Tessera (TSRA) has been posted in VIC a couple times, both with decent success for the authors - the last time 2 years ago, but I believe now may be the most compelling time to own Tessera in recent memory.  I see over 50% upside and downside of 10% based on the newly restructured business and its new go forward strategy.

 

Since the last writeup, Tessera has seen a proxy contest run by Starboard, which resulted in a settlement, a new board, a new management team, and a new strategy.  The new team has simplified the business and corporate strategy, rightsized the cost structure, eliminated money losing operations, changed its market approach from litigious patent enforcer to a value added technology partner to other technology suppliers.

 

In the past, Tessera was a combination of two businesses 1) a highly profitable IP business and 2) an early-stage, money-losing, mems-based smartphone camera supplier.   The outlook for the IP business was generally good, but there remained significant questions as to the sustainability and magnitude of this business on a go-forward basis.  Key IP licenses had yet to be signed or extended to include next generation IP for Samsung, Hynix, and Micron.  And outside of DRAM, there were real questions as to what opportuntiy Tessera really had to grow the business.

 

The mems-based camera business had even more uncertainty.  It was highly unprofitable and had a series of profit and performance timelines and objectives that continued to be pushed out further every year.  While the technology seemed promising, the total magnitude of losses required to achieve a viable business was unknown, but likely quite large.  And worse yet, management seemed dedicated to generating success in this business regardless of the cost to achieve it.

 

And finally, Tessera had a series of relatively large legal disputes to fight in the courts including PTI, Qualcomm, and Amkor.  These had the prospect of being very costly to fight and they offered unknown value to Tessera.

 

The new Tessera has changed into an IP developer with key DRAM, semiconductor, wireless, and digital photography based patents.  DRAM has been and for the forseeable future will be the main contributor to revenue.  Tessera's key IP in xFD, BVA, and 3D-IC should ensure its status as a key provider of technology in the DRAM space for quite a while.  Long term agreements with both Samsung and SKhynix would indicate that at least 2/3 of DRAM suppliers agree with this assessment.  

 

A renewal of the Micron IP contract remains outstanding, and this is the last piece required to fully simplify and de-risk the IP story.  Legacy Micron (before the Elpida merger) generated ~$40m per year from 2010-2012 for Tessera, before its contract expired.  A reasonable assumption for renewal is a similar level of revenue at very high incremental margin.  If we assume 90% margin and $40m of revenue, 35% tax rate, then this contract alone is worth ~$0.43/share for TSRA.

 

The new management team decided in late 2013 to exit the money-losing camera supplier business, and instead refocus on monetizing valuable IP created by that business.  So the cash bleed days are gone in the optics business, and Tessera now is focused on licensing key digital photography IP including facial detection, blink detection, red-eye reduction, video stabilization, and face beautification among other technologies.  These features are now widely used across the smartphone universe, and Tessera has a large opportunity to receive royalties on these technologies.

 

Tessera also has an option remaining on the eventual success of its mems-based smartphone camera business.  Old management had tried to build and grow its own manufacturing and assembly capability to grow the business.  New management has sold off the legacy equipment and is selling non-exclusive licenses to the technology to partners who want to try to develop the technology themselves.  The first license was bought by O-Film.  Tessera received $20.5m for a multi-year agreement to use its photo IP, $7.5m for a non-exclusive use of the mems IP, and undisclosed per unit royalties on future cameras produced by O-Film, or $28m+ for its first major customer for its newly named segment, FotoNation.

 

Tessera management indicated on the Q1 call that the combination of DRAM, FotoNation, and other IP now generates about $150m of recurring revenue per year, starting in 2015.  Upside would come from Micron renewal, growth of the FotoNation base, and new licenses in semiconductor and wireless segments based on the expanded IP portfolio.

 

Finally, Tessera has largely resolved its outstanding litigation.  PTI and Qualcomm were favorably settled for Tessera and avoided major litigation (as were Sony, Renesas, and several other notably names in the semiconductor universe).  Amkor arbitration continues to go in Tessera's favor with an arbitration panel recently awarding Tessera $145m plus ongoing interest (including $20m paid to date), and Tessera continues to seek other arbitration claims from Amkor on infringement of its IP and contracts.  There are also a couple other outstanding litigation procedures later this year including STMico that could continue to add to Tessera's cash balances.

 

Tessera today has a net cash balance of $6.66/share, so ex-cash, TSRA is trading at $15.30/share.  In addition, the Amkor award of $125m would add another $1.50 of net cash after tax, reducing the ex-cash and soon to be cash TSRA value to $13.70.  The remaining business today is generating a base of $150m of revenue based on currently signed IP, which management has indicated will generate 50% operating income.  This equates to $0.90/share of EPS.   So the market is effectively putting a 15x multiple on this business as it stands today, below the multiple for peer RMBS (18x 2015 eps).

 

A Micron royalty for $40m/year would add $0.43/share to the 2015 EPS total, assuming that eventually gets signed.  Given that Samsung and SKHynix have already signed, and Elpida's supplier PTI has recently settled for historical claims through year end 2012, it seems reasonable to assume that Micron will eventually be paying royalties to Tessera also.

 

Each additional FotoNation deal similar to the O-Film deal would incrementally add about $28m of revenue and $0.30/share of EPS.

 

And then there is growth from other Invensas and FotoNation IP, where incremental awards contribute very high incremental margins.

 

So with Micron and one incremental FototNation deal, or some combination of IP awards that generate similar revenue, EPS for 2015 could easily hit $1.60/share.  

 

I think the upside in TSRA is $32+/share - or about 50% higher.  This assumes current net cash, payment by Amkor for the $125m, Micron renewal at $40m of revenue as above, and one incremental FotoNation deal similar to O-Film or some other combination of IP deals that lead to a similar royalty.  This would generate a core business with $1.60/share of EPS and have net cash of $8.10/share and growing.  I value the core business at 15x, which I think is conservative, as there is almost no remaining capex at TSRA - all of its development is effectively expensed through R&D.  Therefore, TSRA would be generating $1.60/yr+ of cash available for buybacks and could generate organic earnings growth simply by effectively deploying its capital.

 

I believe there are clear upsides to the case described above by continued success with IP licensing, more litigation awards from Amkor, PTI, STMicro, and more aggressive return of net cash to shareholders as the shift away from a pure litigation strategy has reduced the need for large net cash balances.  Also, if O-Film or others are successful with the mems-autofocus technology, TSRA may also eventually generate meaningful royalties on camera module production.

 

I think downside in TSRA is $19/share - or down about 10%.  This assumes current net cash, payment by Amkor for the arbitration amount ($125m incremental but nothing for the pending additional Amkor litigation nor any accrued interest which is running at 10% per year), and no Micron re-signing or any other incremental IP awards, so that the business is only generating $0.90/share of eps.  I give this business a 12x multiple.  I think this is very conservative as TSRA should be able to beat each of these assumptions.

 

The key risk with TSRA now is the Micron renewal.  If Micron does not renew, then TSRA will have to purse its claims in court, which will cost more upfront, buy may ultimately lead to a larger settlement on the backend.  The timing and magnitude of this type of litigation is hard to assess, and investors would clearly not look favorably on this.

 

TSRA also has risk in collecting from Amkor as they continue to fight the multiple arbitration panels that rule in favor of TSRA.

 

 

 

 

Micron renewal or litigation.

 

Amkor award or settlement.

 

STMicro litigation or settlement.

 

Incremental IP agreements and announcements.

 

More aggressive return of capital.