Description

Sanken (6707 JP)

Investment Summary

Shares of Japan-based power semiconductor company Sanken currently offer a special situation with a compelling risk-reward. Shares currently trade at a fraction of the value of its 52% stake in Allegro Microsystems (US: “ALGM”), a US based analog semiconductor integrated design company. This is before ascribing any value to Sanken’s $850m revenue core business of supplying power semiconductors to the industrial and white goods (i.e., appliances) end markets. A large Singapore-based hedge fund focused on Japan-based activism (Effissimo) took a sizeable stake in Sanken just over a year ago, which should unlock the value over time. In the interim, Allegro is a well-managed, high quality growth company that is racking up design wins and market leadership in some exciting areas (EV’s, ADAS, hyperscale data center, factory automation, and others), where you can conservatively underwrite mid-to-high teens earnings growth, and compound value while the situation plays out.

Why does this opportunity exist? 

1.  Sanken is listed in Japan which historically has allowed significant dislocations and opportunities to exist (until they don’t)

2.  Sanken is a small cap stock with no active street coverage.  The only broker that publishes occasionally on Sanken is Mitsubishi UFJ, but there is not much of substance to the research.

3.  The market has yet to appreciate recent steps by management to restructure the core Sanken business, which has operated close to break-even over the last four years.   

What can cause this value gap to close? 

In February of 2021, Effissimo Capital initiated a tender offer for 30% of Sanken’s equity at ¥5205 per share, an approximate 7% premium at that time (shares currently ¥4970).  Effissimo is an $8.9 billion activist hedge fund that is based in Singapore and focused exclusively on Japan activism.  They are the largest shareholder of Toshiba, where they have been the architect of an activism campaign. Their efforts contributed to Toshiba moving to split into two companies (infrastructure and devices/semiconductors), while also monetizing non-core assets and pledging capital returns.

We believe similar value-creating levers are available in the case of Sanken. While Effissimo was only able to acquire 20% of Sanken’s outstanding shares via the March 2021 tender, this represents almost double the ownership in the Toshiba situation. We suspect the degree of misvaluation to be higher as well in the much smaller Sanken, which sets the stage for a superior result. We believe the Sanken position today represents the 6th largest holding in Effissimo’s portfolio, and given the tender for 30%, some buying power should remain.  We believe Effissimo will continue to tender for additional shares to at least get to 30% ownership, which is a key level in Japan in terms of shareholder influence.  Ultimately, we believe a sensible activist playbook would be to monetize the ALGM stake (most likely through a sale to a strategic), complete the restructuring of core Sanken, and distribute excess value from ALGM.

Allegro is a valuable strategic asset with extensive intellectual property and technology leadership in strong growth areas.  The revenue base is split between Automotive (69%), Industrial (17%) and other.  In automotive, they are the dominant market share player in the metallic sensor integrated circuit market and benefit via a 60% content uplift in the transition to electric vehicles (“EV”).  It is a fabless semiconductor company and is bringing on new wafer supply that should continue to improve the current gross margins of the business from 54% to 57% by FY24.  As wafer supply constraints dissipate and Allegro continues to optimize its wafer supply from a suboptimal legacy position, we expect strong EPS growth. Our estimates of $1.20 and $1.65 for CY22 and CY23, respectively compare to consensus of $0.92 and $1.11.  We believe ALGM is worth $40 per share on a fundamental basis (using discounted multiples for a growth, mid-cap semi) and strategically worth at least $50 per share (from ~$29.37 now). 

Below is our sum-of-the-parts driven calculation of an upside scenario yielding 140% upside to Sanken at current market prices for ALGM, where there are a few things we would note:

1.  There would be even greater upside in the event ALGM was sold to a strategic buyer, as we strongly suspect it will in the medium term

2.  Even in the absence of any such deal, the ALGM piece should compound in value via earnings growth and cash generation

3.  The value for core Sanken below excludes any strategic actions that could be undertaken to better utilize Polar (their foundry asset), with most likely path to value being a sale of the sub-scale Polar (still of value in a capacity-constrained market) while outsourcing the foundry piece.

4.  There may be ways to avoid the tax bill we calculated on the ultimate ALGM sale, which is significant as it would add ~30% to the return

In our opinion, the Sanken trade does not set up well as a ‘stub’ trade (ie. shorting out the ALGM). While this might appeal to the deep value special situations investor who might have trouble underwriting ALGM’s valuation (26.5x P/E using consensus CY23 EPS), our work has led us to higher earnings estimates and an appreciation for the trajectory of the business. Further, one runs the risk of ALGM being sold for a large premium without the value accruing fully and immediately in shares of Sanken. Below, we lay out the business background and investment merits for ALGM on a standalone basis, which is by far the largest piece of the sum-of-the-parts.

Allegro Microsystems (ALGM)

• Fabless analog semiconductor company, IPO’d October ’20 at $14. Focused on sensor integrated circuits (ICs) that measure motion, speed, position, and current; and application-specific analog power ICs such as motor drivers that can operate in high-temperature and/or high voltage environments

• Over 1,200 active US patents and 10k+ customers with no 10% customers
• Long contract commitments where product peaks around year 7, and often extends > 10 years
• Revenues by product segment (LTM)

o   Magnetic Sensors 65% - #1 player - current, speed, motion, and position sensors

o   Power IC 35% - power mgmt. ICs, DC/DC converters, inverters, motor drivers

• Revenues by end market (LTM)

o   Auto 69% (sensor and power IC’s throughout the powertrain, comfort/convenience systems, ADAS, and EV content to include DC/DC converters, inverters, motor drivers)

o   Ind’l 17% (includes data center, factory automation/robotics, solar, smart home IoT, industrial LiDAR/range finders)

o   other (gaming, PC, printers and peripherals, personal electronics) 14%

• Customers

• Growth Drivers

o   Magnetic sensors content within automotive is growing based on safety advancements, tighter emission standards, and the speed, sensitivity, and accuracy requirements in Advanced Driver Assistance Systems (“ADAS”). Automotive applications include steering, speed sensing, parking, motor torque, seat position, camshaft, brake/oil sensors, emissions, and battery monitoring (in EVs, add inverters, current sensing, and regenerative braking products). Regarding ADAS, as of 2020, 50% of vehicles sold were Level 1 or higher ADAS, which is expected to be 92% by 2032, providing a runway of growth for Allegro’s full suite of Magnetic sensor and photonics solutions. Content per vehicle sees a nice uplift here as well. Management notes that the 2017 Ford F-150 had $4 of their content in the steering system, but because of ADAS, the 2021 version has $12.

o   Auto electrification – Total Hybrid EV (‘HEV’)/ EV production is forecast to grow north of 25% through 2028, and ALGM has said recently that they expect to grow their EV business at a faster rate. ALGM has a particularly strong set of IP within EVs and is the market leader across this portfolio. Their combined content per vehicle (across Magnetic Sensor IC and Power IC) increases by 60% (from $37 for an internal combustion engine vehicle to $59 in a mild or fully electric vehicle). ALGM also has content on EV charging infrastructure. In its February conference call, Allegro reported a design win for the next generation steering systems for Tesla, showing continued leadership where it counts.

o   Power ICs are enjoying a secular tailwind form the conversion to 48V technology. There is an ongoing trend towards 48-volt (“48V”) power systems in a number of ALGM’s industrial end markets. While handling the heavier load caused by increased use of technology, automation, and data, a 48V system is also more efficient, with better thermal performance and a smaller form factor. ALGM has been in a unique position to capitalize on this trend, having gained experience as a supplier of 48V technology to mild-hybrid vehicle platforms. ALGM’s expertise there adds to the moat as they pursue Power IC opportunities in factory and building automation, robotics, data center, infrastructure, and more. Hyperscale data centers are all moving to 48V to enable higher power distribution and to optimize carbon footprint. To this end, in their November ’21 conference call, ALGM discussed newly signed long-term agreements with the 3 largest hyperscale players, which will more than double their data center revenue over the course of the contracts.

o   Note: One nice forward looking metric that gets at this – management reports their design wins in their growth markets. These markets – EV, ADAS, and Industry 4.0 / Data center – had design wins up nearly 100% on a rolling four-quarter basis, with overall wins +25%. These wins have accelerated somewhat; five quarters ago the overall design wins were +20%.

• Valuation and Comps

o   In the table below, we compare ALGM to 4 fabless semiconductor companies, though of course no comparison is perfect. We left in the hybrid comps for what they are worth; really they make more sense just to be aware of as potential strategic buyers. We would note that ALGM grows 400 bps faster than the average of the ‘Fabless Four’ (sorry), yet it trades at a 2.9 turn discount on average EV/EBITDA. In addition:

• This is based on Street estimates, which we see as meaningfully too low. First, CY23 estimates have 14% revenue growth despite design wins trending in the +25% range and secularly fast-growing areas becoming an increasing part of the pie. Also, the global auto SAAR has 25-28% upside to prior peak – even getting some of that back would be a powerful driver.
• There is likely more upside to ALGM gross margins in the medium term, as they ramp up with a better scaled wafer producer (TSMC) and wean themselves off of the legacy foundry (Sanken owned Polar), ideally if and when Sanken divests it to a buyer that can use the capacity.

·         M&A suitors – we think there are a number of possible suitors for ALGM if they were to run a proper process, and a good bit of financial firepower. They include:

Sanken Electric (6707 JP)

In this curious special situation, you don’t need any value from the core parentco operations to underwrite a solid risk/reward in its own equity. In fact, there is negligible ascribed equity value in our sum-of-the-parts above. There is potential for value here, and certainly some option value.

Sanken has been around since the 1930’s; over time it evolved into a power electronics firm. The current product portfolio is mainly semiconductor devices for autos and home appliances, as well as components for industrial machinery, factory automation, printers, and servers.

“Core Sanken”, or Sanken excluding the contribution of Allegro, has struggled to produce consistent profits. However, they have stepped up their restructuring, divestment, and outsourcing actions in recent years. They have also worked to revamp the R&D processes over time and are focused on having more “newness” in the product portfolio. “New” product sales were only 5% in 2015, and have worked their way up to 10% as of 3 quarters ago, but this takes time. They also have developed JV’s and partnerships, including one with STMicro in Power Modules, where the new product cycle has been shortened to 1-2 years compared to 5-6 years historically at Sanken standalone.

These efforts, in particular those to drive more new product introductions, are expected to have a material impact on profitability. Sanken has guided to a 13% operating margin for the fiscal year ending March ’24. If they are able to do so while growing the topline, there would be some upside to the Sanken piece in our sum-of-the-parts.

Risks

1.  Activist fails to bring about any meaningful change; exits stock and, along with followers, leaves a mark

2.  Further compression in growth multiples as interest rates rise

3.  Geopolitical risks to economic activity, especially global auto SAAR

Disclaimer: This does not represent investment advice. This write-up is intended for informational purposes only and you should not make any financial, investment, or trading decisions based upon the author's commentary. Although the information set forth above has been obtained or derived from sources believed to be reliable, the author does not make any representation or warranty, express or implied, as to the information's accuracy or completeness, nor does the author recommend that the above information serve as the basis of any investment decision. At any time, the author of this report may trade in or out of any securities that are mentioned in the write-up without disclosing this information. This is not an offer to sell or a solicitation of an offer to buy any security.

Catalyst

• Activist engaged
• Very strong results expected from ALGM in coming years