Cypress Semiconductor Corp. CY
April 24, 2005 - 3:16pm EST by
cherb405
2005 2006
Price: 12.80 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 1,644 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

In October 2004 I first recommended CY at $8.73. Since then, it has traded as high as $14.92. Over the past month it has corrected, even as the company has announced an important fundamental development that will limit downside and provide the catalyst for significant upside.

My original recommendation was based upon two premises:

1.) the base business was solid, but at a cyclical trough, with valuation to match.

2.) the Sunpower photovoltaic solar cell subsidiary was an undiscovered gem with substantial growth prospects.

At the time of my original report, the Sunpower division was all but ignored by the street analysts. On their conference call last Thurday, Cypress announced that it would explore an IPO of the Sunpower subsidiary. I believe this IPO will command a very significant valuation and be a very potent catalyst for higher prices.

Below, I am reprinting some of my original report with updated numbers and additional commentary.


VALUATION

Cypress stock has advanced 47% since my recommendation, so obviously it is not as cheap. I still there is a great deal of potential appreciation because fundamentals of the base business have bottomed, and the IPO of Sunpower is on the horizon.

Management of Cypress has consistently pointed to the Price / Sales ratio as a good rough-cut metric for assessing CY share price. About 90% of the time, P/S (computed on an annualized latest quarter basis)is 1.53x or better. About 50% the P/S is 2.3 or better. You can use whichever figure you want, but for the purposes of this write-up I will use the median P/S ratio of 2.3. CY is at a cyclical trough in sales, and a higher P/S ratio is probably intellectually justified. Fundamentals for CY base busines (SRAMS, clocks, UBS, etc.) are probably bottoming right in here. Q1:05 likely represented the bottom, tracking to the lower end of the range, and Q2:05 is projected be modestly higher. This is a cyclical business and Cypress has good market share. As the industry recovers, Cypress will participate. Channel inventory is clean and end demand is starting to recover. Like all cyclical businesses, there is nothing to get excited about at the bottom, unless of course you have a value orientation and a reversion to the mean outlook. It's also worth noting that CY shares sold about twice this level a year ago, largely on the strength of $1.00+ earnings estimates for the base business which, of course, didn't actually transpire.

Therefore, in light of the above, this is how I would value the base business.

Last quarters CY base revenues = $190mm

So, ($190mm x 4 x 2.3) / 128.5mm shares = $13.60

You can value it higher or lower depending on your tastes, but this is a reasonable level from a historical perspective.


Now, let's throw Sunpower into the mix. As discussed management has announced that it is going to IPO Sunpower. This was an announcement that I had expected about a year from now, but evidently things are moving faster there than I had expected. In a sign that the company is throwing a lot of resources and talent at Sunpower, Manny Hernandez, the current CFO, will shift to become CFO of Sunpower. Current timing would seem to indicate a Q4 debut for Sunpower.

Sunpower manufactures solar cells which is a very complementary business because it is also based around silicon processing. It is a very synergistic business as Cypress will bring a great deal of the manufacturing and process skills to this business. The solar cell business is a $3+ billion business that is growing about 30% per annum. Currently, it is an undersupplied market and the company can sell all it can manufacture. As proof of this, even though Sunpower revenues were just $11mm in the most recent quarter, it recently signed a 5-year supply agreement with the German company Solon which will amount to over $300mm worth of product over that period.

Importantly, the company has the most efficient solar cell on the market with a 21% efficiency rating, versus a theoretical maximum of 25%. Most market peers are at a 15-17% efficiency. Go to the "Product Archives" section at www.analogzone.com for a more thorough review of the Sunpower product.

Solar cells can be used for a variety of applications, both on-grid and off-grid. Under a scheme known as "net metering", solarcells can even feed electricity back into the grid. Currently, the solar cell market is undersupplied and this situation is not likely to change in the near future.

The company has purchased and converted a plant in the Philippines to manufacture these solar cells. Currently, there is building in place to support $300mm of annual sales. There is equipment in place to manufacture 25 Megawatts of solar cells which should yield in excess of $75mm in revenues. The company is accelerating plans to install an additional 25MW of manufacturing capacity. And now it has announced a third 25MW expansion.

The company has essentially presold all its production for 2005, so the only real issue is getting yields to ramp to acceptable levels. Because the company has routinely manufactured silicon circuits that are two orders of magnitude more complex, this should not be a problem for them.

Current economics are roughly as follows:
Cost to install 25MW = $30-35mm
Revenues from 25MW = $75+mm
Operating Margin = 20%
Operating Profit = $15mm
First year ROI = 50%

The solar energy business is rapidly growing, but the economics still do not match mainstream electricity generation. As the economics converge over time, I would expect an important inflection point in the growth rate of the solar cell business. Without a doubt, high oil and gas prices are helping to converge the two.

With an operating margin of 15-20%, and an industry growth profile of 30% per annum, I believe that Sunpower can be worth at least 5-6x sales, which is up from my previous estimate of 3-4x sales. The important thing to understand here is that this is a very scaleable business with very signficant and open-ended growth prospects.

There are not a lot of pure play solar companies and I suspect this will be a very hot IPO. Even though the share prices of many alternative energy pure play are down sharply, they continue to sell at valuations tha frankly mystify me. One comparable is likely to be Evergreen Solar (ESLR) which sells at about 4x 2006 revenue estimates. ESLR is a much more marginal company with a small balance sheet and far less invested capital. It is unclear to me how they will ramp to $100mm in sales with a great deal of additional investment, which can only be done by accessing the capital markets.

Current Sunpower revenue estimates for 2006 are between $200 and $250mm, yielding a potential IPO in the $1 billion range, or $8 per share range.

Therefore, when we look back at CY as a whole, we get:

CY BASE BUSINESS = $13.60
SUNPOWER IPO = $ 8.00

for a total value of $21.60 or so. In my opinion, the base business has significant room for improvement as well. Sunpower has the potential to be a much much larger business in the next 3-5 years as well. It is a very open ended story with attractive economics and a compelling raison d'etre.

Catalyst

IPO of Sunpower subsidiary. Management doing roadshows starting Monday or Tuesday. Not sure exactly when and where and for how long, but I do know that Lehman is bringing them to NYC on Tuesday.
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