summary

Cirrus Logic is a misunderstood stock due to the high dependence on Apple.

Cirrus Logic has started making inroads in the Android ecosystem.

Cirrus Logic has also expanded its SAM significantly with smart audio accessories, haptic drivers and smart homes.

Cirrus Logic (CRUS) has always been a misunderstood stock and continues being so. This is likely to continue as long as Apple (AAPL), with more than 80% revenue contribution, remains the main customer. We have discussed the investment philosophy which should be adopted while considering a stock such as Cirrus for investment possibilities in our earlier article.

In the meantime, any potentially unfavorable announcement from Apple continues to bring volatility to the stock. This is natural and any investor going ahead with this investment should assess whether they are comfortable with this kind of behavior of the stock price. As discussed in the earlier article, if Cirrus Logic survives the next 3-5 years without losing Apple in the early stages, the potential gains to the investor are significant. However, the volatility in the meantime is expected to remain high.

Recently, the lowered guidance for the next quarter has caused a drop in the stock price. Earlier, the announcement by Apple that it will drop the dongle was a reason why it fell. Most recently, the rumors of Apple halting a production boost for its iPhone XR has caused some upheaval.

However, we think these are par for the course.

The lowered guidance was explained in the shareholder letter.

In the December quarter, we expect revenue to range from $360 million to $400 million, up 4 percent sequentially and down 21 percent year over year at the midpoint. As we have highlighted above and in previous shareholder letters, forecasting revenue in the September and December quarters can be quite challenging as an unexpected change in the timing of shipments can cause large swings in our revenue on a quarterly basis. While guidance for the December quarter reflects a shift in orders late in the quarter from Q3 into Q2, the company’s expectations for this six-month period remain relatively unchanged.

Source: Cirrus Logic Q2 FY19 Letter to Shareholders

This is again reinforced in the opening remarks of the conference call by CEO Jason Rhode.

Cirrus Logic reported revenue of $366.3 million in Q2 of FY '19. Revenue exceeded the high end of guidance, as orders for certain portable products moved into late Q2 from early Q3. Predicting revenue for these quarters can be particularly challenging, as we are typically ramping heavily at the quarter boundary and our customers can and frequently do change individual orders on short notice. While our guidance for the December quarter reflects the shift in orders, we note the company's expectations for this 6-month period remain relatively unchanged.

Source: Cirrus Logic Q2 FY19 Conference Call Transcript

The shift of revenue into an earlier quarter can hardly be labeled as lowering guidance if the full six-month revenue for the two quarters combined is delivered as guided.

This means that there is no cause for a downgrade.

Now let us look at what works for an investor in Cirrus Logic.

The company has been growing at a double-digit growth rate for the last several years. According to the company, the revenue growth rate for the last 10 years is 24% CAGR. Despite the Damocles sword of Apple hanging on its head, it has continued growing at a very fast pace with today's revenues more than 8 times that in 2008.

The balance sheet is pristine with no debt and total cash of nearly $400 million.

Further, the operating cash flow generation for the last two years has been $370 million and $319 million, i.e. around 20-24% of revenues.

The cash flow return on capital (adjusted for free cash) is nearly 40%. It is a clear demonstration of the kind of persistent competitive advantages that Cirrus enjoys in its market of audio chips for smartphones.

Further, the company has been actively trying to diversify its product portfolio. While traditionally it has been in the higher-end audio for smartphones, now it is being designed into mid-tier phones, too, in the Android ecosystem. The mid-tier opportunity, according to Cirrus, is in the range of $500M to $900M over the next 2-3 years.

Further, the trend of Android manufacturers to go for a complete glass interface with no buttons or holes and completely gesture-based navigation is being targeted by Cirrus to offer its own haptic solutions. The company hardly sees much competition in it, given the need for a solution with integrated DSP. In its opinion, it has an advantage over NXP (NXPI) as well in terms of an early lead in development while NXP was busy with the possible Qualcomm (QCOM) takeover.

Based on its estimations, the haptic drivers opportunity is somewhere between $170M and $450M.

Further, it has significant inroads in smart accessories, primarily, digital headsets and MEMS microphones. This opportunity is in the range of $400M to $900M. However, this is going a little bit slower than expected. Probably, getting pushed out beyond 2 years for a significant uptick.

Smart Home and Consumer Audio is another opportunity which is quite small today but should become worth a few hundred million dollars over the next few years. With the Amazon partnership in place, it puts Cirrus logic in the front seat. It is likely that the voice-managed smart home and other smart ecosystems could surprise on the upside with a larger-than-expected market size.

The revenue impact over the next 3 years could be a cumulative $700M or more. This implies an expected CAGR of around 15%. The margins are likely to be maintained and the outstanding stocks are likely to be reduced through repurchases. This would imply an expected EPS growth rate faster than that.

From FY 2021 onward, voice biometrics and other edge computing opportunities should start becoming relevant.

The above data points indicate a company that has a stable and fast-growing business which enjoys significant competitive advantages stemming from its technological expertise in low-power, low latency, audio and integrated DSP for small form factors such as mobile handsets.

The company has substantial growth opportunities in the mobile ecosystem and branching out into other non-mobile areas such as smart homes.

The strong cash flow generation of more than $300 million every year and the small capex requirements below $100 million make it a cash-throwing machine.

The most important question from an investment perspective is: Is the stock available at a significant discount to its intrinsic value?

The current market cap is $2.5B. It has around $0.4B in cash. Adjusting for the same results in an effective market cap of $2.1B.

With operating cash flow of $300M, Cirrus is available at an OCF yield of around 14% with an expected growth around 14-15%.

On an FCF yield basis, it is available at around 9-10% yield with an expected growth around 14-15%.

We think this is a highly attractive situation even after incorporating the risk of the "single, large customer." Of course, needless to reinforce that any investment into this stock cannot be on an isolated basis. A preferred position would be between 5% and 10% of the portfolio for investors who can understand and handle the risks involved.

Disclaimer: This is not a buy or sell recommendation. Readers should do their own research and analysis or consult a registered investment adviser from their jurisdiction before taking positions in any stocks or sectors mentioned above. Equity markets can cause complete loss of capital.

Disclosure: I am/we are long QCOM, AAPL.

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.

Additional disclosure: We are likely to go long the stock in client portfolios at some point in the future, since it's part of our Scientific Alpha AI Thematic baskets. This is subject to fundamentals and valuations not changing substantially unfavorably from the current situation.