Overview

Entropic Communications (ENTR) operates in a niche segment of the $250 billion semiconductor industry, providing solutions that allow video content to be securely delivered, processed, and distributed into and throughout the home.  The company was last written-up on the VIC over three years ago and since that, time there have been some meaningful changes within the company and industry that warrant another analysis.

Industry Background

As the developer and founding member of MoCA (Multimedia over Coax Alliance), Entropic has been responsible for creating the platform on which in-home video networking is based.  Except for AT&T, which uses HomePNA (Home Phoneline Networking Alliance), every cable, satellite, and telecommunications service provider in North America uses the MoCA standard.  MoCA uses a homes coaxial cable network to allow devices like set-top boxes (STB), gaming platforms, routers/gateways and even TV’s to communicate with each other, as well as with the service provider.  The benefit of using coax to distribute content in the home is that it can support the high bandwidth needed for High Definition (HD) video and other broadband services to run simultaneously.  HomePNA, which is limited by the bandwidth of a phone line, has been forced to adopt HomePNA 3.1 which adds Ethernet over Coax as a way to try and overcome these limitations.  Verizon was one of the first to adopt the MoCA standard, as it needed a way to connect its video service from its newly deployed FiOS (fiber optic) network into the home.  But as more cable and satellite companies began offering services like DVR and Video On Demand (VOD) across multiple set-top boxes, the need for a secure, reliable communication into and throughout the home became evident.  Today, the in-home video networking market is approximately $1.6 billion and estimated to grow to $2.3 billion by 2016.

Until recently, cable and satellite companies delivered broadband video into the home and relied on the set-top box to decode and process the data into formatted video for the TV.  Transporting broadband video consumes a significant portion of a service provider’s broadband capacity, especially with the increase in HD video programming, creating problems with video/voice synchronization, latency and video pixilation.  Comcast is already in the process of addressing this issue.  By converting its video content into IP video on its cloud servers, Comcast is able to deliver a much smaller data stream into the home, allowing for interactivity, personal customization and additional services to be offered along side its video content.  The new IP set-top box, the X1, has been streamlined from a hardware device into software platform, reducing its need for processing power in favor of combining all the necessary video components, including the MoCA technology, into a single integrated system on a chip (SoC).  Even though Entropic was a pioneer of MoCA with a market share close to 50%, in recent years that strength has been eroded as ENTR failed to keep pace with the growing trend of embedding its MoCA expertise within a SoC integrated circuit.  Unlike its main competitor, Broadcom, Entropic lacked the design capability of creating a SoC.  In April of 2012, Entropic responded to its short-comings by acquiring a segment of Trident Microsystems responsible for SoC chipset design.  But, because of their delayed response, the company missed a full design and roll-out cycle, including Comcast’s X1 set-top box platform.  In January of 2013, Entropic announced that its TSC 188 SoC, which integrates MoCA 2,0, DLNA, Video on Demand and IP video streaming and HD decoder, will be used in Comcast’s newest STB, the Xi3, which is schedule to begin its rolled out by the 2^nd half of 2014.

Comcast’s decision to deliver video content via IP video is one of the biggest changes to impact the pay-TV industry since the migration from analog to digital in 2009.  As a whole, technological change surrounding video delivery moves at a glacial pace as cable, satellite and telecommunications companies are reluctant to spend the capital to continuously upgrade their set-top boxes.  MoCA 1.1 was rolled out in 2004 and nearly 10 years later, MoCA 2.0, the 2^nd generation, is still in deployment.  The North America pay-TV market is very saturated with MoCA already deployed in approximately 85% of the 100 million U.S. pay-TV subscribers. 

The real industry growth will come from continued international expansion.  In the U.S., pay-TV penetration is approximately 95%, equaled to approximately 100 million subscribers.  In Europe, penetration rates vary greatly country by country.  Sweden is close to the U.S. at 93%, while Italy and Spain are near the bottom at approximately 25%, with the UK and Germany coming in at 50% and 63% respectively.  Recently, there has been an increase in the number of service providers offering VOD and DVR to their subscribers as in-home entertainment is taking hold in Europe and the MoCA 2.0 standard is beginning to find its way into the set-top boxes, routers/gateways, and TVs being sold throughout Europe.

However, all of Europe’s expansion pales in comparison to the type of growth being seen in Latin America.  With a burgeoning middle class, Latin America has seen its pay-TV penetration increase from 36% to 52% since 2008.  Since the countries of Latin America never spent the money to lay cable, most of the penetration and growth in pay-TV has come from satellite providers.  Direct TV has witnessed a Latin America subscriber CAGR of 24% over the past five years and 31% in 2012.  This trend does not appear to be slowing anytime soon.

Company Overview

Entropic is the only pure-play semiconductor company focused on the connected, in-home entertainment market.  Since the company outsources its chip fabrication, 70% of its employees and 66% of its operating expenses go toward R&D.  Even though Entropic was slow to respond to the growing trend of embedding MoCA on an SoC, the company continues to hold top positions in North America and World Wide in video networking, Direct Broadcast Satellite Outdoor Unit, MoCA and STB SoC.

Today, Entropic operates in three distinct segments: Delivering broadcast and IP content into the home through satellite and broadband access solutions, Connecting digital entertainment seamlessly throughout the home via the MoCA standard and with its acquisition of Trident Microsystems, Set-top Box System-on-a-Chip. Of the three segments, Delivery and Connect account for nearly all the current revenue, but by the 2^nd half of 2014 current design wins with Comcast and future expected SoC wins with additional MSOs will increase the company’s revenue streams.

However, the acquisition of Trident Microsystem’s SoC division and the cost of designing its current SoC have put a strain on Entropic’s margins.  R&D increased from 28% of revenue to 46%, SGA moved from 12% to 18% of revenue while operating margins turned negative.  Over the last couple of quarters, Entropic has reduced head count and expenses.  Going forward, the company anticipates that its gross margins will be in the 50-52% range, with expectations that operating margins will grow to 18-20%.  Of course, in order to achieve these goals, ENTR is going to need to leverage off of its SoC segment, so the time frame will be 12-18 months into the future.

Entropic maintains a robust balance sheet with no debt and nearly 40% of its market capitalization in cash and marketable securities, providing the company with downside protection.  However, an investor needs to understand that Entropic’s cash/marketable securities is the company’s way of demonstrating to its customers that it has staying power within the industry.  Nevertheless, ENTR recently announced that it has authorized a $30 million share repurchase program.

Valuation

Entropic can generate revenue of $290 million in 2014.  Assuming an operating margin of 12%, taxes, no change in the 91 million share count, and applying a 12x multiple, values the company at $3.00 per share or approximately the book value of the company.  By 2016 my estimates are for ENTR to generate $380 million in revenue.  Applying the company’s 18% operating margins, taxes, 84 million share count (assuming the full $30 million buyback), and applying a 15x multiple values the company at $7.93 per share.  The multiples being used are at the low to middle end of the industry and do not reflect the large amount of cash sitting on the balance sheet.  Even though much of Entropic’s cash levels are to demonstrate its staying power, the company’s balance sheet does provide significant downside protection.  Additionally, the $30 million share repurchase is a clear indication that management is comfortable with its balance sheet and is looking for ways to filter cash back to its shareholders.