Description

Summary

- Catalyst-rich idea as mis-understood corporate transformation should be completed in late 2015.

- Until recently, Fairchild was a poorly run company. It was run for the benefit of its engineers rather than shareholders, and its stagnant fundamentals and share price reflected that.

- Interestingly, the CEO "found religion" after running the company horribly for years. No activist was involved, and I do not know the reason for Thompson's about-face, but he introduced several radical transformations in the past two years that are beginning to take effect. The full effect will be felt in 2016.

- For those of you old enough to remember, this reminds me of Freescale after the spin-off from Motorola (sans the sexy handset chip biz) a decade ago. These "low-tech" semiconductor companies have relatively stable pricing per unit, and they sell into a broad range of end product markets, including relatively steady automotive, industrial and computing. They do see unit volume fluctuation and they do have operating leverage, but all-in-all, they are fairly stable businesses. As well, they have solid moats (esp in long-model-life products like autos) because once designed into the product, the cost of replacing is high relative to the cost of the chip. 

- First Transformation: quit chasing every product opportunity and focus on a few semiconductor applications--even if not terribly sexy. Engineers love new, sexy ideas, and they love to chase after every product opportunity. This sort of entrepreneurialism has its place, but it is not in a company like Fairchild. They do not have the best engineers in the business. They have finally focused on a few, (mostly non-cutting-edge) applications spread across a wide-variety of end markets, including steadier automotive, industrial, and computing as well as more volatile consumer and mobile. They refer to it as the new "app-centric" approach versus the old "product-centric" approach. In short, this is fancy-talk for reining in salespeople and engineers from chasing low-probability deals and building a disciplined (if not sexy) approach. 

- Second Transformation: Return 100% of free cash flow to shareholders and reining in capex. They have been aggressively buying back shares and have promised to continue doing so. And they have given firm capex projections after the manufacturing consolidation is complete.

- Third Transformation: Transform their horribly inefficient manufacturing strategy by closing and selling redundant facilities and consolidating to their most efficient ones. This will deliver significant cost saving starting in Q4 2015.

- FCS sets up well to be an acquisition target, especially by a PE.

- This name has been hit recently for two related reasons. The high-flying and more cyclical semi names have gotten hit by the cyclical slowdown, and FCS has been hit alongside them. Q2 results were poor but were a bit lumpy due to sales into the channel. The general slowdown, especially in Asia and Europe, affected results, but the market is extrapolating them as though they were a hugely cyclical semiconductor company. There is no doubt they will suffer from a slowdown, but their exposure to the cycle is on the low side for a semi company.

- While far from conclusive, this company has dramatically improved via these transformations, but the stock price remains near its five-year lows.

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Valuation

Diluted Shares = 118.5mm

Stock = $13.3

Market Cap = $1,576mm

Net Cash = $94mm

TEV = $1,482mm

But the company has quite a few NOLs and D&A will exceed capex for quite a few years. I will drive valuation off a normalized tax rate and use capex rather than D&A. So I will give the NOLs and excess D&A some value in an adjusted TEV. As well, there will be some working capital required (esp inventory) as they transform their manufacturing strategy. But adding them all up, we get Adj TEV = $1.4bn

Note as well that the additional restructuring costs should be matched by proceeds from the sale of closed plants so we do not need to add anything to TEV for restructuring costs.

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The mid-point management projections post-transformation (i.e. 2016) (announced at Investor Day 2014) are:

Revenue: $1.6bn

EBITDA: $290mm (this includes stock comp expense)

Capex: $80mm

Normalized Tax Rate: $50mm

So we have normalized unlevered FCF of $160mm . . . less than 9x Adj TEV.

And we expected mid-single digit top-line growth.

Clearly, if they deliver on this, this is very cheap.

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Now, let's get to reality. We are confident they will deliver on the cost-cutting and capex (and they have repeatedly said so), but they are going to fall quite short on the revenue side due to the semi cycle. And the model has a fair amount of operating leverage built into it.

We have incremental EBITDA of 40% (versus average of 24%). And we have incremental unlevered FCF of 25% (versus average of 10%). Management has discussed the incremental gross margin at about 50% on calls. We have discussed incremental margins with management as well as dissected the calls where analyst after analyst tries to get the answer and are confident in these numbers. We should note that their new manufacturing strategy should reduce the operating leverage somewhat and these might be a tad high.

Management restructured around a $1.6bn 2016 revenue projection, but they are not going to achieve that. I think the key here is to realize that Q2 was lumpy bad in a downward cycle . . . And even that extrapolates to revenue greater than $1.4bn. Further, I think using $1.4bn as the mid-cycle revenue number is quite conservative for this sort of semiconductor company that serves a lot of stable markets and has stable pricing per unit. As well, there new product strategy has been paying off, and there is some growth in the pipeline that will start to be realized.

So, if we use $1.4bn, we then have unlevered FCF of $110mm (12.7x) for a business that will have mid-single digit growth.

As well, we believe there is is still some engineering fat from the old days that can be cut. Not Lucent in 1999 fat, but enough fat that if neccesary, management can scale costs down to meet its margin goals on a $14bn revenue. We do not think management is inclined to do this. They think the $1.6bn revenue model will be achieved . . . not in 2016, but shortly thereafter.

This thesis largely rests on the following:

- They are going to deliver the cost-savings they have promised

- They will continue to return FCF to shareholders

- Design wins will be coming through the pipeline and will bump revenue

- The new marketing/engineering strategy will produce steady mid-single-digit growth normalized for the cycle

- The cyclicality of both the revenue and margin of FCS is significantly lower than the market is assuming

Our fair value is normalized FCF of $135mm and a 16x multiple, or Adj TEV of $2.2bn, which gets us a share price of $20.

Risks:

- The main risk here is that we have underestimated the sensitivity to the cycle and FCS suffers pricing pressure as well as unit pressure

Catalyst

Starting in Q4, we should see much improved margins as the transformation results take effect. The results thus far have been very messy and have not shown the cost savings of the manufacturing consolidation.

Continued stock buybacks.

Past design wins flowing through to revenue.

Results demonstrating that Q2 was lumpy and that FCS not as levered to the semiconductor cycle as market has priced at present.

Analysts understanding the transformations and seeing the results.