Bluetooth is in the early stages of adoption.  The first Bluetooth devices were shipped in 2003 and as we all know from our own experience Bluetooth is becoming ubiquitous.  CSR is the market leader.  The company claimed over 50% share of Bluetooth chip shipments in 2006 and close to 60% of design wins, up from 23% market share in 2003.  According to company statements, CSR’s market share was maintained in 2007 as the industry grew by around 33%.  Forecasters expect Bluetooth growth to continue, albeit at a slower rate, with one forecast projecting 1.8 billion units by 2012.  CSR management’s stated goal is 15-20% annual revenue growth and a target of $2 billion in revenues by 2012 with operating margins over 20%.

Of course I’m not suggesting we all become growth chasers and abandon our value-investing roots.  In fact, you don’t have to believe the growth story to see value in CSR. CSR shares, which trade on the LSE, are around 455 pence today, or $9.00 at current exchange rates.  With 135 million fully diluted shares outstanding, the market cap is $1.2 billion.  Subtracting net cash of $205 million yields an enterprise value of $1.0 billion.  Mr. Market is offering you CSR for 8.3 X 2007 free cash flow, which will have been around $120 million in 2007 excluding the patent dispute payment.  Unless you believe CSR’s ability to continue generating cash are in significant jeopardy, the current price seems like a very good entry point.

There are three risks to consider when assessing CSR’s future prospects and cash flows.

1)      The expected growth in Bluetooth applications doesn’t  materialize

2)      CSR loses market share to existing and new entrants

3)      Chip pricing deteriorates significantly, causing CSR’s margins to erode.

The first one gives me the least heartburn.  I don’t like wires and appreciate the value of Bluetooth in reducing the number of wires in my life.  I don’t know of a more consumer friendly technology for creating personal area networks than Bluetooth and I appreciate the nice job the Bluetooth Special Interest Group has done promoting the brand.  Bluetooth is more than mobile phones and headsets.  I mentioned the Wii.  Bluetooth is also being used in the Ford Sync system which is being introduced this year.  And the number of potential applications seems almost endless.  In short, Bluetooth technology is in the early stages of its life cycle and there seems little chance that the Bluetooth chip market will shrink in the medium term.  It may grow more slowly than market forecasters project, but it hard to see it shrinking.

The second risk is a greater concern.  CSR is the leading producer of Bluetooth chips.  Broadcom is #2 followed by a growing host of competitors including Texas instruments, Infineon, Atheros, and others.  Bluetooth went through a series of fits and starts before the technology was commercialized in 2003.  Now that the technology has gone mainstream, many chip producers want a piece of the action.  By virtue of its leadership position, I believe CSR has the technical skills, experience, and customer relationships to maintain a strong presence in the market, especially given the strength of the balance sheet and profit margins.  To protect market share, CSR spends 15% of revenue on R&D.  But I wouldn’t argue that CSR will face a more difficult competitive environment over the next five years and may lose some market share to the upstarts.  Of course Bluetooth is not the only arrow in CSR’s quiver.  In fact, 20% of revenues come from non-Bluetooth applications including Wi-Fi, GPS, and noise cancellation. 

The third risk is also a concern.  The price for Bluetooth chips has come down steadily over the past couple years.  Based on CSR unit shipments and reported revenues, it looks like the company’s average selling price has fallen from over $5 in 2003 to around $2 in 2007.  This is not surprising since prices typically decline as volume ramps up in the early stages of a product’s life cycle.  The offset of course is that manufacturing costs also come down with volume, as do fixed costs per unit (such as R&D and SG&A).   I would certainly expect prices and margins to come down further as Bluetooth chips become more of a commodity.  How far and how fast will be determined by the market.  For what its worth, management’s long-term goal is to maintain operating margins in excess of 20%. 

Bottom line: Even in the face of declining prices, CSR’s margins and free cash flow still look very strong in 2007.  Excluding the one-time payment to settle the patent dispute, the operating margin was just a shade under 20% of revenues and free cash flow was around15%.  While there is clearly uncertainty surrounding the future of CSR, I think the current price reflects all of the downside and gives no probability to a more positive outcome.  If in fact management can come anywhere close to their stated revenue target of $2 billion by 2012 and remain cash flow generative, the upside is an easy double in CSR’s share price.  While not overwhelmed, I’m also glad to see CSR’s chairman bought 55,000 shares at 599 pence per share in December 2007.

Catalyst