Description

In a difficult market for value investing, we continue to find solid technology investments.  This is our third technology (long) write-up in the last month (following MU and LOGM)

Overview

Magnachip (MX) trades at 3.75x EBITDA and 6.3x P/E (consensus estimates) despite a stable business model with low capital requirements and high free cash flow. This is a growing business with several near term and identifiable value accretion / growth opportunities that should drive both revenue and earnings growth.  Further upside is achievable with a reasonable semiconductor industry recovery. We believe MX has $3.18 of earnings power in 2013, pro forma for refinancing its senior notes (callable in April 2014), which, at a 10x multiple, offers close to 100% upside from current levels (current 15% FCF yield).  MX is an analog mixed signal semiconductor manufacturer based in South Korea with blue-chip clients and more than 2,200 products in the mobile device, consumer electronics, computing, automotive, and industrial industries.

Business Model

Magnachip operates a hybrid business model, serving as both a foundry provider for fabless semiconductor manufacturers while also designing and manufacturing its own power management and display drivers. MX is in the process of transitioning its wafers away from lower priced, lower margin wafer foundry products to higher priced, higher margin internally designed products. MX is able to smooth the product cycles of its two largest customers, Samsung and Apple, by back-filling its fab with external foundry services for fabless manufacturers in order to achieve steady utilization rates and profit margins. This hybrid model has enabled MX to meet or exceed revenues and gross profit margin guidance for all 9 quarters since its IPO, including Q1-13, despite a severe production slowdown at CRUS and other key AAPL suppliers.

In addition, the analog mixed signal market is less capital intensive and more stable than the digital market (occupied by TSMC, Global Foundries, etc.), and given wafer prices that are less than half of those earned by digital foundry players, there is no incentive for digital foundries to move into the analog space or for new entrants to spend the capital required to build a new fab.

Management

MX is focused on building sustainable growth, controlling expenses, and allocating capital efficiently to maximize value for shareholders. MX is led by CEO Park Sang, formerly the CEO of Hynix Semiconductor and an executive at Intel, who owns a significant stake in the company and is aligned with shareholders. Based on his public comments, Park Sang appears to be highly focused on generating stable cash flows and creating value for shareholders through share buybacks and steady, sustainable growth. MX recently added YJ Kim, formerly responsible for 70% of the revenues at Cavium (CAVM), to run its Display business and capitalize on the growth opportunities in that area.

Financial Overview

By transitioning capacity to higher dollar value internal products in its Display and Power segments, MX can grow revenues and gross profit margins while spending fewer cap-ex dollars vs. peers (7% of revenues over last 3 years on average vs. 12% average for peers). MX management’s goal is to grow revenues at 5% - 15% annually and improve gross profit margin by 1% - 2% annually. Rolling forward these guidance mid-points vs. 2012 yields $900mm revenues, $300mm gross profit, $170mm Adjusted EBITDA, $86mm FCF, and $3.18 of EPS (assuming 10.5% $200mm bonds refinanced at 6%, currently trading at 111). At a 10x multiple, MX offers 100% upside from current price of $15.91 (MX peers (FCS, ONNN, Rohm, Infineon) trade >10x 2014 P/E). We believe a 10x multiple is appropriate given MX’s stable business model, growth opportunities, and favorable cash characteristics ($280mm of NOLs and limited cap ex requirements). We believe there is upside to these estimates in 2013 and 2014, based on new product cycles at AAPL and Samsung and continuing shift in its business model to higher value products.

Upside Opportunities

MX has moved quickly into the smartphone and tablet markets and is leveraged to capture the continued explosive growth in these products worldwide. In addition, Samsung and AAPL represent ~40% of MX’s revenues (either directly or through intermediate suppliers), positioning them with the two strongest and fastest growing players. MX has also diversified into faster growing segments within analog semis, particularly power management, which is becoming more critical over time given the explosion in screen size, content, and screen resolution on mobile devices.

MX is well-positioned in the fast-growing AMOLED market, both for smartphones and eventually for TVs, as a key supplier for Samsung and LG. Samsung and LG could both introduce AMOLED TVs at competitive prices by the end of this year (or in 2014), which yields 2-3x the content per TV for MX vs. an LCD TV (LCD TVs are currently 12% of revenues, implying significant upside from widespread adoption). MX is also developing products for flexible display smartphones and tablets, which Samsung could introduce within a year, along with sensors for e-compasses, motion gesture, and temperature and humidity, all representing additional content per smartphone for MX. In addition, MX is designing products for the fast-growing LED lighting segment for green energy applications, as well as “energy harvesting” sensors, to power chips with natural kinetic energy in a variety of consumer applications.

Why is MX materially undervalued?

We believe MX is materially undervalued, primarily due to 3 factors, which we do not see as issues for long term value investors:

1)     MX went bankrupt in 2009: MX spun out from Hynix Semiconductor in 2004 and underwent a financial restructuring in 2009, due to inappropriate leverage levels, and eventually emerged in an IPO at $14 per share in March of 2011 with $200mm of 10.5% bonds. Since 2009, MX has

1. diversified into its more stable current hybrid business model
2. expanded aggressively into fast growing smartphone and tablet markets
3. reduced its current leverage level to below 1.5x, with recently improved credit ratings, and its bonds trading at 111

Restructuring left the company with $280mm of NOLs at year end 2012, and MX only expects to pay $10mm - $15mm annually in cash taxes for the foreseeable future.

2)     Avenue Capital, MX’s largest shareholder, has been selling its stake: Avenue stepped in during the 2009 restructuring, and held a 70% stake post-IPO. Since then, Avenue has reduced its stake to ~20%. We believe that Avenue’s cost basis is only $1 or $2, and they are currently marketing for a new fund. Avenue, a primarily distressed debt firm, is exiting to fully realize a highly successful investment in line with standard practice. We believe an eventual complete exit will be a positive catalyst for the stock and remove a key overhang.

3)     MX is based in South Korea: We believe that US investors assign a discount to MX as it is based in South Korea, however we feel that this positioning is actually an advantage due its proximity to Samsung and LG. Samsung values local suppliers, particularly for its cutting edge AMOLED technologies and other high growth products which cannot be leaked to competitors. For certain key components in the Galaxy S4, MX will be the sole secondary supplier to Samsung internal. This close working relationship can provide meaningful upside to MX going forward. We believe that the physical proximity and cultural / language similarities are key advantages for MX with Samsung.

Conclusion

We believe MX is a compelling value investment, with 100% upside in the next year, based on its continued execution and refinancing its bonds to market rates.  If any of these emerging technologies take hold, it is possible we see a more meaningful earnings multiple (say 12-15x), which would yield upside of as much as 200%.

Catalyst