Description

Cypress is a broad line semiconductor company serving a variety of end markets. Semiconductors, as a group, have been among the worst performing goups, so valuations are quite low.


VALUATION

Cypress has been around a long time, so there is a great deal of price history. Management has consistently pointed to the Price / Sales ratio as a good indicator of valuation. (P/S ratio is computed on the basis of annualized recent quarter sales. Price is used as a proxy for enterprise value, which will be discussed later.)

Over the past twenty or so years, the P/S ratio has been above 1.53 90% of the time. (Please refer to their latest website presentation for a graphical representation of this.)

The current P/S ratio, as historically defined, is

(125mm shares x $8.73) / (219.6mm * 4) = 1.24x

There are various reasons why this ratio may overstate the valuation relative to historical norms.

1.) Sales are projected to decline to $200mm in Q4, which the company believes will represent the bottom.

2.) There is net debt of about $200mm. Historically the company has not carried any debt, so one may wish to use an EV/S calculation instead of a P/S calculation.

In the interests of conservatism, adjusting for (1) and (2) above, yields an multiple of 1.62x.

In either case, valuation relative to historic averages shows an attractive entry point. In my mind, this is a necessary but not sufficient feature to recommend the stock.

Valuation is depressed because the base semiconductor business is under pressure. Earlier this year, the stock was selling as high as $23-24 on the basis of a healthy semiconductor business. The company is priced for a continuing malaise in the semi business, but to the extent the semi business recovers, there is considerable upside from the base business. As the valuation shows, there is probably relatively little downside from the basis business, barring some sort of extraordinary deterioration here.


CATALYST

Over the past two years, the company has invested in a number of complementary subsidiaries in the hopes of diversifying their revenue stream. One of these subsidiaries, the Sunpower division, is about to make a real difference.

Cypress originally purchased 57% of Sunpower at a bargain price, with an option to purchase the balance. They have recently elected this option and now own almost 100% of the company.

Sunpower manufactures solar cells which is a very complementary business because it is also based around silicon processing. The solar cell business is a $1 billion business that is growing about 30% per annum. Currently, it is an undersupplied market and the company can sell all it can manufacture. 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.

Solar cells can be used for a variety of applications, both on-grid and off-grid. Under a scheme known as "net metering", solar cells can even feed electricity back into the grid. Currently, the solar cell market is undersupplied.

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.

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 revenues from Sunpower are de minimus. Anticipated sales for 2005 are $113mm, although there is meaningful upside as the company is planning a more aggressive ramp.

Out year estimates are currently as follows:

2005: $113mm
2006: $150mm
2007: $250mm
2008: $400mm

Importantly, this is a very scaleable business with good economics. 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 3-4x sales. This would equate to a valuation next year as follows, based on annualized revenues of $150mm x 3 = $450mm, or almost $4 per share. This is highly significant for an $8 stock that is otherwise attractively priced.

Catalyst

Substantial growth in revenues from the Sunpower division as the new plant ramps up. These revenues will be separately disclosed and people will begin to assign a real value to this division. The company has considered monetizing the subsidiary as an IPO. This would not happen for a while, but is part of their thinking.