Description

Zilog is a supplier of 8 bit microcontrollers that represents an attractive turnaround story of a failed LBO. With anticipated 2003 EBITDA of just over $10 million as compared to a pre-bankruptcy, pre-LBO level of over $75 million, the upside potential of owning this stock is high.

Catalysts

1. Significant design wins, new orders and other indications of operational success.
2. NASDAQ listing.
3. Potential sale of the company.

Background

Zilog produces microcontrollers that are used in a wide range of applications such as: controlling the charging cycle of a battery charger; acting as the CPU in office equipment such as printers; in remote controls for televisions, VCRs or DVDs; or controlling automotive systems such as alarms or remote engine starters. The company offers some 550 products to almost 6,000 OEMs and end-users worldwide. After recent downsizing, Zilog has over 650 employees.

The company was purchased in 1998 by Texas Pacific Group in a leveraged transaction for about $400 million. At that time, Zilog’s operational strategy was diverted away from longstanding microcontroller products and customers in order to develop an IP router on a single chip product. With the downturn in the semiconductor industry starting in 2000, the failure of the router on a chip product, the inability of the company to meet product rollovers with existing customers, and lost new business opportunities, Zilog filed a prepackaged bankruptcy plan from which it emerged in May 2002.

Notable recent developments include the hiring (in 2001) of the current CEO who refocused Zilog on its core products and customers and returned the company to profitability. On a less positive note, since emerging from bankruptcy, Zilog has continued to suffer from weak demand for microcontrollers and has reduced guidance, most recently at the time the company reported its 2002 results.

At this time, Zilog has a “base” business of some $100 million (projected 2003) of revenues for existing (mostly) microcontroller products. In 4Q02, Zilog launched a new flash memory-based microcontroller family of products targeted at this faster growing segment of the market for which it is targeting 2003 sales of $5 to $10 million.

Capitalization Profile

Recent stock price $2.75
52 week range $1.65 to $6.60
Shares outstanding 29.5 million (excludes options and adjusted for recent repurchases)
Significant owners Capital Research (25%), PW Willow Fund (15%), ING Investments (4%), Fuller & Thaler (1%), Lehman Brothers (1%)
Management ownership 6%
Equity market capitalization $81.1 million
Total debt $5.0 million
Cash and cash equivalents $22.5 million (after recent repurchases)
Total enterprise value $63.6 million

Projected Financial Performance and Valuation Analysis

Summarized here is company’s guidance as I interpret it for 2003. These numbers exclude special charges and reorganization items.

($ in millions, calendar year) 2003E

Net sales $107.50
EBITDA 10.75
EBITDA margin 10%

Depreciation & amortization (a) 6.00
Operating income 4.75

Interest income 0.40
Interest expense (0.40)
Income before taxes 4.75
Taxes 2.00
“Pro forma” net income $2.75

Shares outstanding 29.5
EPS $0.09

Capital expenditures $2.00
Free cash flow (b) 6.75

Multiples:
TEV/sales 0.6x
TEV/EBITDA 5.9
TEV/FCF 9.4

Equity/“pro forma” net income (c) 29.5x
Equity/FCF (c) 12.0

(a) Excludes amortization of fresh start-related intangible assets. Annualized 1Q03 rate.
(b) EBITDA less capital expenditures less taxes. Interest income and expense on a net basis do not impact this number (they are roughly the same amount).
(c) Note the effect created by the low yielding cash balance and high depreciation and amortization charges (in part due to fresh start accounting) which make the equity multiples less attractive than the TEV multiples.

Investment Considerations

The Zilog story is straightforward. Key points are as follows:

Turnaround/Growth Potential – After refocusing on its core microcontroller business, Zilog has stabilized after its tumultuous LBO years. However, its target market (for 8 bit microcontrollers) has nevertheless been difficult and was some $4 billion in 2002 down approximately 20% over 2001. Growth rates of some 5% to 10% have been predicted for 2003-2005 although such predictions are often wrong and growth rates vary by market segment. That being said, with a known architecture and an established customer base, since emerging from bankruptcy, Zilog has been gaining market share and has revamped its marketing, distribution and R&D activities (primarily to be more focused on core products) and should be well positioned for any rebound in the microcontroller market.

Also, with new flash memory-based products, which the company did not have until recently, Zilog should establish and gain share in this faster growing segment of the market. Flash-based products account for about 35% of the market and have been projected to grow at 25% annually over the next few years. These products are aimed in part at recapturing customers who may have converted older Zilog microcontrollers to alternative technologies during the company’s LBO years.

Incidentally, Zilog’s new flash-based products have been well received by developers, especially the eZ80Acclaim! offering which has a unique web connection functionality.

Margin Expansion – Competitors of Zilog typically operate with margins that are much higher than those of Zilog itself. Microchip (NASDAQ: MCHP) has EBITDA margins of over 40%, ST Microelectronics (NYSE: STM) has margins of over 30%, and Atmel (NASDAQ: ATML), which is going through its own operational difficulties and is not profitable, expects EBITDA margins of some 12% this year. Prior to its LBO, Zilog had EBITDA margins of almost 30%. Thus, Zilog may have significant operational leverage to improve profitability. This may be reflected in the second half of 2003 given that late in the first quarter, Zilog reduced headcount while recording utilization rates at its fabrication facility of 30%. Utilization rates have since recovered to 50% to 60%.

Limited Downside – Given Zilog’s recent restructuring, which resulted in the company having only one remaining fabrication facility and included considerable other cutbacks, Zilog’s cost structure has relatively few fixed cost elements. As a result, continued declines in the market for semiconductors should not induce (significant) losses. In any event, Zilog will be protected by its cash balance and its ability to further cut costs, especially in the manufacturing area.

Low Valuation – By most measures, Zilog is a relatively cheap stock with about a quarter of the company’s equity value represented by cash and the business trading at multiples of 0.6x sales, 5.9x EBITDA and 9.4x unlevered free cash flow for projected 2003 results which anticipate a relatively low EBITDA of just over $10 million. It’s worth keeping in mind that under difficult circumstances in 2002, Zilog reported over $20 million of EBITDA and in 1997, prior to the LBO, Zilog reported EBITDA of over $75 million.

Anyway, depending on the 2003 forecasts you use, Microchip sports a revenue multiple of around 6x, an EBITDA multiple of over 13x, and a FCF multiple of over 20x. ST Microelectronics has a revenue multiple of about 2.5x, an EBITDA multiple of around 9x, and a FCF multiple of well over 15x. Even Atmel trades at 1x revenues, almost 9x EBITDA, and some 20x FCF. While admittedly much larger companies than Zilog, none of these comparables offers the same sort of turnaround potential.

Where should this company trade? If you assume Zilog can produce free cash flow (before the impact of cash/debt) of $6.75 million in 2003 (I think this is a low measure of the company’s earnings power) and you apply a dividend growth model multiple (i.e. 1/(r-g)) with r, the expected rate of return on investment/discount rate equal to 15%, and g, the expected growth rate of the free cash flow number equal to 7%, the projected industry growth rate, or a multiple of 12.5x, we get a TEV of $84.4 million. Add net cash of $17.5 million and divide by 29.5 million shares outstanding you get a per share price of $3.45. If you think that Zilog could grow its free cash flow over time at a rate that is greater than 10%, as I do, then the price target becomes much more attractive. For example, use 10% as the growth rate, the multiple becomes 20x, and the valuation goes to $5.17 per share. Should Zilog be able to regain its former glory, the share price appreciation potential could be more significant.

In any event, the current trading level of Zilog does not reflect the company’s potential and a share price of $5 to $6 is more appropriate give comparable company multiples.

Motivated Management – Zilog’s management team and advisors have significant experience in the semiconductor sector and the CEO worked at the company prior to the LBO (presumably he knows where the skeletons lie) so they are well equipped to make the company successful. In addition, the group recently deferred some bonus payments in order to demonstrate commitment to the business. I view this as a positive.

NASDAQ Listing – At some point, assuming the company meets the listing requirements, Zilog is likely to shift from the OTC Bulletin Board to the NASDAQ if only as part of its IR strategy. This move is also likely to be a sought after by some the company’s shareholders (former bondholders, for example) who will want liquidity for their holdings and should be an important catalyst for Zilog’s shares, especially if it results in positive research.

Possible Sale of the Company – Absent an increase in the stock price, Zilog would be an attractive acquisition for other companies in the semiconductor sector. Not least of the attractions are Zilog’s redeveloping franchise, profitability and healthy balance sheet. With no market recognition of Zilog’s fundamental value, this may be something else former bondholders chose to encourage.

Words of Caution

Zilog has a production facility that is being held for sale. If this facility is sold, the proceeds will go to former bondholders. If not sold, the future liability to close the facility will be small, but there will be some cost. Zilog currently spends around $300,000 per quarter to maintain this facility.

The company’s recovery is unlikely to be driven by one-time, big news events since rebuilding the company will involve a number of design wins with a number of customers. In addition, sales of Zilog’s de-emphasized (during its restructuring) products will probably continue to decline (sales of modem products, for example).

Zilog’s reported earnings (as opposed to pro forma) will be negatively impacted for several years by non-cash amortization charges derived from fresh start accounting. Even adjusting for these charges, Zilog has relatively a high PE multiple.

Lastly, a number of former bondholders/shareholders may chose to exit their investment in Zilog (based on former trading levels of the bonds, I guess their basis may be as low as $1.00 to $1.50 per share after adjusting for a return from the facility being held for sale at the current book value) which factor may cause significant price movements in the stock.

Catalyst

1. Significant design wins, new orders and other indications of operational success.
2. NASDAQ listing.
3. Potential sale of the company.