Actions Semiconductor is a cheap (20% free cash yield in ’07 and 14% LTM), high growth, high ROIC company, with minimal capital requirements that conservatively offers 50% upside.

 

ACTS is a fabless semiconductor company based in China. It is the dominant provider of low end systems on a chip (SoC) solutions to the MP3 and personal media player (PMP) market.  Being fabless, its main focus is on R&D/product development, so it has virtually no capex.  ACTS has great customer relationships because it is known for hand holding with the lower end OEM’s that are not that technologically sophisticated, so that the OEM’s can add more functionality and get their product to market quicker.  ACTS accomplishes this with a flexible architecture, using digital signal processors (DSP), which allows customers to port new applications and software quickly and easily.  The competition for the most part use application specific integrated circuits (ASIC), which usually require the entire semiconductor to be redesigned to add any functionality.

 

ACTS does very little business in the US where brand name products dominate the marketplace.  In the rest of the world, where ACTS focuses, more generic type MP3 players are prevalent.  Some of ACTS major customers are Aigo, Tomy, Lenovo, Zarva, Thomson, Hyundai, NEC.

 

I realize that this website isn’t called Growth Investors Club, but the secular growth is compelling and who doesn’t like getting growth for free?  Market forecasts for NAND Flash based MP3 players are for 20-25% growth through ’09 to 231 million units, and that the PMP market will grow from 18 million in ‘06 to 88 million units in ’10.

 

ACTS is predominantly an MP3 SoC provider at this point.  It is currently making inroads in higher end areas, like the PMP market, by offering SoC’s with better video functionality.  It will also be developing solutions for MP3 player phones, as well.  ACTS management realizes that they have to broaden their product portfolio to maintain their margins and growth rate.

 

Having a dominant position and a fabless business model results in great economics.  ‘05’s ROIC was 56% and LTM 39%.   In ’05 ACTS converted 97% of net income into free cash.  Not bad considering that net income and revenue grew 178% and 161%, respectively. 

 

ACTS should ship almost 77 million units in ’06, which is 40-43% market share, based on industry projections of 180-190 million units.  This is substantial, considering that the iPod (which ACTS is not designed into) makes up about 20% of the MP3 market, so of everything else ACTS controls more than ½ of the non iPod market.  Within China it is estimated to have 70-80% market share.

 

ACTS is the low cost producer.  Engineering costs in China are 1/10 of what they are in the US and 1/3 of what they are in Taiwan.  All manufacturing is outsourced, predominantly to Hejian Technology.  ACTS is also driving down costs through line width shrinks with its foundry partner and is transitioning from .25 micron to .18.  About 50% output is at .18 now, which should help support margins.  As a result, ACTS’s operating margins are about 20% better than its peers.

 

 

 

ACTS currently enjoys a very low tax rate at 7.5% since the Chinese government was trying to encourage technology investment.  Eventually its tax rate will rise, but the timing and level are uncertain.  It is possible that in ’08 and beyond the tax rate could rise to the mid-teens to 30%.

 

Also keep in mind that ACTS will generate roughly $100 million of free cash flow in ’07, so there will be another $100 million on the balance sheet.

 

Longer term, ACTS expects 30% industry unit growth and 20-25% ASP erosion per year for the foreseeable future.  Due to product innovation it expects to be able to grow units at 35-40% with lower ASP declines.

 

Asian consumer electronics semi stocks (Mediatek, Sunplus, Sonix, Silicon Motion, Novatek, Himax) trade anywhere from 11-19x ’07 EPS, with the average about 15x.  One could argue that ACTS deserves a premium since none of these competitors enjoys as strong margins or competitive position, and ACTS trades in the US.  ACTS should trade at the low end of the peer range at the very least, which would equate to $12.75.

I don’t normally invest in stocks just because they are going to “beat” earnings, but I think that a strong case can be made for ACTS results to be considerably better than the current consensus in ’07.

 

New distribution deals will increase market share in ‘07.  ACTS has been picking up more and more distributors, which an integral part of its strategy to take share globally.  ACTS had been using many smaller distributors, but recently has announced agreements with 2 large distributors, World Peace Industrial and GMI Technology.  GMI Technology named ACTS its sole supplier of SoC’s, which is a major blow to SGTL, which did roughly 18% of its revenue through GMI.  World Peace Industrial is the #1 distributor in Asia and #3 globally.  It was also an important distribution channel for SGTL.  It ships about 1 million MP3 SoC’s per month, so in the back half of ’07 this could potentially add $20 million or revenue on a run rate basis.  Both of these distributors give ACTS access to new geographies and new, larger customers. 

 

New products will also provide upside to consensus estimates.  The 13 series will offer a higher end product for the PMP market than ACTS already offers, which equates to higher margins.  It will support storage of over 2GB of flash and will use be compatible with the prevalent open standards of software for video in usage today, so it will open new markets to ACTS.  The 13 series is already beta testing with customers and should be in volume by the second half.

 

ACTS was subject to an exclusionary order by the ITC that barred it from selling one of its product lines in the US (I will address this in more detail in the “Risk” section), but the introduction of its 7500 and 9 series will allow it to re-enter the US market, which would be additive to projections.

 

SNDK is trialing ACTS SoC’s.  Not only would a customer win like this boost numbers significantly, but it would validate ACTS’s technology and value proposition through a win with a tier 1 OEM.

 

Pricing in the NAND Flash market has been weak and is expected to deteriorate further.  Cheaper flash means cheaper MP3 players, which should catalyze demand for ACTS’s products.

 

The industry is highly competitive and ACTS relies predominantly one end market at this point.  Any company that boasts ROIC and growth rates like this is bound to attract attention and invite competition.  ASP erosion is a fact of life in all segments of the semiconductor industry.  The successful competitors are the ones that engineer costs out of the product the quickest.  As I mentioned earlier, ACTS is the low cost producer.  SGTL, PLAY, Samsung, and Telechips are ACTS’s main competitors.  SGTL is on the ropes.  PLAY is losing share.  Samsung is a formidable competitor though. 

 

Hejian Technology is ACTS’s primary foundry, so ACTS relies on Hejian for the vast majority of its product supply.

 

ACTS has been involved in patent litigation in the past.  On 9/15/06 the ITC ruled that ACTS’s 207X, 208X, and 209X infringed on SGTL patents.  As a result, the ITC barred ACTS from selling these products in the US.  There were no damages awarded and the exclusion order has not had much impact on ACTS’s top line.  US sales are probably 5-10% of total and the product lines in question are being phased out.  The risk is that SGTL tries to pursue a similar outcome in Europe.  However, as I mentioned before SGTL is troubled and going through a management transition, and ACTS is migrating to newer products that do not infringe, so I do not think it is likely that SGTL will bother, especially because by the time anything could be done in Europe the 207X, 208X, and 209X would be basically obsolete anyway.  In a shrewd bit of strategery, ACTS actually sued SGTL for patent infringement in China, so litigation could actually turn out to be a positive.

 

ACTS shareholders include many esteemed value investors.  Just take a look at the top 3 holders: 1) Janus 2) Stratix Asset Mgmt 3) SAC.  Uh… ok so these guys aren’t exactly value investors.  Some of you snarkier VIC members might not consider them investors at all.  Nonetheless, these are smart guys (Janus aside) who know their stuff, but I would caution that if they decide to exit en masse, it could end up looking like the 3 stooges trying to walk through a doorway at the same time, so I’d be remiss if I didn’t mention this as a risk, even though it does not relate to the fundamentals.