Description

Pericom Semiconductor (PSEM) is a niche semiconductor company. PSEM is undergoing a transformation that is being masked by its legacy products and restructuring. Hence, PSEM is mispriced by the market. As the new PSEM emerges in the numbers, I expect that investors will realize the true underlying value of this company and will provide a catalyst for substantial price appreciation down the road.

Company Background

During the bubble years of 1999 - 2000, PSEM grew rapidly with primarily one product line, high speed interface products for the computer and communications industries. It rode the boom years during the internet bubble, and grew sales to as high as $108 millions in FY2001 (ending on June 30, 2001). Subsequently, it rode the crash of the internet bubble down and recorded sales of $47 millions in FY2002. Sales grew to $66 millions in FY2004. Analysts are projecting FY2005 revenue to come in at around $81 million.

In the last several years, PSEM has also focused on the investment of marketing and applications centers in China, having offices in Taiwan, Hong Kong and Shanghai (through a joint venture). Its strategy is to address the growing design-in needs of that region. Foreign sales represented over 70% of revenue in FY2004.

PSEM is a “fabless” semiconductor company. Its manufacturing and testing are subcontracted to various manufacturing companies. Hence, the capital expenditures are very modest ($3 millions in FY2004). It sells directly to end customers, or through distributors. As more and more or the manufacturing of its end customers are out-sourced to contract manufacturers (CM), sales to CMs represent a larger and larger piece of its overall revenue.

On the balance sheet, PSEM has $143 million of cash and short term investment, approximately $5.4 per share, based on 26.5 million shares outstanding. PSEM did not have to dip very much into its cash reserve during the transition years from 2002 to 2004. During FY2004, its cash position changed by about $4 million. It has no debt on its balance sheet.

Company transformation

PSEM entered the internet bubble years of 1999 to 2000 with a narrow product line of interface products. Because of the boom in the build out of the internet, PSEM’s sales zoomed to $108 millions in FY2001. The second half of FY2001 (the first half of year 2001) represented the start of the precipitous fall of revenue and profits for PSEM to which it still has not recovered.

In the intervening years, PSEM diversified its product lines. As of the end of FY2004, it has expanded its product lines to include 5 different lines covering a broad spectrum of interface, timing and frequency control applications. PSEM’s end markets have also been broadened to cover various applications within the computing and the communications market place. As a result, it has a broader set of products addressing a broader set of markets.

From 2001 to today, the market of PSEM products has been extremely competitive. As a result, PSEM has to be price competitive, especially with its legacy products, in order to hold on to its market share. Consequently, its gross margin has declined. Gross margin reached a high of 42.3% during FY2001, and declined to a low of 29% in FY2002. Gross margin slowly recovered to 32% in FY2004.

Even in the second quarter of FY2005, gross margin was at an unattractive 31%. Gross profit was $5,998K against a revenue of $19,217K. However, if we look beneath the cover, the story is very different. The gross profit in 2Q of FY2005 was impaired by an inventory write down of $1,044K of obsolete products and restructuring cost of $680K associated with an acquisition. Gross profit was improved due to sales of $778K of inventory that had been written off. Adjusting for all these items, the gross margin was a respectable 37.7%.

More importantly, new product revenues continue to grow rapidly. New product revenues accounted for 49% of IC revenue during the fourth quarter of FY2004, compared to 40% of the prior period. In addition, new product revenues grew 56% year over year. These new products are proprietary and tend to carry higher margins, ranging from 50% to as high as 60%.

As the new products grow and the legacy products decline, higher gross profit drop through will have a significant effect on the bottom line. We can look at one such (simplified) scenario. Base case:

FY2005
Revenue, $M (note 1) 81
Net, $M (note 1) (1.0)
EPS, $ (27 millions shares) (0.04)

Growth and gross margin improvement scenario (45% drop through in FY2006, 50% thereafter). This assumes that high new margin products will grow and low margin legacy products will decline in revenue:

FY2006 FY2007 FY2008 FY2009
Revenue, $M (note 2) 97 115 135 160
Gross profit drop through 7.2 16.2 26.2 38.7
Net, $M (note 3) 2.7 7.6 13.0 20.0
EPS, $ (27 million shares) 0.1 0.28 0.48 0.74
Value at Forward PE of 25 7.0 12.0 18.5
Price with $5.4 cash 12.4 17.4 23.9

Note 1: Industry analysts’ estimates.
Note2: My estimates, with growth of 18% per year.
Note 3: Assuming all operating expenses to grow at 5% per year and a 35% effective tax rate.

Another way to triangulate the value of PSEM going forward is to look at its EV/Sales ratio. Netting out its cash of $143 millions, its EV/S is 1.1 (92/81), which is very low compared to the 2.5 to 4 given to most semiconductor companies. I suppose that PSEM is worth a low EV/S ratio because of a low gross margin of 32%. However, because of the transformation and incremental drop through of gross margin of new products are in the 50% - 60% range, a industry average EV/S ratio is warranted. Hence, using this valuation method:

FY2006 FY2007 FY2008 FY2009
Revenue, $M 97 115 135 160
EV at EV/S of 2.5, $M 243 288 338 400
Market Cap, $M 386 431 481 543
Price/share. $ at 27m shares 14.3 16.0 17.8

Both methods result in a doubling of price in 2 years and further price growth in subsequent years.

Risks

1. The higher margin will not materialize. This risk is small as there are ample evidence already that the new products are commanding higher margins.

2. Growth will not materialize. PSEM is subject to the cyclical nature of the semiconductor industry and the electronics end markets. We are in the fifth year after the bursting of the internet bubble. Last time when we had a bubble (the PC driven bubble of 1985) it took the industry approximately 5 years to start to grow again. If history is a good guide, the semiconductor industry will start to grow soon. PSEM is well position to capture the growth in its niche.

3. With $5.4 per share of cash and a close-to-zero burn rate, the down side risk is low from here.

Disclosure: I own PSEM shares.

Catalysts

1. Continue expansion of gross margin.
2. Expansion in the semiconductor industry and PSEM sales.

Catalyst

1. Continue expansion of gross margin.
2. Expansion in the semiconductor industry and PSEM sales.