Jazz Technologies (JAZ) is a busted going-public transaction for (what is currently) a single wafer-level semiconductor fab facility located in Newport Beach, CA. The fab is focused primarily on specialty analog and mixed-signal products. The entity has a decent and high profile management team, several readily-identifiable catalysts and, I believe, an asymmetric risk-reward profile that makes it an interesting potential investment for anybody who can look thru the next couple of quarters. The stock sells at a material discount to its public comparables, at roughly 1x and 11x trailing revs and EBIT, respectively (vs. comp range of 2-5x revs and 15-30x EBIT). In addition, given likely changes in the corporate profile over the next couple of years the upside from an intrinsic value perspective could be impressive, with potential peak earnings power implying a 4x P/E multiple off of the current share price, and mid-cycle earnings power implying an 8x PE.

Steve308 posted a couple of very nicely timed write-ups on SPAC warrants several months ago. JAZ started life as a SPAC as well, and a little over a month ago received shareholder approval to purchase Jazz Semiconductor. Jazz Semiconductor was spun out of Conexant in 2002 in conjunction with a concurrent investment by Carlyle Group (the Jazz Semiconductor shareholder group prior to purchase by JAZ included Carlyle, Conexant, and RF Micro). Approval for SPAC deals has become markedly more challenging in 2007, as the backlog of deals grows and shareholders have become more discerning in terms of their willingness to approve transactions. In JAZ’s case, a number of last minute gyrations took place in order to get the deal pushed through, including a giveback by the management team of 35% of its carried interest, an incremental $7.3mm investment by the SPAC’s officers and directors, and a $10mm investment by Conexant. The latter two investments were used to fund the repurchase of shares from shareholders who were expected to vote against the proposed transaction. In addition, the deal’s underwriters leaned heavily on a number of equity buyers and “traditional” SPAC investors to purchase equity prior to the vote and subsequently vote for approval. Underwriters of SPAC deals have a material incentive to help get the deals approved, as a portion of their underwriting fees are contingent on approval. Traditional SPAC holders will sometimes step in and help support a deal in this manner, so that they can continue to get priority allocations when the deals first go public. In JAZ’s case, the efforts paid off and the deal was approved with the narrowest of possible margins. In the days and weeks since approval, however, the stock has dropped precipitously (in what has become recently a fairly common pattern) as the “unnatural” holders who got jammed with equity pre-deal in order to help ensure approval began dumping their shares. As the selling depressed the price, other marginal holders jumped on board, stop losses likely got hit, and the stock dropped by roughly 25% to its current trading level of $3.90/shr. At this point, the shares seem to have stabilized and the shareholder base turnover is likely largely complete.

As mentioned, the company currently operates a single fab facility in Newport Beach, CA, manufacturing specialty analog and mixed specialty products. Mixed analog/digital products are often used in communications-oriented applications (typical end markets include cell phone, WiFi, wireline, modems, GPS, and Bluetooth apps) where a nexus is required between electromagnetic analog signals (i.e. wireless spectrum communications) and traditional digital ICs. These products occupy a strongly growing subsegment of the semiconductor industry, with estimates of growth rates roughly double those of the overall semiconductor industry (18% in 2006 vs. 9% for overall semi). The products are typically characterized by less need for extreme miniaturization, but correspondingly more specialized design requirements. The niche has historically not been large enough to merit focus by industry heavyweights whom are typically focused on much higher volume leading-edge CMOS circuits. The product requirements allow the manufacturers to use older (i.e. 2^nd and 3^rd generation) production equipment, which can often be purchased at attractive prices after having been fully depreciated by the original owners.

JAZ management includes a number of well-known ex-Apple executives, including CEO Gil Amelio (ex-CEO of Apple), President and COO Ellen Hancock (ex-EVP/CTO of Apple), and EVP/CTO Steve Wozniak (co-founder of Apple). Gil and Ellen also served, respectively, as Chairman/CEO and EVP/COO of National Semiconductor and, in addition, Gil was the former President of Rockwell Communication Systems (now Conexant – Jazz Semi’s original owner). This management team has deep experience in the semiconductor industry and knows the asset that they have purchased well. While their track record at prior endeavors has been mixed, I consider them to be an extremely high caliber team for a company of this size.

Since closing the acquisition, management has moved aggressively to cut costs at the Newport Beach facility. Roughly 15% of salaried employees were let go and $6mm of total costs were taken out. This more than makes up for the incremental $3.5mm of “SPAC” costs (i.e. senior mgmt comp + public company costs) that will arise. Moreover, mgmt believes that there may be as much as $10mm of incremental costs that can come out of the existing business over time. The CFO, Paul Pittman, believes that they now have a cost structure that will allow them to be cash flow breakeven (after debt service) at the bottom of the cycle, and materially cash generative as the cycle is more favorable.

Last year, Jazz Semiconductor did $230mm of revenues and $31mm of EBITDA (adjusted for non-recurring deal expenses and the like). With $10mm of maintenance capex at the facility, this yields what I am calling $21mm of “economic” EBIT. As mentioned, there are new public company costs on top of the entity, but these have been more than offset by cost cuts at the operating level. 2006 was a near-term peak year for the company’s products, so 2007 results are likely to come in. First quarter 2007 results showed a sequential decline on the top line as well-publicized inventory adjustments in the channel have temporarily depressed demand. This adjustment appears to now be passing (see recent TI results), and growth should resume by the back half of the year.

Capital structure includes the following:

23.9mm common shares

$167mm convert; converts @ $7.33/shr

46.2mm warrants; $5 strike

$30mm cash

With the convert and warrants both underwater currently (28% upside until warrants are in the money, near double before converts are in the money), I get a basic EV of $93mm equity (23.9mm shrs @ $3.90/shr) + $137mm net debt (convert less cash) = $230mm. This yields trailing multiples of 1.0x revs and 11x “economic” EBIT. These multiples represent material discounts to public competitors that trade at 2-5x revs 15-30x EBIT. On a revenue multiple basis, some discount is arguably warranted as JAZ’s Newport Beach-based facility puts it at a cost disadvantage to its Asian-based competitors. At today’s levels, you have 28% upside in the current stock price before you begin to feel dilution from the warrants, and the stock has to nearly double before the converts come into the money.

What makes the investment prospect interesting, however, is not the current company profile, but what the management team plans to create with it. This high profile management team did not sign on to run a single fab entity. The plan is to leverage the company’s IP onto a much broader platform, and grow revenues and cash flow correspondingly. Within the year, management expects to close on the purchase of an Asian-based 2^nd generation fab. This will have a number of important ramifications: 1) the Asian-based fab will significantly lower the company’s cost structure, giving it an enhanced ability to prevail in competitive bidding situations, 2) addition of a 2^nd fab will materially increase the prospective customer base, as many customers refuse to do business with single-fab entities due to concerns over business risk, 3) enhanced ability to leverage the IP and corporate overhead over a much larger revenue base.

For rough order of magnitude, management believes that it will spend roughly $180mm to buy a fully-depreciated Asian-based fab (several are available, and talks are ongoing) and an additional $25mm to refurbish. Year 1 that fab probably produces $30mm of EBITDA (6.8x), 3 years out $65mm of EBITDA (3.2x). Management believes that ultimately such a fab could produce $500mm of revenue and $115mm+ of EBITDA in a fully-loaded (i.e. peak cycle) year. More importantly, by adding a second fab, JAZ likely gets a 500bp improvement in potential margins, either mid-cycle to mid-cycle or peak-to-peak, given the combination of operating leverage and improved cost position.

There are clearly a lot of variables to consider when trying to value JAZ pro-forma for a 2^nd fab purchase, but here is my stab at both a peak and mid-cycle scenario:

$750mm revs ($275mm existing fab, $475mm Asian fab)

23% EBITDA margins (per mgmt guidance) = $173mm EBITDA

$50mm maint capex

$123mm economic EBIT

$7.5mm interest expense

$75mm fully-taxed net income (35% tax rate)

$0.93/shr net income (see shr count below)

Funding for new fab (50% equity, 50% debt):

Uses:

Purchase price = $205mm (incl incr capex)

Sources:

$15mm cash on hand

$87.5mm debt

$102.5mm equity (issued at current price)

Cap structure:

23.9mm shrs (current)

22.8mm shrs (convertible converts to equity)

26.1mm shrs (issued to finance 50% of fab @ current price)

7.7mm warrants (assume treasury method – repurchased @ $6/wrnt)

= 80.5mm shrs

$87.5mm debt

$15mm cash

Multiples @ $3.90/shr (current):

4.2x net income

2.2x EBITDA

3.1x economic EBIT

$650mm revs ($240mm existing fab, $410mm Asian fab)

18% EBITDA margins (per mgmt guidance) = $117mm EBITDA

$50mm maint capex

$67mm economic EBIT

$7.5mm interest expense

$39mm fully-taxed net income (35% tax rate)

$0.48/shr net income (see shr count below)

Funding for new fab (50% equity, 50% debt):

Uses:

Purchase price = $205mm (incl incr capex)

Sources:

$15mm cash on hand

$87.5mm debt

$102.5mm equity (issued at current price)

Cap structure:

23.9mm shrs (current)

22.8mm shrs (convertible converts)

26.1mm shrs (issued to finance 50% of fab)

7.7mm warrants (assume treasury method – repurchased @ $6/wrnt)

= 80.5mm shrs

$87.5mm debt

$15mm cash

Multiples @ $3.90/shr (current):

8.1x net income

3.3x EBITDA

5.8x economic EBIT

So what is it worth? I believe that it is easy to justify a 15x multiple off mid-cycle EPS for an industry subsegment that grows the top line at >10% over the cycle. If this is the case, the stock could be worth $7.20/shr, or roughly 85% above today’s price. At this price, the convert is still marginally out-of-the-money and associated dilution is lower. However, I have chosen to assume conversion in order to be conservative and, in addition, because there are so many moving pieces. You can obviously make your own choices.

Additional upside could come from better tax planning (tax rates below 35% are likely, given > half of production will be in Asia), as well as the associated tax shield resulting from the asset purchase of the 2^nd fab (since I am using “economic” EBIT, based on maintenance capex, I am implicitly ignoring this tax shield). Moreover, as I mentioned, the company can currently shield roughly $50mm of pre-tax income, which I have not included in my valuation (present value of probably $0.40/shr assuming it all accrues to current existing equity outstanding). Finally, management has been extremely aggressive recently in purchasing warrants as the prices have come in, thereby materially lessening future potential dilution to the extent the operating plan works as hoped.

Currently, it is only covered by Think Equity, the underwriter, but I expect it to garner incremental sell-side interest over the next couple of quarters.

Risks:

Some remaining customer concentration (Conexant), current downturn in semi cycle is more prolonged than expected, warrant dilution, overpayment for new fab