Description

Investment Summary

Exar Corporation (“EXAR” or the “Company”) is a small-cap, fabless semiconductor company that sells analog mixed-signal integrated circuits. After going through many iterations of M&A and turnarounds over the last ten years, the company is poised for a turnaround that will most likely end in its sale. In the current turnaround, Management is delivering ahead of its plans by reducing costs and increasing gross margin, driving higher margin sales to Tier 1 customers (e.g. HPE, Verifone, Honeywell, EMC), and divesting a recently purchased lower margin business. As the company refocuses, our conversations with industry professionals indicate that EXAR can, and is, taking incremental market share during a period of industry consolidation by being a nimble low cost provider that steps in as the second source supplier for contracts. The company already has design wins in hand to bring results halfway towards Management’s Fiscal 2018 plan where quarterly revenue is ~45% higher, and we think market share wins get them the rest of the way.

We think this opportunity is underfollowed and underappreciated with investors given the small market cap, as well as investor fatigue from previous turn arounds causing skepticism that Management will hit current long-term guidance. News of shipment delays for a few newer customers, in the wake of a shortfall of smartphone content expectations, are adding to the uncertainty. Further, based on consensus estimates and a Bloomberg TEV, EXAR looks in-line or even expensive compared with comps. But pro forma for the sale of a recently divested business, factoring in recent design wins in higher margin products, and assuming the design wins continue even at a more moderate pace, EXAR trades at just 1.5x revenue (comps ~4x) and 7.7x EV/EBIT (comps ~13x).

Finally, our industry conversations suggest the end-game with EXAR could be a sale of the company. It is an accretive tuck-in for larger and currently acquisitive analog mixed-signal semiconductor players, and could even be a target for Chinese buyers which are pushing up the value chain in the space (and who recently bought a divested division from EXAR). In the purchase agreement for the recently divested division, EXAR has specifically carved out an exception to the no-shop provision, allowing them to “solicit, initiate, and knowingly encourage” bids for the remaining company which we think is telling of Management’s likely endgame. The company has been for sale in the past, but this was prior to the divestiture of the lower quality Integrated Memory Logic (“iML”) business and we believe that the remaining EXAR business is a more attractive target. Lastly, there is an older, long-time investor on the board who is likely motivated to sell.

In our bullish/takeout case, we value the core business at $13/share using a 4.5x revenue takeout multiple, plus ~$4/share in pro forma cash on the balance sheet (which could be used for value-enhancing buybacks or dividends while we wait for a sale). This yields an upside of 77% in under 2 years. In the absence of a takeout, we believe that EXAR could trade to 12x EV/EBIT by next year, or $12/share, which includes the assumption of a buyback of 6% of the share count. This equates to an upside of 31%. Neither of these scenarios give any credit for FCF generated over the investment horizon, or for accretive tuck-in acquisitions that may occur.

Company Overview and Background

EXAR is a fabless semiconductor company that designs and sells analog mix-signal integrated circuits. Its products mainly focus on certain functions on a chip board: interface (transmitting and receiving data), high performance analog (bridging various types of inputs and outputs), and power management (regulating power throughout the circuit board). EXAR chips are primarily sold to the Industrial and Infrastructure markets for use in end-products such as servers, networking equipment, data storage/compression, or point of sale terminals.

Source: EXAR Earnings Presentation

EXAR was started in 1971 and has been public since the 1980s. Recent history of the company has been checkered, having had 5 different CEOs since 2007. After struggling post-financial crisis, the company appointed industry veteran Lou DiNardo as CEO in 2012. DiNardo reduced costs drastically by laying off ~40% of the workforce and eventually took the company in a new direction in 2014 by acquiring lower margin, higher growth, consumer focused iML which provided mixed-signal chips for displays in TVs, tablets, and notebooks. EXAR ran into headwinds shortly thereafter and received inbound interest for a sale in 2015, which led to the formal announcement of a strategic alternatives process. That process failed and DiNardo was replaced by Board Chairman Richard Leza in October 2015. As Interim CEO, Leza instituted another round of restructuring to simplify products, improve gross margins and focus on Tier 1 customers. His tenure culminated with the sale of iML in June 2016 for $136mm (originally purchased in 2014 for $94mm), and CFO Ryan Benton (originally hired by DiNardo) was appointed as the new CEO and currently runs the company.

Note: EXAR fiscal year ends 3/31. FY2017E is the year ended 3/31/2017, and FY2018E is the year ended 2018E. All prices as of 11/10/16.

INVESTMENT HIGHLIGHTS

EXAR is a small cap semiconductor company that is in the midst of a meaningful turnaround which is currently underappreciated by investors

EXAR is a small cap company that has been in “turnaround” mode since the financial crisis. While Lou DiNardo was hailed positively as a turnaround expert and made big changes to the company, he ultimately took the direction of acquisitions and expanded the company rather than reducing its footprint. In the most recent round of restructuring started by Interim CEO, and currently led by the new CEO (and former CFO), the company is working to reduce its footprint, increase margin, and shift towards higher value-add chips.

So far, Management has executed well and exceeded expectations consistently.

• After targeting gross margins of 50% and $1mm in COGS reduction within two years, the company delivered on that target within a year and now targets 55% and $3mm COGS reduction
  
  Source: EXAR Earnings Presentation
  
  

• Manufacturing and supply chain (most notably, Assembly & Test which was primarily in Malaysia) is being relocated to China to be closer to customers and suppliers and drive further gross margin expansion. In addition, Management believes that the lower cost structure enables EXAR to compete more effectively in more commoditized markets
  
  Source: EXAR Earnings Presentation
  
  

• Management has driven revenue growth by focusing the sales force on higher margin, “Advanced” products to Tier 1 customers, such as HPE
  
  Source: EXAR Earnings Presentation
  
  

• Sold the iML business for $136mm in cash, for a ~30% gain on the asset in 2 years and a simplified, narrower strategy for the organization

• Executed a sale-leaseback of their headquarters bringing in $24mm of cash onto the balance sheet

We think this turnaround will stick because it shrinks and refocuses the company in a time when there are organic market share gains to be had within EXAR’s core markets.

Industry consolidation opens up the opportunity to take small incremental share which is significant to EXAR

There has been a wave of recently closed, announced and rumored purchases in the semiconductor space (Intersil/Renesas, Analog Devices/Linear Technologies, Avago/Broadcom, Infineon/Cree, NXP/Freescale, and NXP/Qualcomm to name a few). According to numerous conversations with industry participants, former employees and senior executives, industry consolidation is opening up small pockets of opportunity for EXAR to take share. These small pockets of opportunity will allow EXAR to hit its longer-term financial targets.

As companies are distracted and sales forces are cut, EXAR is able to step in and pitch new business. Customers are also looking to incorporate second sources of products as their main supplier base consolidates, and EXAR has had good traction in winning new mandates. Combined with the focus on Tier 1 customers and incentivizing the sales team, EXAR has been able to win and will continue to win business. For example, after a merger between Infineon and IRF, HPE did not want to have a sole-source supplier for servers, which opened up business to EXAR. We believe that this has given EXAR credibility that will enable the Company to compete effectively for space in the design of the 6 other major server players in the world.

One new EXAR customer we spoke with felt that after getting an initial toehold into a customer and being designed into a system, EXAR is in a good position to continue to win follow on business. Based on the Company’s strategy of targeting higher end business, we think this follow on business can be higher margin going forward. That same customer told us that EXAR has been recently very aggressive in pricing its products and very quick with its go-to-market capability to gain that initial foot in the door and drive business. We think EXAR is pressing its advantage from its new Asian-focused operations, breadth of IP portfolio and behind the scenes costs reductions to win business.

We believe that the market is not full discounting EXAR’s FY18 guidance in part due to impatience, and in part due to EXAR’s “design wins” being viewed as homogenous when there is in fact a wide spectrum of predictability, profitability, longevity, and follow-on growth. On the lower end of that spectrum is the Chinese smartphone market, where EXAR has disappointed on design wins as the smartphones themselves were not well received or never made it to launch. This market still remains an opportunity for them. On the higher end of the spectrum are already-won Tier 1 customers such as IBM and HPE, where some EXAR chips are designed in and follow-on growth can come from further penetration of the account. EXAR can also use these wins to establish a presence in power management for servers and can gain share with other server players.

Management guidance and pro forma valuation is compelling

After the iML sale, the company set its next round of financial targets for FY18 of $40mm of revenue, 55% gross margins, 20% operating margins, and 15 cents of EPS per quarter. Though these targets look like big leaps from recent quarterly run rate numbers of $27.6mm of revenue (+45% growth), over the last 18 months the company has competed for and won significant business that is in hand but currently in the R&D, test and design phase. It takes time for this business to flow through the numbers, and it can be lumpy, but the “design wins” are in hand and will become revenue over time, and so EXAR is about half of the way to their FY18 guide on a run rate basis.

We also believe that the new CEO is playing his cards close to the chest and setting conservative targets that he can meet or exceed in the coming quarters. Given EXAR’s track record of beating a two year gross margin target in under a year, we think this is a fair assumption.

This meaningful increase in profitability, combined with the pending closing of the iML sale, creates a dynamic where the company looks expensive on current/unadjusted numbers but cheap on pro forma numbers.

Looking at a “consensus” or a “Bloomberg” TEV, the company optically trades for an expensive at 3.4x revenue, 30.6x EV/EBIT and 30.7x P/E.

But adjusting for the sale of their iML business (closed on 11/9, bringing cash balance to a pro forma total of ~$225mm or $4.5/share) and looking at pro forma multiples based on design wins, EXAR trades at 1.8x revenue, 10.5x EV/EBIT and 10.7x P/E ex cash.

Note: EBIT is defined as non-GAAP operating profit which excludes SBC, amortization, and restructuring/one time charges

More meaningfully, we think that Management’s FY2018E guide, which is ~1.5 years away and which they will most likely under promise and over deliver, are the more relevant multiples. A former EXAR employee we talked to spoke highly of CEO Ryan Benton, and felt that as a first time CEO he would put out, and hit, reasonable expectations. He is also the former CFO and understands the art of setting public company expectations. Based on Management FY2018E guidance, EXAR trades for 1.5x revenue, 7.7x EV/EBIT, and 8.0x P/E ex cash.

Relative to other analog and mixed-signal semiconductor providers at an average of ~4.0x 17E revenue and ~13x 17E EV/EBIT, we think EXAR is extremely undervalued.

Source: Bloomberg

There is a high potential the company will get sold and Management is working towards that

Finally, we think that management is setting the company up for a sale. The company has been rumored to be for sale in the past, but in times when the business was struggling and shifting. In its current iteration, EXAR is moving towards revenue growth, better gross margin, and incremental market share growth driven by consolidation in the industry. We think EXAR will be much more meaningful to a buyer now, and accretive to a number of different parties. If we assume Management’s FY18 annualized guide of $160mm in revenue and $88mm in gross profit, and ~75% of SG&A can be removed, we get to about $75mm in EBIT contribution that EXAR brings to an acquirer. We have discussed typical SG&A synergies with industry professionals, and we believe that the redundancies in sales force as well as overhead can be a compelling source of hidden value in a situation like EXAR’s. We think there are a number of buyers that would be interested in a bite sized acquisition that would be immediately accretive to operating income:

Source: Bloomberg

There is also the possibility of a Chinese buyer coming into the picture, which we heard from multiple conversations with industry participants. iML was sold to a Chinese consortium, and so other buyers would presumably have comfort with EXAR. 70% of EXAR’s revenue come from Asia and management has moved assembly and test operations there in recent quarters. There has been a strong push the last few years from state-backed or pseudo state-backed entities specifically in the semiconductor space. Large deals face significant regulatory hurdles through CFIUS, but smaller deals have a higher chance of going through.

The Company currently has a ~15% owner and board seat, Alonim Investments. Alonim is an entity controlled by billionaire Robert Miller, who owns Future Electronics, which is a major customer of EXAR. Miller is ~70 years old, and has been involved with the company since 2007. Our conversations with industry participants indicate he would most likely support a sale of EXAR, and the previously announced 2015 strategic alternatives process backs this up.

Finally, as part of the iML sale, we thought there was an interesting carve-out in the purchase agreement. This carve-out was added as a risk factor to EXAR’s latest 10Q, but looks to be more of an opportunity than a risk:

The Purchase Agreement contains provisions that could discourage a potential competing acquirer of iML and could also have the practical impact of discouraging a potential acquisition of Exar. 

The Purchase Agreement contains “no solicitation” provisions that restrict our ability to solicit, initiate, or knowingly encourage, facilitate or induce third party proposals for the acquisition of iML. In addition, our sale of iML could have the practical impact of discouraging a potential acquisition of Exar until the sale of iML is consummated even though the Purchase Agreement contains an exception from the “no solicitation” provisions that allow us to solicit, initiate and knowingly encourage third party proposals for the sale of Exar, provided that the iML business is excluded from these discussions.

EXAR management specifically carved out language that allows them to solicit and “knowingly encourage” third party bids for the remaining company, as long as the iML sale stays intact. While a sale in the near term may not happen, we think that Management specifically carving this out indicates their thinking on what the possible endgame is for EXAR, and the goal they are working towards. Management has standard change of control provisions as well as non-GAAP Revenue and EBIT targets to incentivize performance.

If the company is not sold, then it has $225mm or $4.5/share in cash on its balance sheet for buybacks, dividends or tuck-in M&A. Management has not clearly outlined plans for what to do with the cash which we think is leading investors to fear the uncertainty, and even improperly discount the chances of a large or transformative acquisition (essentially, misusing the cash). Management has been clear they have no plans to do large M&A, and instead will do at most one or two tuck-in acquisitions to increase their engineering depth (especially in Asia) or IP portfolio. Uncertainty around use of cash should abate in the next few quarters as the company has said they will wait for the cash to be in the bank before making any decisions, and that cash finally hit their bank account on 11/9.

Valuation and Price Target

We value EXAR using a takeout multiple of 4.5x FY2018E management guided sales of $160mm, or ~$13/share plus $4.5/share in cash for a target price of $17, or 77% upside. We chose a 4.5x forward revenue multiple based on a discount to recent takeout multiples in the space (ADI/LLTC at ~8x EV/forward Sales and Renesas/ISIL at ~5x EV /forward Sales) as well as current forward revenue multiples for comps. We think this value should be realized in about ~1.5 years, yielding an IRR of 46%.

If a takeout does not occur, we believe that EXAR could trade to 12x forward EV/EBIT by next year, or $12, which includes the assumption of a buyback of 6% of the shares outstanding (~$30mm in share repurchases). This equates to an upside of 31%, or an IRR of 20% over ~1.5 years.

Neither of these scenarios give any credit for FCF generated over the investment horizon, or for accretive tuck-in acquisitions that may occur.

Risks

• Macroeconomic conditions

• Operational execution or delays

• Misuse of cash balance post-iML sale closing, such as a large acquisition

Catalyst

• Announcement of buybacks, dividends, or tuck-in acquisitions using iML sale proceeds

• Announcements of new design wins and achievement of FY2018 financial targets

• Sale of the company