Description

I believe Emcore (EMKR) represents a compelling long opportunity at current levels.

• Company has executed extremely well over a multi-year period since new CEO came in 3+ years ago
• However, there have been some hiccups the last couple quarters, which have hit the stock and created the current buying opportunity – I believe these issues have been well-explained and are temporary
• Near-term street numbers are likely too low – stock can more than double near-term if they execute to their guidance and one puts a reasonable multiple on EPS run-rate a couple quarters out (potentially $0.80 annualized EPS)
• The industry backdrop in the their biggest current end-market (CATV) seems healthy
• They have a large nascent growth opportunity in Defense that can double the size of the company over a multi-year time horizon along with providing a margin uplift; at the current stock price, you essentially get a free call option on this business
• Management has been shareholder-friendly in recent years, returning capital in buybacks and a large one-time dividend; they may start buying back stock again soon
• Stock has solid downside protection from current levels: over 40% of market cap in cash (and not burning cash), trades only modestly above TBV, has huge NOLs

What do they do?

At its core, EMKR focuses on mixed signal optics chips and deploys this core technology in various applications. The vast majority of its business is products that go into the cable TV (CATV) end market, but they also serve satcom, wireless, navigation/defense, and telecom networking. EMKR uses its indium phosphide wafer fabrication facility in CA as the basis for producing all of its products. In general EMKR focuses on production of the core chips using their own fab, while outsourcing a lot the construction of full components and subsystems to either their facilities in China or to external partners. They break out their business in 3 product lines:

• Broadband (CATV, satcom, wireless)
• Chip Devices (serves telcom/datacom)
• Navigation Systems (serves defense)

For CATV (79% of FY17 revenue and the bulk of their ‘broadband’ segment), and without getting into too much detail, EMKR’s wide range of fiber optic transmitters, receivers, amplifiers, switches, lasers, etc “comprise a complete end-to-end CATV system” (as they state it).

For everything else (21% of FY17 revenue), satcom and chip devices have been the largest, but navigation (more below) represents the biggest potential revenue opportunity.

I go into more detail on the CATV and Navigation pieces of their business below.

New Management & Improved Fundamentals

EMKR essentially went through a wholesale leadership change starting 4 years ago, which was catalyzed by an activist investor (Stephen Becker).

And financial performance has improved dramatically since…

Note that EPS here (and below) is non-GAAP (adds back SBC) and is untaxed. The company has $425M in NOLs (discussed more below) so they will not be a cash taxpayer for the foreseeable future.

The improved financial performance has been both due to internal actions taken and growth in the CATV market:

• When the new CEO came in (he had previously been with the company ~15 years earlier), he worked on re-building customer relationships that had been damaged largely due to missed delivery deadlines. Much of the revenue growth seen in FY15 is attributable to regaining lost market share.
• There was a strong focus on cost controls – as can be seen, OpEx was held nearly flat as revenue more than doubled over a 3 year period. 4 facilities were consolidated down to 2. Headcount was reduced by roughly 1/3.
• The company did begin to benefit starting in FY16 from growth in CATV driven by the industry’s DOCSIS 3.1 rollout.

Altogether, under new management revenues more than doubled while they went from large losses to healthy profitability. While there have been some issues the last couple quarters that have hit the stock (addressed below), the company has executed quite well under current management over a multi-year period.

Recent results – some disappointments

Despite the strong multi-year performance, recently the company has had some hiccups, resulting in the stock being down over 50% from its 52 week high. Each of the last two quarterly reports have been accompanied by weak forward guidance:

• Q417 report in December 2017: The company guided Q118 (Dec ’17) revenues below consensus (~$25M vs consensus ~$28M & actual finally came in at $24M). The reason given for the shortfall was that they were discontinuing one CATV product line (RF on Glass, or RFoG) because pricing/margins had made it uneconomic – EMKR margins had likely fallen sub-20% versus mid-30% corporate average so they got out. Basically they were sharing large pieces of product margin with both the OEM and the distributor due to the product being co-owned by all 3 (an unusual situation that was unique to this one product). They are qualifying a replacement that they alone own and they believe can have around corporate average margins; they should start to see revenue here in Q3 (June ’18 quarter), and get back to a more normalized run-rate by Q4. This product had been doing over $4M/qtr (was ~$18M in FY17), so this was a big revenue hit. They should be able to get most of the revenue back once the new product is qualified.
• Q118 report in February 2018: Again, they guided forward (Q218) revenues below consensus (~$22M versus ~$27M). The reason for the expected continued decline in revenues was another issue in CATV (also expected to be temporary in nature). In this case, one CATV customer (I believe ARRS) is going through a manufacturing facility consolidation. In doing so, they saw that across facilities, they had too much inventory. EMKR’s understanding is that this inventory correction will take about two quarters to work through. I estimate the impact of this is about another $3M hit per quarter through Q3 (June ’18 quarter) on top of the RFoG issue.

So together, these two issues explain roughly a $7M-$8M decline in quarterly revenues that they’re currently seeing (revenue trough should be in Q2), taking them down from ~$30M/quarter in revenue to the low $20Ms. And, as a result, the stock has been marked down about 50% off its 52 week highs (with the EV down by more like 2/3).

FY18 Guidance - Street Consensus Seems Too Low

It’s interesting that while management does not give formal revenue guidance out beyond one quarter, in the most recent call, they gave enough data to triangulate in on a full year FY18 revenue number. My discussions with the company about this indicate that this was not accidental/unintentional and they agree with the math below. The implied revenue number based on the guidance data points they’ve given is MUCH higher than where the newly lowered street numbers are. The street has clearly set a low bar after a couple misses. Here are the data points they gave and how it translates into an implied full year estimate (all from the recent Q118 earnings call):

• 79% of FY17 revenue was CATV, this % is expected to be 63%-67% in FY18
• CATV revenue, in $ terms, is expected to decline by $23M-$27M Y/Y in FY18
• Q218 Revenue $21M-$23M
• R&D in $s flat to up from Q1 through balance of FY18, SG&A to trend down
• Expect to exit FY18 at 15% non-GAAP EBIT margins

Here is how I’ve penciled out the quarters to match the implied annual revenue guidance (Q1 is actual, Q2 has been specifically guided to on the top line):

Street consensus numbers (4 analysts) are:

As can be seen, taking guidance at face value suggests the company can roughly double consensus EPS in 2H18 and exit the year at a $0.80 annual EPS run-rate. Clearly very attractive on a $5.50 stock with $2.30/shr in cash. Using a 15x multiple on that Q4 run-rate and adding in the cash, yields a $14+ stock.

The obvious question here is whether this revenue ramp from ~$22M in Q2 to mid-$30Ms in Q4 is reasonable. My take is that a normalization of CATV revenue puts them back in the neighborhood of $30M (they’ve done low $30Ms in quarterly revenue going back to early CY17). At the Needham conference in January, the CEO talked about growth in Chip Devices of around 100% Y/Y in FY18 (off a few $M/qtr base) and growth of several hundred percent in Navigation (Q1 was ~$1M), so the pieces seem to be there for guidance to be achievable (i.e. achieving that mid-$30Ms revenue level by Q4), though they obviously have to execute well. Given the delta between guidance and where the street is at, they should at least have some margin for error in exceeding consensus. Obviously there is a fair amount of speculation here on my part. The main point here is that this is what the company is guiding to and it’s way ahead of the street. From the outside, it’s impossible to know for sure everything they see in how they’ll get there, but I like the seemingly low bar that’s in place for them.

CATV Market

Given that CATV is still expected to be in the neighborhood of 2/3 of revenue in FY18, it will remain the biggest driver of the business overall in the near term, for better or worse. The biggest driver right now for CATV infrastructure spend is DOCSIS 3.1, where I believe we are still in the early innings. To assess some industry numbers, we can look at both EMKR’s CATV customers (equipment OEMs) and cable MSOs.

EMKR has consistently had two large OEM customers for their CATV products, ARRS and CSCO, with ARRS being somewhat larger. Together the two have historically represented 75% or more of EMKR’s CATV revenues. Given ARRS is more of a pure play into cable MSOs (CSCO is far too diversified to yield any read-through on EMKR’s CATV business), ARRS’s outlook is probably the most instructive to look to for trends in EMKR’s CATV business. Current estimates call for ARRS to grow revenues by 9% Y/Y in CY18, indicating a healthy backdrop in CATV.

We can also look at CapEx expectations for the major cable operators. The biggest drivers of industry spend (as I understand it) are shown here (Comcast/Charter in N.A., Liberty Global in Europe):

The cable CapEx numbers create a somewhat mixed picture with Charter/Liberty, in aggregate, relatively flat, and Comcast appearing to decline. When I’ve dug into Comcast a bit, what I’ve learned is that the bigger piece of the CapEx decline is in CPE (customer premise equipment, or set-top boxes) rather than infrastructure (what impacts EMKR). Taken together, I’d characterize the environment in cable as likely flat to very slightly down in CY18.

Taking into account both the expectations for ARRS and the cable operators paints a mixed, perhaps very modestly negative picture, but nowhere near as negative as EMKR’s communicated expectation for a ~25% decline in their CATV business in FY18 (due largely to the couple issues already discussed), suggesting EMKR should be much more likely to see a meaningful upward reversion in their CATV business from currently depressed levels rather than a further erosion.

Navigation/Defense Opportunity

The Navigation/Defense opportunity is relatively nascent for EMKR yet it represents a very large opportunity relative to the current size of EMKR’s business. It currently is less than 5% of revenue (I believe it is essentially all one program currently), but is expected to grow by a “couple hundred percent” in FY18 vs FY17. EMKR is leveraging its core mixed signal optics technology to sell FOG (fiber optic gyroscope) technology to be used for navigation in various defense applications. Basically, the background here is that in sensitive defense applications, traditional GPS technology is insufficient because it can too easily be denied/”jammed”, thus the need for fiber optic gyro technology. Currently, EMKR is the only merchant supplier selling FOGs. While all defense OEMs produce products (autonomous vehicles, missiles, etc) that utilize the technology, currently NOC and HON are the predominant producers of FOGs. Thus, other defense suppliers are often in the odd position of having to acquire this technology currently from one of their competitors. The opportunity for EMKR is thus to supply to RTN, LMT, BAE Systems, etc. This is approximately a $1.5B TAM, with about half available to EMKR (i.e. non-NOC, HON programs). It will take some time to keep winning programs to move toward the multi-year goal of this being on the order of a ~$100M business (similar size to CATV is a stated multi-year target), but the progress disclosed so far is:

• Have finalized the first year of what should eventually become a 5 year sole-source deal with Raytheon (MTS-B program) – the one year deal gives them ‘excellent visibility’ for FY18 – I believe that as of the December quarter (Q1) this represented essentially all of their Navigation revenue (~$1M in the quarter). Previously FOGs had been supplied by NOC to the MTS-B program, but EMKR has now taken this business.
• Starting to ship FOGs to another Tier 1 defense prime contractor in the March quarter.
• Expect to deliver prototypes of airborne IMUs (Inertial Measurement Units) in FY18 – they expect this to become a “multi-year mid 8-figure program.” IMUs are a set of 3 FOG units along with some other technology, so a much higher per unit ASP.

At this point, this business is too small to move the needle much in the near term, but over a couple years can represent a meaningful revenue growth driver at above corporate average GMs. Achieving their multi-year goals here in terms of revenue scale could represent a “home run” scenario for the stock and at the current valuation, I’d argue you’re basically getting a free call option on this business.

Shareholder-friendly capital allocation

• Over the last several years, the company has returned $84M to shareholders (post the sale of several business units)
• $45M in dutch auction tender in June 2015 @ $6.55/shr
• $1.50 special dividend in July 2016 ($39M)
• Also, one other interesting thing of note that has been poorly disclosed, i.e. not in filings or transcripts is that they’ve been restricted from repurchasing shares for a 3 year period post the June 2015 dutch auction tender offer when they bought back $45M of stock (explained as a 382 issue). So essentially in 4 months from now, they will be able to repurchase shares again. This was stated last month in a presentation at the Needham conference. What was also stated was that they’re not seeing a lot of opportunity for M&A and that they only need $20M-$30M of cash to run the business. Given their history of returning cash to shareholders in recent years and with their stock near multi-year lows currently, I would not be surprised if we’re only months away from the first buybacks in 3 years, which would be a nicely value-accretive positive catalyst at these levels in my view.

Downside protection

As highlighted above, if the company executes as guided, this can potentially be a mid-teens stock by year end (and potentially much higher on a multi-year basis if Navigation takes off). In addition to this very attractive upside, I think there’s fairly solid downside protection here for a number of reasons:

• Cash/share of $2.30 represents 42% of its market cap. Cash is held in the US. Despite revenue expecting to drop by over 30% in the Mar ’18 quarter from its peak quarter in CY17, they are expected to remain roughly breakeven on the bottom line. The Mar ’18 quarter should be the trough revenue quarter.
• TBV is $121M or $4.35/shr, putting P/TBV at just 1.27x. In FY17, the company posted a low teens ROE (non-GAAP).
• NOLs of $425M (deferred tax assets of $159M, or $5.70/shr undiscounted). These were as of Sep ’17 (their last FY end). The deferred tax asset number would likely need to be re-valued down due to the lowering of the corporate tax rate, but nonetheless this is a substantial asset.

Risks

• The couple issues in CATV that have hurt recent results could prove longer lasting and/or other issues in the core CATV business could pop up, thus keeping CATV revenues constrained at lower levels for longer
• Defense business fails to ramp materially (though I’d argue there’s nothing really being priced in here for growth from this business)
• Management equity ownership is relatively low here, with the CEO owning just over 1% of S/O and officers and directors in aggregate owning only 2% of S/O; also no insider buying despite significant stock price decline since last summer

Catalyst

• Rebound of quarterly results in 2H18 (and upside versus consensus)
• Demonstrated growth/traction in Navigation/Defense
• New buyback initiation