Summary:
Profits at Silicom should grow over 80% in the next two years (2017 → 2019) which should result in the stock price materially outperforming the S&P 500 and Russell 2000.  Silicom reported 2017 sales of $125 million, but more importantly design wins for additional sales exceeded $100 million. New orders are a leading indicator that sales and EPS growth will accelerate in 2018.

Why Does This Investment Opportunity Exist?

Silicom is a small cap company with a $500 million market capitalization and only 2 analysts publishing research. The company headquarters is overseas and they do not attend investor conferences in the United States. Thus the company is not well covered by buy-side or sell-side analysts. As a result it is not surprising that investors have not yet fully recognized the dramatic improvement in the future growth prospects for Silicom.

After describing the business below, this stock recommendation gets more interesting at the investment thesis section.

Business Description:

Exponential growth in data and internet traffic dramatically increase the need for connectivity and bandwidth solutions.  This tailwind has helped Silicom to grow sales at a 27% CAGR in the past 7 years and operating profits at a 37% CAGR.

Silicom has over 150 networking customers with 400+ active product designs generating sales.

These customers include: Cisco, Juniper, McAfee, Citrix, Checkpoint Software, Dell,  & IBM.

Silicom’s customers are constantly striving to improve the performance of their products.

One common customer challenge is slow server performance. Silicom solves this problem by off-loading tasks performed by the server  (CPU) central processing unit such as encryption and compression.

In essence Silicom allows their customers to outsource some of their R&D to Silicom. The OEMs do this because Silicom can more rapidly develop solutions for hardware acceleration, low-latency, encryption, virtualization, time stamping at a lower cost than the OEMs.

Silicom’s customers sell products for use in data centers, WAN optimization, internet security, network monitoring, and cyber security.

Silicom has a good business model:

It takes 12-18 months for Silicom to win a design win. After the product launches, Silicom’s product design has a 3-5 year lifespan.  Each adapter card Silicom ships has an average price of $350, but price points for new design wins are higher.  For most design wins Silicom is the exclusive supplier.

Sales visibility is good as 96% of Silicom sales are classified as repeat revenue.

Product prices tend to fall 3-5% per year, but costs fall at a similar pace.

Return on equity is 18%.

Design Wins Drive Future Sales Growth:

There were two years in 2014-2015 that sales growth slowed as Silicom was not able to increase the dollar value of its design wins. Fortunately an expansion into new vertical markets such as data centers and the cloud has resulted in an increase in the current dollar value of design wins. Silicom was also able to acquire new technical skills with (FPGAs) field programmable gate-arrays that will contribute materially to sales in the future.

Investment Thesis:

Silicom is benefitting directly as the technology architecture shifts from on-premise networking devices,  to devices deployed  in the cloud. In the past Silicom’s sales were limited to networking firms such as Cisco.  Then they expanded into the cyber-security realm (36% of sales), and now Silicom is selling to cloud vendors.

There are many ways to invest. In the technology sector momentum investing can be very successful.

The ideal situation involves a new product cycle that causes a firm’s sales growth to accelerate, positive earnings surprises and the valuation of the firm to be rerated upwards. Silicom represents such an example.  Silicom has reported record design win activity in 2017 from new products, which is translating into faster sales growth and quarterly earnings well above the Wall Street estimates. We believe that Silicom’s EPS in 2019 will be 41% above today’s Wall Street analyst consensus. (see table above)  Silicom is valued at a 12x P/E on our 2019 EPS estimates of $5.20. As Silicom reports this more rapid year over year EPS growth of 40%, it seems reasonable that the firm’s P/E will be rerated upwards to 20x or 25x 2019 EPS estimates. As a result Silicom’s stock price may reach $104 over the next 2 years which provides 60% upside.

Design wins exceeding  $100 million per year in 2017:

Forecasting  profits at Silicom is a function of understanding the dollar value of new design wins at the company. These design wins add to the base of revenue that the company is already generating.

The good news is that design wins in 2017 have exceeded $100 million in future annual sales. That represents 80% of the current 2017 years sales of $125 million for the entire company.

Here is a recent quote from the company the illustrates the improving fundamentals at Silicom.

“THE REVENUE POTENTIAL PER DESIGN WIN WITH MAJOR CLOUD, DATA CENTER AND SERVICE PROVIDER CUSTOMERS  IN THE PIPELINE TODAY IS HIGHER BY AN ORDER OF MAGNITUDE THAN OUR DESIGN WINS OF THE PAST. “

Our 2019 EPS estimates are actually still conservative. We only incorporate the new design wins in place. We have not included design wins  that Silicom will close over the next 15 months that will add to our current 2019 sales estimates.

Operating Leverage Is Possible:

Silicom has 260 employees which translates into $480,000 in sales/employee.

In the past a design win that generated $1 million in sales annually was celebrated. Today some new design wins for the datacenter and cloud end markets are expected to generate $10 million in annual sales and even more in some cases.  A similar number of engineers is winning these $10 million versus

$1 million designs wins.  The larger wins have lower gross margins, but the operating margin contribution from these new design wins will certainly be higher than the corporate average. Thus  profits at Silicom are likely to grow faster than sales.

Small Cap Stocks Are Not Well Covered:

Only 2 sell-side firms at Needham and Joseph Gunnar cover Silicom. This partially explains why investors are not fully aware of the dramatic improvement in fundamentals at Silicom during 2017. The company does not attend many investor conferences  and there are no direct competitors that are public. As a result Silicom falls through the cracks among the other thousands of companies that are public.

Management is Very Bullish:

We have followed the Silicom management team for the past five years. Historically they have been very conservative in their public dialogue with investors. Thus it is remarkable how management’s commentary on the business outlook has changed.  In the June 2017 quarterly call the CEO stated that Silicom has reached a strategic inflection point in our growth trajectory.  On the September 2017 quarterly call the CEO stated that the company is perfectly positioned to drive sales in the next gen datacenter and cloud.

Risks:

Gross Margins Will Decline:

Gross margins have declined 700 basis points in the two years ended 2017,  as management is focused on maximizing pre-tax profits even if it means gross margins decline. This has spooked investors as management reiterated a 32-36% gross margin target, but flat operating margins. In the technology sector  companies with declining gross margins can see their valuation multiple contract.

Design Wins Have Been Disappointing In The Past:

In the 2013 -2015 time-frame the dollar value of design wins at Silicom did not grow year over year. As a result sales growth quickly slowed to  a 5-10% year over year pace.

Sales growth limited by sales growth at its networking customers

Silicom’s sales growth is impacted by the health of their customers.  If sales at Silicom’s customers decline, this will lead to weaker sales at Silicom.  Today a number of Silicom’s long-time customers have seen their sales mature.  Corporate sales growth at Cisco, Juniper, and Brocade are declining year over year. Silicom can only grow at these customers by providing additional functionality in their design wins.

The good news is that Silicom still has plenty of opportunity to further penetrate its customer’s product portfolio.  Silicom’s customers combined sales exceed $100 Billion compared to annual sales of $125 million at Silicom. This 12 basis point penetration rate of the customer base sales, shows how much more opportunity remains for Silicom to add value at its customers.

Customers being acquired can lead to destocking of inventory and short-term sales slowdown.

Silicom has had a few quarters in the past where sales fell below management’s guidance.

One past reason for weak sales was a result of OEM customers being acquired. At times there would be inventory destocking which led to a temporary slow-down in customer orders at Silicom.

Customer Product launches can be delayed and Silicom product sales are delayed as well.

At other times Silicom sales might miss management’s guidance if a large customer delayed their launch of a new product that included a Silicom adapter card.  This could happen again.

Foreign Currency RIsk

Most employees work in Israel, while most sales are denominated in USA dollars. A large increase in the value of the Israeli Shekel relative to the dollar would  increase operating expenses.

Competition:

The biggest competitive threat is from Silicom’s own customers.  Everything Silicom does can be done by their OEM customers  in-house. So far customers have decided to outsource  development of these solutions since Silicom has a faster time to market and sells OEMs the various  adapters at lower prices than the OEMs could realize in-house.  

There are  independent companies competing with Silicom, but none of them have the breadth of solutions that are available at Silicom.  Cavium competes for encryption sales. Interface Masters competes in server adapters. NetOptics competes in bypass switches.