Description

Xperi Corporation (XPER US)

September 2017

Investment Recommendation:

Xperi (NASDAQ: XPER) is a San Jose, CA-based R&D house engaged in licensing its existing IP (~5,500 patents issued and pending globally) and, with its more than 450 engineers, developing new technologies across semiconductor packaging and interconnect, audio encoding/decoding, as well as digital photography/computational imaging.  At a recent price of $27, the company has a market capitalization of $1.35B and an enterprise value of $1.83B.  Shares have sold off violently since Q4 earnings (released in February 2017) due to a wider-than-expected revenue guidance range provided for 2017, and are down ~40% YTD (vs. a +20% return for the NASDAQ).  In my view, the market has grown overly concerned about two primary issues: 1) Samsung, a 25% customer in 2016, has, so far, failed to relicense certain DRAM-related IP, which was the driver of the unexpectedly wide revenue guide; and 2) an ongoing, and ultimately uncertain, patent infringement litigation with Broadcom related to Xperi’s ‘231 and ‘946 patents.  I believe these items are actually interconnected, as I suspect Samsung is simply stalling/posturing on a license renewal until there’s more clarity on a Broadcom resolution.

Another factor potentially weighing on shares is that on 8/10/17, Broadcom filed its own lawsuit against two XPER subsidiaries (DTS, Inc. and Phorus, Inc.) for alleged infringement of US Patent No. 6,684,060.  At issue is Xperi’s PlayFi technology that allows for advanced wireless operation of speakers (think an off-the-shelf “Sonos” module for use by high-end speaker manufacturers that lack integrated circuitry know-how).  XPER believes the suit to be completely without merit and doesn't rule it out as an attempt to create additional pressure on XPER shares.  Perhaps Broadcom believes that the lower XPER’s share price, the more shareholders will push the company to settle the ‘231/‘946 matter.  With this as context, the share repurchase announcement made on 8/16/17 could be viewed as a bit of signaling to Broadcom, on the part of XPER, that it won’t be strong-armed into entering into a settlement simply to appease shareholders.

Excluding any revenue from Broadcom (which would represent completely newfound revenue) along with the at-issue Samsung revenues, the company trades at 8.0x this year’s operating cash flow (OCF) of $155mm.  Notwithstanding the volatility I would expect should neither Broadcom nor Samsung go the company’s way, I believe this level of underlying FCF generation provides a very reasonable valuation floor.  On this point, I note that I view underlying cash flows as steady-to-growing in 2018 and beyond given a mix of newer technologies in the works and increased HD Radio penetration (which is more a secular penetration story, than a cyclical SAAR one).

However, I expect the Broadcom matter to be resolved in the company’s favor within a few months.  I further expect Samsung to fall in line either once Broadcom is resolved or, perhaps more likely in as little as a few weeks, when it sees the writing on the wall.  In this more realistic—albeit not certain—scenario whereby both Broadcom and Samsung matters are resolved in the company’s favor, shares are trading at 6.0x this year’s OCF.  I believe this is simply too cheap given the importance of Xperi’s technologies to its semiconductor customers, the stability of the audio business (better known as DTS), growth potential of developing technologies, overall gross margin profile (98%+), and the capital-light nature of the business.

But, what’s truly asymmetric about the setup is that a favorable Broadcom outcome, and the associated validation of the ‘231 and ‘946 patent families, should also have a cascading effect on Xperi’s business, given management’s belief that there are many companies currently using this IP without a license.  As Jon Kirchner, CEO, recently posited (Q2 2017 call): “the new revenue opportunities associated with this patent family, beyond [read: in addition to] our two ongoing matters [Broadcom and Samsung] represents at least several hundred million dollars in the midterm.”  On a market cap of $1.35B, “hundreds of millions of dollars” is not chump change.

Amid what I believe to be something close to maximum pessimism, catalysts are numerous and include: 1) a favorable resolution to the Broadcom litigation within a few months; 2) a Samsung relicensing (or, if need be, the start of litigation) hopefully within a few weeks; 3) a massive ~$160mm share repurchase authorization (~12% of market cap at today’s prices) which the company, on 8/16/17, indicated it would start to utilize aggressively; 4) debt pay-down; and 5) completion of the DTS acquisition integration cost saves (note that Xperi is the rebranded company resulting from the December 2016 merger of Tessera and DTS).  And a quick aside regarding the DTS acquisition; in addition to acquiring a permanent CEO in the form of Jon Kirchner, the business also serves to diversify away from the "black box-ey" and "patent troll-ey" nature of the old Tesssera business, which may even begin to change the company's go-to-market strategy.  Thus going foward, I would expect the company to engage in a more collaborative (DTS-like) approach to partnering with customers to help solve their problems (see DBI, ZiBond).

In short, with Xperi, investors seem to be confusing uncertainty of outcome with risk of permanent capital impairment.  Cheap and with clearly-defined catalysts, I recommend buying shares at current levels.  I see an unheroic path to 60% returns based on 10x my estimate of 2018 OCF.  Note that shares are liquid ($10mm+ ADTV), and at today’s price, yield 3.0% ($0.20 quarterly dividend).  Note that there are other factors to the story (e.g. Amkor revenue roll-off, potential for method claims w/ patents set to expire next year, etc.) which I'm happy to discuss in the Messages section.

A bit more detail on the Broadcom situation:

Beginning on May 23, 2016, a variety of XPER subsidiaries filed IP infringement claims against Broadcom, certain of its subsidiaries, and/or certain of its customers.  Please see the table below for details:

Essentially XPER’s cases have been proceeding very well in Germany, where two separate bench trials ended with findings in Xperi’s favor.  Two broad injunctions were mandated whereby Broadcom and its customers are to cease offering, distributing, using, or importing (or possessing for said reasons) the infringing products in Germany; recall infringing products from the German market; destroy or have destroyed infringing products in their possession in Germany; and provide an accounting of their infringing activities.  Xperi is adamant that Broadcom is not properly adhering to the stipulations of the injunction.

In addition, XPER has made good progress in its US International Trade Commission (ITC) suit, whereby on 6/30/17, in her Initial Determination (ID), the Administrative Law Judge (ALJ) determined that Respondents violated section 337 of the Tariff Act of 1930.  Specifically, at least some portion of all three patents were found to have been infringed upon, domestic industry was demonstrated for one of the patents, and two patents were not shown to be invalid.  As currently planned, 9/29/17 is the deadline for the ITC to determine whether it will review the ID, with a target date for completion of the investigation of 12/1/17.  As it is rare that an ITC ID is “overturned,” I believe these looming target dates will serve as positive catalysts for the stock

Catalyst

1) a favorable resolution to the Broadcom litigation within a few months; 2) a Samsung relicensing (or, if need be, the start of litigation) hopefully within a few weeks; 3) a massive ~$160mm share repurchase authorization (~12% of market cap at today’s prices) which the company, on 8/16/17, indicated it would start to utilize aggressively; 4) debt pay-down; and 5) completion of the DTS acquisition integration cost saves