Value Play: Lattice Semiconductor (Nasdaq: LSCC)

Back in August I recommended Silicon Image (SIMG), a technological — and intellectual — leader in high-speed data connectivity, with over 500 patents. The company’s intellectual property is a “picks and shovels” play on the “Internet of Things” which is a huge market opportunity over the coming decade, perhaps the biggest market opportunity in human history. It turns out that I was not the only investor bullish on Silicon Image’s future. On Tuesday, January 27th, Silicon Image agreed to be acquired by Lattice Semiconductor (LSCC) for $7.30 per share in cash.

Although I’m disappointed that the management team at Silicon Image agreed to sell the company for such a low price, the fact remains that Roadrunner subscribers who bought the stock at the time it was recommended in August 2014 enjoyed a profit of almost 50% in less than six months. My next thought was how lucky Lattice Semiconductor must feel to be able to purchase Silicon Image at such a bargain price. And then it dawned on me that perhaps I could still reap the full value of Silicon Image’s investment potential by purchasing  its acquirer, Lattice Semiconductor! The two companies are of similar size, so it’s not like the growth of Silicon Image’s business would be unable to “move the needle” of a much larger parent. In fact, if the two companies were human, they could easily be mistaken for siblings:

Lattice Semiconductor and Silicon Image Have Similar Financials

* Lattice is incurring $350 million in debt to acquire Silicon Image, but this debt will only constitute about one-third of total capital (shareholder equity plus debt), which is very reasonable and still reflects a strong balance sheet.

My one reservation was the elevated price of Lattice Semiconductor, which had outperformed the Nasdaq and S&P 500 over the past year on stellar financial results:

Lattice Price Performance and Valuation: What Difference a Few Days Make!

Like manna from heaven, Lattice Semiconductor’s stock price has dropped 16.5% since the takeover announcement and is now a real bargain compared to its future business prospects. The reason for the price drop was the release of fourth-quarter financials which missed analyst estimates for both revenues and earnings. The misses were trivial and temporary and traders overreacted, which is great news for long-term investors such as Roadrunner Stocks. As Lattice CEO Darin Billerbeck stated in the Q4 press release, the 2014 fiscal year saw solid growth with much more growth to come in future years:

Revenue for the full year 2014 was up 10.1% and EPS was up 110.5%, as compared to the full year 2013, while gross margin improved to 56.3%, as compared to 53.6% for the full year 2013. This growth directly reflects our successful execution, operations focus, and the breadth and diversity of our customer base. Over the last twelve months, we have introduced next generations of all our key product families targeting the consumer, communications and industrial markets, enhancing our already strong product solutions portfolio. Most importantly, we continue to execute on the major strategic and operational initiatives designed to further accelerate our market penetration, and drive our revenue and EPS growth in the coming years. We are creating a global leader in wired and wireless connectivity solutions, while building value for all of our shareholders.

Profitable Niche in Logic Chips Among Giant Competitors

Lattice Semiconductor’s business focus is programmable logic devices (PLDs), which manage the interchange and manipulation of digital signals within a computer system. Its two much-larger competitors are Xilinx and Altera, but Lattice competes successfully against these PLD giants not by going head-to-head, but by finding profitable niche markets that the big boys don’t focus on. During last year’s second-quarter conference call in July 2014, CEO Billerbeck explained the company’s strategy:

I am often asked what is our long-term goal at Lattice; is it the catch with Altera and Xilinx? No. Short-term positioning the company for a sale? No. Our goal is growth, to grow Lattice into $1 billion company over time. We believe this is the best way to drive continued shareholder value. To achieve this goal, we must have the right strategy. So what’s our strategy to get to $1 billion revenue over time? We need to go even bigger in consumer; additionally, we need to double our industrial and our communication business; and finally, we need to buy something.

Lattice’s revenue breakdown by end market is as follows:

Source: Lattice-Silicon Image Merger Presentation (slide no. 11)

Most of Lattice’s sales are to Asia customers, which primarily means China and includes the build-out of China Mobile’s 4G LTE mobile networks and supplying the low-end smartphone market.

Google and Cisco Systems are Providing Lattice With Big Profit Opportunities in Mobile

But Lattice also has won business from high-end U.S. customers such as Google, which selected Lattice to supply PLDs for its “Project Ara” modular smartphone initiative. With a modular platform, you can pick the camera you want for your phone rather than picking your phone for the camera. Google’s goal is to provide smartphones to the 5 billion people who don’t have one yet, which provides a very large market opportunity for Lattice.

Another large market opportunity for Lattice involves small-cell wireless base stations to improve performance of high-speed 4G cellular networks. According to WinterGreen Research, the market for small-cell base station will growth from $420 million in 2012 to $5.98 billion in 2019, an annualized growth rate of 46.1%. The tremendous growth forecast is due to the fact that “there is no other way to build out wireless data infrastructure in an economical manner.” In May 2013, Cisco Systems acquired U.K.-based Ubiquisys , a leader in 3G and LTE small-cell wireless base stations, and in July 2013 Qualcomm established a partnership with Alcatel-Lucent for the  purpose of developing small-cell wireless base stations.

FPGA is the New Thing in Logic Chips and Lattice is the Leader

Lattice is perfectly positioned to win business in the small-cell space because its market leadership in field-programmable gate arrays (FPGAs), which are specialized PDLs that offer many advantages over traditional PDLs, including:

• Lower cost
• Lower power
• Smaller size
• Performance and capacity improvement of between 50-100 percent.

Right now, Lattice’s production is two-thirds traditional PDLs and one-third FPGAs. Both are important for the company’s future growth, but I am most excited about the new, creative uses for FPGAs. As CEO Billerbeck stated back in October during the third-quarter conference call:

We’ve broken the FPGA rules by offering programmable solutions that are low power, small form factor and extremely low cost. We’ve opened new markets that never existed for FPGAs and continue to find new opportunities every day. Fast and first to market where it matters the most. When I look back at 2014, we have achieved everything we’ve said and more. We continue to be bullish on building the world’s best programmable solutions and opening up more markets that traditionally haven’t used FPGAs due to their cost, size and power. I can’t be more proud of our team, our brand and the opportunities in front of us.

According to Wall Street semiconductor analyst Ian Ing of MKM Partners:

We continue to believe LSCC is favorably exposed at Cisco-Ubiquisys. However, disruptive forces to deliver more efficient telco bandwidth and capacity (including small cells) is a longer-term headwind to Altera and Xilinx, as the FPGAs play best in large, lower volume equipment implemented with specialized hardware.

Combination of Lattice with Silicon Image is an Unbeatable One-Stop Shop Category Killer

Lattice had a great future in profitable niches for data connectivity as a stand-alone company, but its future is beyond great when combined with Silicon Image’s consumer-focused technology and patent portfolio. When you combine Lattice’s FPGAs with Silicon Image’s Application-Specific Standard Products (ASSPs), you’ve created a one-stop shop for the full array of data-connectivity products in both consumer and enterprise, early adopters and mainstream users. The merger presentation provides all of the juicy integration benefits, but I’ll focus on the following:

• Slide nos. 13-14: At least $32 million in synergistic cost savings within one year of transaction close. Given that Lattice has 118 million shares outstanding, $32 million in extra profit amounts to $0.28 per share. After removing a one-time, non-recurring tax benefit in the full-year earnings for 2014, Lattice earned $0.30 in 2014, so an extra $0.28 in earnings per share from synergies will literally almost double the company’s profitability!

• Slide nos. 5 and 10: Lattice’s FPGAs enable design flexibility and fast time to market, whereas  Silicon Image’s ASSP’s are standard, mainstream components that capitalize on long-term relationships and usage. Putting both products under one roof will enable Lattice to capture the full spectrum of a customer’s data-connectivity needs and generate much-higher lifetime revenues from each customer.

Lattice is Perfect Combination of Cheap Valuation and Growing Earnings

Last month in reference to Rayonier Advanced Materials, I wrote that the best time to buy a stock is when business conditions are depressed and valuations are low. Let me amend that by saying an even better time to buy a stock is when business conditions are good and improving and yet valuations are low. Lattice’s business grew nicely in 2014 and 2015 looks even better with the Silicon Image acquisition and the expected strong comeback in the consumer business segment, yet the stock is cheap and trading near its 52-week low! Core earnings are forecast to rise at least 34.5% in 2015 and yet the stock is trading at rock-bottom enterprise value-to-EBITDA ratio of 7.2 times that is near five-year lows. Other valuation measures are also below Lattice’s five-year average levels.

I think the disconnect between Lattice’s undervalued stock and its bright future earnings prospects is based on investors mistakenly focusing on Lattice’s past erratic financial results. Looking a the past 10 years, Lattice has not exhibited consistent earnings growth. But the past is definitely not prologue for Lattice. Lattice has completely transformed itself and successfully adapted under a new management team led by current CEO and 18-year Intel veteran Darin Billerbeck since November 2010. Now is the perfect time to invest in Lattice.

Lattice Semiconductor  is a buy up to $8; I’m also adding the stock to my Value Portfolio.

Value Sell Alert

To make room for Lattice Semiconductor, Roadrunner is selling:

• Silicon Image (SIMG)

I have seen no sign that a higher offer will materialize for Silicon Image, so it looks like the $7.30 per share offer from Lattice Semiconductor will be the winning and only bid.  Consequently, with Silicon Image currently trading at $7.25, there is only a nickel per share of potential upside in the stock if the takeover occurs as expected by the end of March. It is not worth waiting around 30-45 days to receive an extra nickel per share, so I”m recommending a sale of SIMG and using the sales proceeds to buy into LSCC, which offers exceptionally high appreciation potential both from its own field-programmable gate array (FPGA) business and the soon-to-be-acquired Silicon Image high-speed 60GHz “WiGig” and mobile high-definition link (MHL) data-connectivity businesses, which are both involved in the “Internet of Things.” Although I think Silicon Image sold itself too cheaply, the good news is that Silicon Image has appreciated in price by almost 50% since it was recommended by Roadrunner Stocks back in August (less than six months ago).

Silicon Image is being sold from the Value Portfolio.

Momentum Buy:

The Ensign Group (Nasdaq: ENSG)

The Ensign Group provides a broad spectrum of skilled nursing and assisted living services, physical, occupational and speech therapies, home health and home care services, hospice services, urgent care services and other rehabilitative and healthcare services at 143 facilities in 12 Western and Midwestern states.

The company is a holding company with no direct operating assets, employees or revenues. It operates through wholly-owned subsidiaries, which provides for better managerial decision-making at the local level.  It’s specialty is acquiring under-performing health-care properties at a discount and then improving operations and profits. In June 2014, the company spun-off a real-estate REIT which took almost all of Ensign’s debt with it, so Ensign’s balance sheet is now much stronger.  On February 11th, the company priced a stock offering at $41 per share, which has temporarily caused the stock price to decline, but such price dips turn out to be excellent purchase entry points.

• Price gain between 12 months ago and 3 months ago = 93.47% (100th percentile)
• Price gain over the past 2 months = -3.59%
• Price gain over the past month = -4.40%
• Roadrunner Momentum Rating: 93.47 – (-3.59) – (3*-4.40) = 110.27

The Ensign Group is a buy up to $48.50; I’m also adding the stock to my Momentum Portfolio.

Momentum Sell Alert

To make room for the new momentum stock, Roadrunner will be selling the following price laggard: 

• Autohome (ATHM)
  
  The economic slowdown in China is hurting Internet advertising which is the main source of revenue and income for automobile information websites like Autohome. Although Autohome and Bitauto are similar companies, I’ve decided to keep Bitauto because it has a stronger relationship with auto dealers and can generate profits from services offered to the dealers even if the Internet advertising revenue from consumers drops off. In contrast, Autohome is more of a one-trick pony with no profit drivers other than Internet advertising.  Consequently, Autohome is the stock to sell.