Description

Silicom (SILC) is a little-known networking company that trades at a value multiple belying its rapid revenue and earnings growth.  Silicom currently trades at 10x 2017E EPS and is growing revenue at 25%.  I have written up the company before but there are a few nuances that have changed to improve the story and fortunately these enhancements coincide with a cheap multiple for the stock at these levels.

Silicom primarily supplies network interface cards (NICs) that go into network appliances such as WAN Optimization boxes, firewalls, intrusion prevention devices, application delivery controllers (ADCs), network monitoring devices, storage devices, etc.  The company has over 100 customers and has never lost a customer due to its fanatical customer service.  Silicom supplies over 200 different products, far outstripping its closest competitor, privately held Interface Masters, who has 35.  This combination of product diversity and customer service has created a high barrier to entry and Silicom is the de facto standard when companies are looking to add NICs to their appliances.

Silicom has always had a strong investment thesis as it supplies growing markets while penetrating new customers and introducing new products.  This combination of attributes generated a four year period (2010 – 2014) during which the company grew revenue at a 35% CAGR and expanded operating margins by 500 basis points.   This growth was driven by its WAN Optimization customers that were growing very rapidly at that time.  Growth in the WAN Optimization has since dropped off due to increasing penetration in the 2014 – 2015 timeframe and Silicom’s overall revenue growth dropped to the single digits.

While WAN Optimization has been declining as a percentage of Silicom’s revenue and is currently less than 10%, cybersecurity has been taking its place and now accounts for about 35% of the company’s sales.  As various types of cybercrimes have  been on the rise, the need for cybersecurity at enterprises and service providers has correspondingly increased, as well.  In our estimation, firewalls and intrusions prevention devices have made up the bulk of Silicom’s cybersecurity sales.  Recently other types of security devices have picked up such as Web Application Firewalls (WAFs) and Email security appliances.  As security is top of mind for CEOs and CIOs, this sector promises to have secular growth, benefitting Silicom as well, for the foreseeable future. 

2016 has started out on a much better note with revenue growth of 30% for the first nine months of the year.  This included a blowout second quarter with revenues coming in at $26 million, well above guidance of $22 million.  This growth was driven by a mix of security, storage, and ADC customers with recent design wins beginning to layer in additional revenue over existing programs.

One of the aspects that make Silicom a good business is the long lifecycles of their design wins with their customers.  It usually takes the company six to twelve months of collaboration with their customers to secure a design win in one of their products.  Once launched, these business to business products usually have a three to five year lifecycle meaning that Silicon has a stable base of business to look to each quarter.  Now demand for each of the customers’ products may fluctuate from quarter to quarter but there is an underlying stability of business that you don’t find in consumer facing products such as smartphones where a new model comes out each year.

Silicom has made two small acquisitions over the past few years whose benefits are beginning to materialize at the present time.  Fiberblaze was a company that sold NICs based on Field Programmable Gate Arrays (FPGAs) which are very high end programmable processors used for compute-intensive applications.  Silicom has folded Fiberblaze’s technology into its own offering and the result was a big design win for time-stamping cards at a major network monitoring player.  Time-stamping cards insert a time stamp on each packet that they process which is very important in financial applications. These cards have a substantially higher price tag than Silicom’s other cards and as such represent a large opportunity for the company.

Silicom’s other acquisition was a company called ADI Technology which makes inexpensive cards and appliances based on Intel’s Atom chip.  Obtaining these appliances was timely for Silicom because of a new application called SD-WAN.  SD-WAN proposes a software application running on inexpensive appliances to implement a flexible traffic routing solution between branch offices and the Cloud.  The objective is to save companies money while speeding up their traffic.  Versa Networks, one of the early leaders in the SD-WAN space, has picked Silicom’s ADI box as one of its three appliances to implement SD-WAN solutions.  So far the model has been that the telecom service providers have been buying the SD-WAN solutions and have been offering them to their corporate customers on a hosted basis.  These represent huge opportunities for Silicom as deals could lie in the $10 million+ range compared to $1-2 million for the usual Silicom design win.

The combination of time stamp and SD-WAN has the capability of accelerating Silicom’s revenue over the next few years resulting in a stretch rivaling its 2010 – 2014 run.  Shares of SILC topped out at $70 during that period and it is not inconceivable that we could exceed those levels this time around (on much higher revenue and profits). If the company can reach $125 million in revenue in 2017 and $3.34 in EPS, then a 20x multiple plus $5.41 in net cash on the company’s balance sheet results in a $72 price target.

Silicom’s attractive financial model and accelerating revenue growth also make it a candidate for an acquisition.  The company has a very tight relationship with Intel (INTC) and could aid Intel as a working subsidiary.  Other strategic buyers such as Super Micro Computer (SMCI), Lanner Inc., or Advantech could find revenue synergies with Silcom.  In addition, at current cheap multiples, private equity firms could have an interest as well.

Catalyst

I think that Q4 earnings could be a positive catalyst as could an acqusition of the company as mentioned in my write-up.