MAGMA DESIGN AUTOMATION INC LAVA
June 08, 2010 - 3:35pm EST by
Lukai
2010 2011
Price: 2.61 EPS $0.15 $0.21
Shares Out. (in M): 72 P/E 17.5x 12.3x
Market Cap (in $M): 189 P/FCF 12.8x 12.1x
Net Debt (in $M): -25 EBIT 14 17
TEV ($): 164 TEV/EBIT 11.6x 9.9x

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Description

We believe that an investor can conservatively realize 95% appreciation in a year's time on an investment in LAVA at current prices with limited downside.
 
THE COMPANY
 
If you have a cell phone, you own at least one device that was designed using LAVA's software. LAVA develops EDA software for IC development selling time-based licenses (typically 3 years) along with engineering and support services. While little known to the investment community, LAVA is well known among EDA customers boasting a top-tier client base and a broad array of designs reliant on their products. As the fourth largest public EDA company, LAVA differentiates by focusing on next generation process nodes with products able to tackle quickly and precisely the hardest and biggest design projects. LAVA has its roots in digital implementation but has expanded into analog/mixed-signal, circuit simulation and physical verification. Industry applications include wireless, memory, broadband and other digital applications.
 
 
INVESTMENT SUMMARY
 
In the past six quarters LAVA has expanded op margin by over 23%, reduced and refinanced debt and resumed revenue and bookings growth. Meanwhile, LAVA more than doubled its addressable market and entered a significant growth cycle with bookings expected to grow 30% this year. LAVA has clear revenue and earnings visibility, generates healthy cash flow, and has a capable, experienced, and committed management team. Despite this, investors can participate in the stock for 5-10x normalized FCF.
 
The three keys to the story are core business stability, growth via new products, and continued margin expansion. Digital Implementation is LAVA's core and contributes 70% to the top line. LAVA has long-term contracts with many of the largest IC developers in the world and despite recent product refreshes we assume this business remains flat. The growth story is Circuit Simulation; a newer market opportunity based on their FineSim product. FineSim currently books roughly $6m per quarter in revenue though we expect that it'll book roughly $20m per quarter exiting FY11 (Apr) due to its vast speed advantage with no trade off in accuracy. LAVA seeded the market with FineSim over the last couple of years and as competitor licenses expire LAVA's customers are making a full switch to FineSim. Given the typical length of contract in the industry we believe bookings will be very strong over the next 12-18 months as Synopsis contracts roll off. Having said that, we still fail to arrive at the lofty growth numbers given by this conservative management team.
 
In recent discussions, management has stated that they expect core digital implementation to reduce to 50% of revenue from 70% but expect an increase in absolute digital implementation dollars. The implication is a more than 40% firm-wide growth rate over the next 2-3 years. The profitability impact of this growth will be compounded by significantly expanded margins.
LAVA had historically generated 23% pro forma operating margins. Lengthy litigation (settled) with Synopsis cut these margins by more than half in '05/'06. In '07, LAVA expanded engineering heads by ~30% and still were able to get back to the 17% mark before the recession hit. In fact, Q2/3 '09 were the only two quarters in company history that op margin was negative and LAVA has since steadily marched back to 12% with 20-25% being the mid-term target. Additionally, LAVA had generated 23% op margins with products that required 2-3x more support cost than those from which growth will come in the near-term.
 
What's more is that LAVA was generating $20-40m of annual cash flow during '04 to '06 and we believe they can get back there in the next 18-24 months. At an average of $25m of normalized FCF, LAVA trades for less than 8x. If LAVA can achieve $35m of FCF (which we believe is feasible) the equity is trading for around 5x fully diluted.
 
 
DETAILED INVESTMENT STORY
 
Core Business - Digital Implementation
 
LAVA has its roots in Digital Implementation and the core business centers on Talus, a software product for the Place and Route stage in the design of integrated circuits (ICs). The first step (placement) involves deciding where to place all electronic components, circuitry and logic elements in a generally limited amount of space. This is followed by routing, which decides the exact design of all the wires needed to connect the placed components. This step must implement the desired connections while following the rules and limitations of the manufacturing process. This boilerplate regurgitation is meant to give readers an appreciation for how mission critical and complicated Place and Route software is.
 
With relatively smaller resources, LAVA has been a successful competitor by focusing on next generation process technology. The driving force behind the manufacture of ICs is miniaturization, and process technology boils down to the size of the finished transistor and other components. The smaller the transistors, the more transistors in the same area, the faster they switch, the less energy they require and the cooler the chip runs all else equal. The size features are ever smaller; having once been measured in micrometers they're now measured in nanometers. Rather than competing on older process nodes, LAVA has found success competing at the leading edge.
 
Our work suggests the core business is stable with potential upside. Management is focused on maintaining their enviable customer base. Key customers such as Texas Instruments and NVIDIA have contracts out to 2013 / 2014 respectively. Qualcomm and Broadcom have another 18 months on their contracts. Meanwhile, LAVA is introducing new products with enhanced functionality and significant measurable improvements in processing times to combat competitive threats and provide leverage in contract negotiations.
 
 
High Growth Area - Circuit Simulation
 
The high cost of photolithographicmasks and other manufacturing prerequisites make it essential to design a circuit to be nearly perfect before a newly designed IC is first built. Simulating the circuit with a "Simulation Program with Integrated Circuit Emphasis" (SPICE) is the industry-standard way to verify circuit operation at the transistor level before committing to manufacturing an IC.
 
LAVA acquired ACAD Corp in July 2006 and subsequently introduced the FineSim Pro Circuit Simulator for analog and memory design. This represented a new and large market for LAVA. The acquisition brought an unmatched architectural framework for Circuit Simulation allowing LAVA to dramatically increase performance. LAVA is able to demonstrate a 3-5x performance gain over Synopsys' solution while providing more accurate results.
 
LAVA has already deployed FineSim in 13 of the Top 25 semiconductor companies. Primary adopters are AMD, Hynix, Maxim, Panasonic, Toshiba, TSMC, Samsung. The tool has also allowed LAVA to enter the memory business, help existing customers verify mixed-signal circuits, and expand the customer base to analog companies. The industry's typical length of contract however, is 3 years. We've confirmed that even though FineSim provides for significant efficiencies, semi-cos wont double pay for design software (i.e. they wont shelve the Synopsys solution and pay for a broad rollout of FineSim until the Synopsys contract lapses.) In response, LAVA has sold FineSim only into the most power hungry applications at leading semi-cos and once the Synopsys contracts roll, FineSim has been broadly rolled out.
 
Given the performance advantage and unique market position FineSim has become the fastest growing product LAVA has ever had as a company. FineSim has booked an average of $6m per quarter but ramped to $20m in F4Q10 (Apr). For FY10 LAVA booked roughly $40m in revenue and while they expect bookings to increase in FY11, they're only baking in $40m for FineSim to remain conservative. 
 
We believe that FineSim's performance advantage has plenty of runway as Synopsys has had a difficult time even coming close to the speed. Feedback from the industry suggests Synopsys' issues can only be resolved through an architectural overhaul which would be expensive and take several years.
 
 
Margin Expansion
 
During '03 and '04 LAVA was generating 23-24% pro forma operating margins. During '05 and '06, Synopsys brought litigation against LAVA for patents relating to design methods. The legal costs cut margins by half or more until the case was settled for a paltry $12.5m. Around December '06, LAVA began adding heads to their R&D team to the tune of over 100 additional engineers. Even with this significant investment in talent LAVA was able to get back to the 17% op margin level before the recession hit and brought op margins negative for two quarters.
Exacerbating the margin impact of the recession was management's decision to move the business to a ratable revenue recognition model which delayed recognition of revenue. It took management a couple of quarters to figure out how deep the recession was and made restructurings accordingly. As such, Q2/3 '09 were the only negative op margin quarters in the history of the company. As ratable revenue begins to flow through to the income statement LAVA has steadily recouped op margin achieving a pro forma 12.7% in the most recently reported quarter, up from -17% in F2Q09.
 
More importantly, we believe there's room for significant op margin expansion from here. In the '03/'04 time frame during which LAVA was generating 23% op margins they were doing so with product families that were much more support intensive. With new product families like circuit simulation, one Application Engineer can perform five evaluations whereas the Talus product could take three to five application engineers to perform one evaluation.  This is a significant improvement in efficiency which we believe will further boost margins.
 
 
Development of Addressable Market
 
As EDA is a mature market, LAVA has taken steps to expand their revenue opportunity through product development and acquisition in adjacent markets. For example, many of LAVA's customers were using their tools for digital design but were also doing mixed-signal designs. LAVA developed capabilities to meet their needs for developing analog IP in mixed-signal chips (Titan).
 
($mm) Mkt. Size Original Current Product
Place & Route 550 1 1 Talus, Tekton
Synthesis, DFT 365 0 1 Talus, Tekton
Analysis 150 0 1 Talus, Tekton 
Sign-off 120 0 1 Talus, Tekton
Circuit Simulation 325 0 1 FineSim 
Physical Verification 235 0 1 Quartz 
Analog Mixed-Signal 200 0 1 Titan 
Total   550 1,945  
 
 
Capital Structure
 
Adjusting LAVA's balance sheet for the recent debt transactions and assuming full notes conversion and stock options results in a $217.8m market value and $191.8m enterprise value.
LAVA has made significant strides in restructuring its balance sheet. Late last year LAVA did a notes exchange during which more than half of the converts expiring 5/15/10 were exchanged for converts expiring in 2014. The new 6% converts were struck at a very low $1.80 but given the debt market and the impending redemption date I don't know that I wouldn't have done the same. The remaining original notes were ultimately paid down just a few weeks ago and so the balance sheet will look slightly different than the most recent quarter end. As such, I thought it would be helpful to lay out the adjusted capital structure in an easy to understand table.
 
CAPITALIZATION          
  5/2/10  Adjustment  5/15/10  Adjustment 

Assume Dilution

Current Price 2.61   2.61   2.61

 

         
Basic Shares 51,561   51,561   51,561 
Converts  0    15,702 15,702 

Options

 0   5,000  5,000 
Market Value  134,574   134,574    188,606 
           
Cash & Equiv. 57,518  (23,206)  34,312    34,312 
ST Investment 16,837    16,837    16,837 

Total Cash

74,355    51,149    51,149 
           
Secured Credit Line  11,162   11,162    11,162 
Term Debt (Current) 1,688    1,688    1,688 
Convertible Notes 23,206  (23,206)   

0

Short Term Debt  36,056   12,850    12,850 
           
Convertible Subordinated 28,263    28,263  (28,263)   
Term Debt 13,312    13,312    13,312 
Long Term Debt  41,575   41,575    26,162 
Total Debt 77,631   54,425    26,162 
           
Enterprise Value  137,850   137,850    163,619 
 

Please note that the Conversion assumption will hit LAVA's GAAP income statement only after LAVA generates $1.5m in quarterly GAAP pre-tax earnings at which point excluding conversion shares would be anti-dilutive. I assume conversion in my EPS and valuation however, as well as an additional 5.0m options for a 2011 total of 72.3m diluted shares to remain conservative.

Financials and Valuation

LAVA made the switch to a highly ratable revenue model which has clouded the growth and profitability profile of the business. We believe that this is a primary reason for the asymmetric risk reward opportunity in the stock. A typical quarter will draw revenue from backlog of about 95% of the total which leads to clear revenue and EPS visibility. This mutes the growth profile however and makes the stock look reasonably valued on the basis of multiples. Due to the resulting disconnect between the P&L and Cash Flow statements, we base our valuation on cash flows.
 
We value LAVA using a conservative 10-year DCF which assumes a 7% sales CAGR with most of the growth coming in the next 3 years and operating margins achieving / maintaining 20% by 2014. We assume a full tax rate but give a $50m credit for NOLs which begin to expire in 2019. Using a 10% WACC and 3% perpetual growth results in our target of $5.07. At this price LAVA would trade for 23.9x '11 earnings which is a rich valuation. Given earnings growth of over 40% however, LAVA's PEG would still be substantially below 0.5x. In addition, this model leaves plenty of room for margin upside as we believe LAVA can achieve adjusted margins north of 20%. To illustrate, if we keep all assumptions the same but move margins to 25% by 2015 LAVA would be worth close to $6. Neither of these scenarios is as aggressive as management on the revenue growth.
 
What's more is that LAVA was generating $20-40m of annual cash flow during '04 to '06 and we believe they can get back there in the next 18-24 months. At an average of $25m of normalized FCF, LAVA trades for less than 9x. If they can achieve $35m of FCF (which we believe is feasible) they're trading for around 6x.
 
 
Period 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0
Year 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
                     
Sales 131,107 144,218 165,851 182,436 191,558 201,136 211,192 221,752 230,622 237,541
Growth % 6.5% 10.0% 15.0% 10.0% 5.0% 5.0% 5.0% 5.0% 4.0% 3.0%
                     
EBIT 16,536 21,633 29,853 36,487 38,312 40,227 42,238 44,350 46,124 47,508
Margin % 12.6% 15.0% 18.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%
                     
Tax 5,787 7,571 10,449 12,771 13,409 14,079 14,783 15,523 16,144 16,628
Rate % 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0%
NOPAT 10,748 14,061 19,405 23,717 24,902 26,148 27,455 28,828 29,981 30,880
                     
Other Adj. 3,000 1,033 (3,245) (2,488) (1,368) (1,437) (1,509) (1,584) (1,331) (1,038)
Unlevered FCF 13,748 15,095 16,160 21,229 23,534 24,711 25,946 27,244 28,650 29,842
Discounted 12,498 12,475 12,141 14,500 14,613 13,949 13,315 12,709 12,151 11,506
                     
Net Present Value 129,856                  
Terminal Value 161,418                  
Enterprise Value 291,273                  
                     
Net Debt (24,987)                  
NOL Carryforward 50,000                  
Equity Value 366,260                  
                     
Share Value            5.07                  
Diluted Shares 72,263                  

Other

Management

While management doesn't own as much stock as we'd like, most senior executives are not independently wealthy and we believe that voluntary executive pay cuts and significant efforts to retain employees through the downturn indicate commitment to the long-term success of the business and thus alignment with shareholders.
What the Street Is Missing
LAVA's shift to a ratable model has masked strength in the business as measured by cash flow and bookings growth. Also, LAVA's multiple to adjusted EPS is about the same as its peer group despite strong cash flow and above average growth.
Risks
We view double-dip recession resulting in a weak tech spend environment as the biggest risk to the stock. While we don't have a great read on this, we believe that LAVA's customer base is healthy and management is committed to controlling expenses (e.g. management took a large voluntary pay cut last year.) Further, LAVA doesn't depend on end-markets; rather they benefit from design starts.
Market turmoil during the preceding 30 months has lead to conservative spending by LAVA's customer base and the employment market for developers is far from robust. Therefore, failure to grow new markets, including Circuit Simulation, is the largest risk to our thesis. FineSim traction has been strong however, and LAVA's stable core business and healthy cash flow mitigates the risk of permanent capital loss, in our view.
Conclusion
LAVA emerged from '09 a stronger company. With a stable core business, an expanded addressable market and new product cycle, we believe LAVA provides compelling upside with low risk of permanent capital loss. We model continued cash flow development with revenue growth and margin expansion over the next several quarters resulting in our $5.06 price target.
 
 

Catalyst

 

Next earnings release (8/26/10 Est) - Management tends to sandbag, then beat and raise.

Bookings growth

Incremental product introductions

Revenue development via maturation of ratable model (a loaded spring)

Management is getting out on the road to tell the story. Also, potential for new analyst coverage.

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    Description

    We believe that an investor can conservatively realize 95% appreciation in a year's time on an investment in LAVA at current prices with limited downside.
     
    THE COMPANY
     
    If you have a cell phone, you own at least one device that was designed using LAVA's software. LAVA develops EDA software for IC development selling time-based licenses (typically 3 years) along with engineering and support services. While little known to the investment community, LAVA is well known among EDA customers boasting a top-tier client base and a broad array of designs reliant on their products. As the fourth largest public EDA company, LAVA differentiates by focusing on next generation process nodes with products able to tackle quickly and precisely the hardest and biggest design projects. LAVA has its roots in digital implementation but has expanded into analog/mixed-signal, circuit simulation and physical verification. Industry applications include wireless, memory, broadband and other digital applications.
     
     
    INVESTMENT SUMMARY
     
    In the past six quarters LAVA has expanded op margin by over 23%, reduced and refinanced debt and resumed revenue and bookings growth. Meanwhile, LAVA more than doubled its addressable market and entered a significant growth cycle with bookings expected to grow 30% this year. LAVA has clear revenue and earnings visibility, generates healthy cash flow, and has a capable, experienced, and committed management team. Despite this, investors can participate in the stock for 5-10x normalized FCF.
     
    The three keys to the story are core business stability, growth via new products, and continued margin expansion. Digital Implementation is LAVA's core and contributes 70% to the top line. LAVA has long-term contracts with many of the largest IC developers in the world and despite recent product refreshes we assume this business remains flat. The growth story is Circuit Simulation; a newer market opportunity based on their FineSim product. FineSim currently books roughly $6m per quarter in revenue though we expect that it'll book roughly $20m per quarter exiting FY11 (Apr) due to its vast speed advantage with no trade off in accuracy. LAVA seeded the market with FineSim over the last couple of years and as competitor licenses expire LAVA's customers are making a full switch to FineSim. Given the typical length of contract in the industry we believe bookings will be very strong over the next 12-18 months as Synopsis contracts roll off. Having said that, we still fail to arrive at the lofty growth numbers given by this conservative management team.
     
    In recent discussions, management has stated that they expect core digital implementation to reduce to 50% of revenue from 70% but expect an increase in absolute digital implementation dollars. The implication is a more than 40% firm-wide growth rate over the next 2-3 years. The profitability impact of this growth will be compounded by significantly expanded margins.
    LAVA had historically generated 23% pro forma operating margins. Lengthy litigation (settled) with Synopsis cut these margins by more than half in '05/'06. In '07, LAVA expanded engineering heads by ~30% and still were able to get back to the 17% mark before the recession hit. In fact, Q2/3 '09 were the only two quarters in company history that op margin was negative and LAVA has since steadily marched back to 12% with 20-25% being the mid-term target. Additionally, LAVA had generated 23% op margins with products that required 2-3x more support cost than those from which growth will come in the near-term.
     
    What's more is that LAVA was generating $20-40m of annual cash flow during '04 to '06 and we believe they can get back there in the next 18-24 months. At an average of $25m of normalized FCF, LAVA trades for less than 8x. If LAVA can achieve $35m of FCF (which we believe is feasible) the equity is trading for around 5x fully diluted.
     
     
    DETAILED INVESTMENT STORY
     
    Core Business - Digital Implementation
     
    LAVA has its roots in Digital Implementation and the core business centers on Talus, a software product for the Place and Route stage in the design of integrated circuits (ICs). The first step (placement) involves deciding where to place all electronic components, circuitry and logic elements in a generally limited amount of space. This is followed by routing, which decides the exact design of all the wires needed to connect the placed components. This step must implement the desired connections while following the rules and limitations of the manufacturing process. This boilerplate regurgitation is meant to give readers an appreciation for how mission critical and complicated Place and Route software is.
     
    With relatively smaller resources, LAVA has been a successful competitor by focusing on next generation process technology. The driving force behind the manufacture of ICs is miniaturization, and process technology boils down to the size of the finished transistor and other components. The smaller the transistors, the more transistors in the same area, the faster they switch, the less energy they require and the cooler the chip runs all else equal. The size features are ever smaller; having once been measured in micrometers they're now measured in nanometers. Rather than competing on older process nodes, LAVA has found success competing at the leading edge.
     
    Our work suggests the core business is stable with potential upside. Management is focused on maintaining their enviable customer base. Key customers such as Texas Instruments and NVIDIA have contracts out to 2013 / 2014 respectively. Qualcomm and Broadcom have another 18 months on their contracts. Meanwhile, LAVA is introducing new products with enhanced functionality and significant measurable improvements in processing times to combat competitive threats and provide leverage in contract negotiations.
     
     
    High Growth Area - Circuit Simulation
     
    The high cost of photolithographicmasks and other manufacturing prerequisites make it essential to design a circuit to be nearly perfect before a newly designed IC is first built. Simulating the circuit with a "Simulation Program with Integrated Circuit Emphasis" (SPICE) is the industry-standard way to verify circuit operation at the transistor level before committing to manufacturing an IC.
     
    LAVA acquired ACAD Corp in July 2006 and subsequently introduced the FineSim Pro Circuit Simulator for analog and memory design. This represented a new and large market for LAVA. The acquisition brought an unmatched architectural framework for Circuit Simulation allowing LAVA to dramatically increase performance. LAVA is able to demonstrate a 3-5x performance gain over Synopsys' solution while providing more accurate results.
     
    LAVA has already deployed FineSim in 13 of the Top 25 semiconductor companies. Primary adopters are AMD, Hynix, Maxim, Panasonic, Toshiba, TSMC, Samsung. The tool has also allowed LAVA to enter the memory business, help existing customers verify mixed-signal circuits, and expand the customer base to analog companies. The industry's typical length of contract however, is 3 years. We've confirmed that even though FineSim provides for significant efficiencies, semi-cos wont double pay for design software (i.e. they wont shelve the Synopsys solution and pay for a broad rollout of FineSim until the Synopsys contract lapses.) In response, LAVA has sold FineSim only into the most power hungry applications at leading semi-cos and once the Synopsys contracts roll, FineSim has been broadly rolled out.
     
    Given the performance advantage and unique market position FineSim has become the fastest growing product LAVA has ever had as a company. FineSim has booked an average of $6m per quarter but ramped to $20m in F4Q10 (Apr). For FY10 LAVA booked roughly $40m in revenue and while they expect bookings to increase in FY11, they're only baking in $40m for FineSim to remain conservative. 
     
    We believe that FineSim's performance advantage has plenty of runway as Synopsys has had a difficult time even coming close to the speed. Feedback from the industry suggests Synopsys' issues can only be resolved through an architectural overhaul which would be expensive and take several years.
     
     
    Margin Expansion
     
    During '03 and '04 LAVA was generating 23-24% pro forma operating margins. During '05 and '06, Synopsys brought litigation against LAVA for patents relating to design methods. The legal costs cut margins by half or more until the case was settled for a paltry $12.5m. Around December '06, LAVA began adding heads to their R&D team to the tune of over 100 additional engineers. Even with this significant investment in talent LAVA was able to get back to the 17% op margin level before the recession hit and brought op margins negative for two quarters.
    Exacerbating the margin impact of the recession was management's decision to move the business to a ratable revenue recognition model which delayed recognition of revenue. It took management a couple of quarters to figure out how deep the recession was and made restructurings accordingly. As such, Q2/3 '09 were the only negative op margin quarters in the history of the company. As ratable revenue begins to flow through to the income statement LAVA has steadily recouped op margin achieving a pro forma 12.7% in the most recently reported quarter, up from -17% in F2Q09.
     
    More importantly, we believe there's room for significant op margin expansion from here. In the '03/'04 time frame during which LAVA was generating 23% op margins they were doing so with product families that were much more support intensive. With new product families like circuit simulation, one Application Engineer can perform five evaluations whereas the Talus product could take three to five application engineers to perform one evaluation.  This is a significant improvement in efficiency which we believe will further boost margins.
     
     
    Development of Addressable Market
     
    As EDA is a mature market, LAVA has taken steps to expand their revenue opportunity through product development and acquisition in adjacent markets. For example, many of LAVA's customers were using their tools for digital design but were also doing mixed-signal designs. LAVA developed capabilities to meet their needs for developing analog IP in mixed-signal chips (Titan).
     
    ($mm) Mkt. Size Original Current Product
    Place & Route 550 1 1 Talus, Tekton
    Synthesis, DFT 365 0 1 Talus, Tekton
    Analysis 150 0 1 Talus, Tekton 
    Sign-off 120 0 1 Talus, Tekton
    Circuit Simulation 325 0 1 FineSim 
    Physical Verification 235 0 1 Quartz 
    Analog Mixed-Signal 200 0 1 Titan 
    Total   550 1,945  
     
     
    Capital Structure
     
    Adjusting LAVA's balance sheet for the recent debt transactions and assuming full notes conversion and stock options results in a $217.8m market value and $191.8m enterprise value.
    LAVA has made significant strides in restructuring its balance sheet. Late last year LAVA did a notes exchange during which more than half of the converts expiring 5/15/10 were exchanged for converts expiring in 2014. The new 6% converts were struck at a very low $1.80 but given the debt market and the impending redemption date I don't know that I wouldn't have done the same. The remaining original notes were ultimately paid down just a few weeks ago and so the balance sheet will look slightly different than the most recent quarter end. As such, I thought it would be helpful to lay out the adjusted capital structure in an easy to understand table.
     
    CAPITALIZATION          
      5/2/10  Adjustment  5/15/10  Adjustment 

    Assume Dilution

    Current Price 2.61   2.61   2.61

     

             
    Basic Shares 51,561   51,561   51,561 
    Converts  0    15,702 15,702 

    Options

     0   5,000  5,000 
    Market Value  134,574   134,574    188,606 
               
    Cash & Equiv. 57,518  (23,206)  34,312    34,312 
    ST Investment 16,837    16,837    16,837 

    Total Cash

    74,355    51,149    51,149 
               
    Secured Credit Line  11,162   11,162    11,162 
    Term Debt (Current) 1,688    1,688    1,688 
    Convertible Notes 23,206  (23,206)   

    0

    Short Term Debt  36,056   12,850    12,850 
               
    Convertible Subordinated 28,263    28,263  (28,263)   
    Term Debt 13,312    13,312    13,312 
    Long Term Debt  41,575   41,575    26,162 
    Total Debt 77,631   54,425    26,162 
               
    Enterprise Value  137,850   137,850    163,619 
     

    Please note that the Conversion assumption will hit LAVA's GAAP income statement only after LAVA generates $1.5m in quarterly GAAP pre-tax earnings at which point excluding conversion shares would be anti-dilutive. I assume conversion in my EPS and valuation however, as well as an additional 5.0m options for a 2011 total of 72.3m diluted shares to remain conservative.

    Financials and Valuation

    LAVA made the switch to a highly ratable revenue model which has clouded the growth and profitability profile of the business. We believe that this is a primary reason for the asymmetric risk reward opportunity in the stock. A typical quarter will draw revenue from backlog of about 95% of the total which leads to clear revenue and EPS visibility. This mutes the growth profile however and makes the stock look reasonably valued on the basis of multiples. Due to the resulting disconnect between the P&L and Cash Flow statements, we base our valuation on cash flows.
     
    We value LAVA using a conservative 10-year DCF which assumes a 7% sales CAGR with most of the growth coming in the next 3 years and operating margins achieving / maintaining 20% by 2014. We assume a full tax rate but give a $50m credit for NOLs which begin to expire in 2019. Using a 10% WACC and 3% perpetual growth results in our target of $5.07. At this price LAVA would trade for 23.9x '11 earnings which is a rich valuation. Given earnings growth of over 40% however, LAVA's PEG would still be substantially below 0.5x. In addition, this model leaves plenty of room for margin upside as we believe LAVA can achieve adjusted margins north of 20%. To illustrate, if we keep all assumptions the same but move margins to 25% by 2015 LAVA would be worth close to $6. Neither of these scenarios is as aggressive as management on the revenue growth.
     
    What's more is that LAVA was generating $20-40m of annual cash flow during '04 to '06 and we believe they can get back there in the next 18-24 months. At an average of $25m of normalized FCF, LAVA trades for less than 9x. If they can achieve $35m of FCF (which we believe is feasible) they're trading for around 6x.
     
     
    Period 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0
    Year 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
                         
    Sales 131,107 144,218 165,851 182,436 191,558 201,136 211,192 221,752 230,622 237,541
    Growth % 6.5% 10.0% 15.0% 10.0% 5.0% 5.0% 5.0% 5.0% 4.0% 3.0%
                         
    EBIT 16,536 21,633 29,853 36,487 38,312 40,227 42,238 44,350 46,124 47,508
    Margin % 12.6% 15.0% 18.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%
                         
    Tax 5,787 7,571 10,449 12,771 13,409 14,079 14,783 15,523 16,144 16,628
    Rate % 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0%
    NOPAT 10,748 14,061 19,405 23,717 24,902 26,148 27,455 28,828 29,981 30,880
                         
    Other Adj. 3,000 1,033 (3,245) (2,488) (1,368) (1,437) (1,509) (1,584) (1,331) (1,038)
    Unlevered FCF 13,748 15,095 16,160 21,229 23,534 24,711 25,946 27,244 28,650 29,842
    Discounted 12,498 12,475 12,141 14,500 14,613 13,949 13,315 12,709 12,151 11,506
                         
    Net Present Value 129,856                  
    Terminal Value 161,418                  
    Enterprise Value 291,273                  
                         
    Net Debt (24,987)                  
    NOL Carryforward 50,000                  
    Equity Value 366,260                  
                         
    Share Value            5.07                  
    Diluted Shares 72,263                  

    Other

    Management

    While management doesn't own as much stock as we'd like, most senior executives are not independently wealthy and we believe that voluntary executive pay cuts and significant efforts to retain employees through the downturn indicate commitment to the long-term success of the business and thus alignment with shareholders.
    What the Street Is Missing
    LAVA's shift to a ratable model has masked strength in the business as measured by cash flow and bookings growth. Also, LAVA's multiple to adjusted EPS is about the same as its peer group despite strong cash flow and above average growth.
    Risks
    We view double-dip recession resulting in a weak tech spend environment as the biggest risk to the stock. While we don't have a great read on this, we believe that LAVA's customer base is healthy and management is committed to controlling expenses (e.g. management took a large voluntary pay cut last year.) Further, LAVA doesn't depend on end-markets; rather they benefit from design starts.
    Market turmoil during the preceding 30 months has lead to conservative spending by LAVA's customer base and the employment market for developers is far from robust. Therefore, failure to grow new markets, including Circuit Simulation, is the largest risk to our thesis. FineSim traction has been strong however, and LAVA's stable core business and healthy cash flow mitigates the risk of permanent capital loss, in our view.
    Conclusion
    LAVA emerged from '09 a stronger company. With a stable core business, an expanded addressable market and new product cycle, we believe LAVA provides compelling upside with low risk of permanent capital loss. We model continued cash flow development with revenue growth and margin expansion over the next several quarters resulting in our $5.06 price target.
     
     

    Catalyst

     

    Next earnings release (8/26/10 Est) - Management tends to sandbag, then beat and raise.

    Bookings growth

    Incremental product introductions

    Revenue development via maturation of ratable model (a loaded spring)

    Management is getting out on the road to tell the story. Also, potential for new analyst coverage.

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