Cirrus Logic – Seriously Cheap

• Cirrus Logic has not kept pace with the rise of the NASDAQ this year leaving it as one of the few value plays left in the technology space.
• The company is poised to benefit from many of the hot emerging areas in the technology space such as the smart home and connected car.
• This company is well off its highs, has a strong balance sheet, has impressive cash flow, and we still see significant growth potential.

Cirrus Logic is one of the few technology companies with a long term positive outlook that is not hovering at a 52 week or all time high.  In fact despite the 5% jump on Friday, the company is still 20% below its 52 week high and is only up 0.85% for the year.  We think the future for Cirrus Logic is bright given the emerging opportunities for the portable audio chip maker.  Cirrus Logic has grown sales by an annual average of 29.2% over the last five years.  EPS grew by an annual average of 24.90% over the same time period.  If you believe that Cirrus can grow earnings at even half this rate for next five years, like we do, then the company is significantly undervalued at current levels.  Added to the growth potential, Cirrus has a strong balance sheet which includes no long term debt.

The Company

Cirrus Logic is a portable audio chipmaker.  They are a leader in high performance low-power integrated circuits for audio and voice signal processing applications.   The company’s products cover every aspect of audio in electronics from capture to playback.  Their components are found in smart phones, tablets, digital headsets, and as will be discussed more below smart home applications.  If you have an Apple iPhone, you are using Cirrus components.  Per the 2017 Annual Report, the company targets growing markets where it can leverage its expertise in analog and digital signal processing to solve complex problems.

The company basically operates in two segments which are portable audio products and non-portable audio products.  The portable audio products are used in mobile applications such as smart phones and tablets while the non portable audio products are used in smart home applications as well as automotive and industrial applications.

Cirrus contracts out the production of their semiconductors so they are a fables semiconductor supplier.  We view this as a positive since it reduces capital expenditures.  Additionally, the company says that the outsourced manufacturing strategy allows it to concentrate on its design strengths while minimizing fixed costs.  They use a variety of foundries including those of Taiwan Semiconductor (TSM) and MagnaChip Semiconductor. 

The company’s main competitors include Qualcomm, AAC Technologies, AKM Semiconductor Inc, and Analog Devices Inc. to name a few.  Cirrus and its competitors have more frequent opportunities to achieve wins in the portable audio device segment due to the shorter product life cycles compared to non-portable audio market which provides more reliable continued revenue streams.

Voice-as-an-interface

One driving force we want to highlight is voice-as-an-interface.  Here we are talking about human interaction with computers or other electronics through speech in order to initiate a response.  One product that already highlights this as a growth area for Cirrus is the Amazon Voice Capture Development Kit.  As stated by Jason Rhode, the Cirrus CEO, in the 2018 first quarter call, the Voice Capture Development kit “enables a wide range of consumer OEMs to bring Alexa-enabled smart home products to market faster and more efficiently.”  The Amazon Alexa Voice Service adds voice control to connected products that have a microphone or speaker.

He went on to state that he expects voice-as-an-interface to be a really huge driving force in the industry.  There are many opportunities for Cirrus in this emerging area.  This was emphasized by Jason Rhode in the conference call as he noted that where Cirrus really sees its strength is in improving performance via algorithms embedded in a device to provide audio and voice performance in ultra low power, low latency applications.

Our Answer to a Recent Underperform Rating

Customer concentration is by far the biggest concern for Cirrus with the Apple (AAPL) iPhone accounting for somewhere between 75 to 80% of revenue.  A Bank of America analyst recently issued an underperform rating on the stock with a $50 price target largely related to this concern.  The rational was that revenue from the iPhone may not increase after fiscal 2018.   We think there are sufficient opportunities aside from the iPhone to allow for continued growth.  Again keep in mind that the share price of Cirrus should increase substantially if the company can just grow earnings by less than half the annual average of the last five years.  The company already counts many other major companies as customers including Samsung, Lenovo, and Ford to name just a few. 

With emerging opportunities for their components to be used in more products such as those related to biometrics and in applications using voice as an interface, the company should be able to reduce the share of revenue coming from Apple.  At the very least, we expect to see revenue from other companies increase going forward even if Apple remains by far the largest customer.  One other example of this was highlighted on the 2018 Q1 call.  The company mentioned ramped production of a recently introduced hi-fi DAC and a boosted amplifier with a customer in China for a flagship smart phone that was introduced in the summer.

In order to justify the underperform rating mentioned a very short term outlook is required.  The rating analysis mentions that significant revenue won’t be generated from emerging opportunities such as Android smart phones and wearables for at least two to three years.  We do not view this guidance as overly helpful to investors given that it rarely makes sense to judge potential investments by placing emphasis on what is happening in the twelve months or the next couple of quarters.  If you do not think a company has a positive long term outlook, you would likely never consider investing in it to begin with.  Similarly, if you think a company has a bright long term future, how much emphasis would you place on the next quarter?  Trying to time the market generally costs more in missed opportunity than it saves.  We believe that companies as well as investors that focus more on narrow short term results rather than long term value underperform. 

Add to this that Cirrus is currently significantly undervalued based on a discounted cash flow model as well as relative to its peers.  It seems that any temporary slowdown in growth is already priced in.  This just makes it even more likely that the company can surprise to the upside.  Keep in mind that we are talking about a company with a current P/E ratio of 13.33, a forward PE ratio of 11.88, and an average long term EPS growth estimate of 20%.  Finding overvalued technology companies priced to perfection is actually very easy in the current elevated market making a sell rating on a company with Cirrus’ valuation even more illogical.

Research and Development

The company spends a significant amount on R&D which is required to keep up with the fast changing technology and continue to provide innovative solutions to its clients.  Per the annual report, for fiscal 2017, 2016, and 2015 research and development expenses totaled $303.7 million, $269.2 million, and $197.9 million, respectively.  The 2017 increase in spending was largely attributed to the 16% increase in R&D headcount.  The company now employs over 1,000 engineers. 

 

When an analyst asked about the lack of debt and potential uses for the generated cash, the first part of the CEO’s reply was focused on the continued investment in R&D as well as adding small technology acquisitions over time.  We think that this approach makes sense given the number of growth opportunities that should present themselves in the near term and coming years.  Buybacks were also briefly mentioned as a possibility as something that will be looked at on an opportunistic basis. 

A big part of staying on the cutting edge and driving innovation for technology companies is the ability to retain top engineering talent.  On this front, Cirrus was ranked 14^th in the Forbes list of best places to work for small and medium-sized technology companies.  The company has a 3.8 out of 5 rating on Glassdoor.  Overall, at a high level based on reviews and ratings, it appears that Cirrus Logic provides an environment that allows it to retain and hire the engineering talent required to drive innovation and grow the business.

Valuation

We will consider a discounted cash flow model with the inputs provided below.  For the long term EPS growth rate, we will not use the average annual growth rate of the last five years, 24.9%, or the overly optimistic average analyst estimate of 20%.  Instead we will use half of the average analyst estimate, 10% in addition to applying a 10% discount rate.  The model will also not assume any share buybacks even though a share repurchase program has been authorized.  In the last few years the share count has actually increased slightly every year. A future P/E of 15 is used in the model which is higher than the current P/E of 13.33 but is lower than the average P/E of the sector, 16.31.  The model inputs are summarized below:

• Discount rate or desired annual return:  10%
• EPS (ttm): $4.28
• Average annual EPS growth rate estimate for the next five years:  10%
• Expected future P/E:  15

Using the inputs provided above, the DCF model tells us that Cirrus is trading at 89% of fair value when using a 10% discount rate.

Another model we considered was even more conservative and used a 10 year time period.  In this model we used the same 10% growth rate for the first five years and then assumed that the growth rate would decline by one percent each year for the remaining five years.  Under this ultra conservative scenario, the model finds that Cirrus is trading at 102% of fair value.  Given that this overly pessimistic model still shows Cirrus Logic as fairly valued, we think the DCF models confirm that Cirrus is a buy at current levels.

Financial Highlights

We mentioned previously that Cirrus Logic operates under a model that is light on capital expenditures.  This has allowed for impressive cash flow.  The table below shows that cash flow from operations easily covered investments in property, plant and equipment.  The table also shows the cost of acquisitions in the last 10 years.

Source: barchart

Looking at the income statement for the last 5 years, we see impressive increases in sales.  We see the recent upward trend continuing, even if not at the same impressive rates as the last couple of years, given the expanding opportunities for their components to be used in a wider array of applications.  We think the 10% average annual increase in earnings used in our DCF model above is achievable and has a relatively high probability of being surpassed.  Sales grew by 23.6% on a quarter over quarter basis providing further indication that Cirrus is not slowing down.

Source: barchart

Other positives to keep in mind are the lack of long term debt and the impressive current ratio of 4.0.  On a slightly more negative note, the balance sheet shows an accumulated deficit.  However, it is becoming less negative at an impressive rate and should change to showing retained earnings shortly.

Source: barchart

We think that Cirrus Logic underperforming the NASDAQ by such a wide margin provides new investors with an opportunity to acquire the shares at a fair or even discounted price.  This is based on the discounted cash flow model and the emerging opportunities for the company to broaden its client base and the likely increase in the number of applications for its components.

Final Thoughts

Cirrus Logic is one of the few value plays left in the technology industry.  We see this as an interesting opportunity not only because of valuation but because it is a growth story.  Its audio components are directly related to many hot growth areas such as the connected car, smart home, and secure user identification or authentication.  Yes, Apple is a big customer and we are concerned about customer concentration.  However, the company does have about 3,000 customers world-wide and we think the company can expand on these relationships to build its business with them in these new emerging areas. 

Although the company does not pay a dividend as a result of the focus on growth, there is an opportunity for investors to obtain a yield boost via options.  We recommend looking at the possibility of using a buy-write strategy.  One example would be to sell the call expiring on March 16^th with a strike price of $75.  The seller receives $55 per contract sold or $0.55 per share based on the current bid.  This equates to an annualized return of over 2%.  Note, that in this case the investor would only need to sell his or her shares if the stock price increased by over 31% from the current price of $57.02 in slightly over four and a half months. 

Finally, for investors that are adverse to buying something that just went up over five percent in a single day, we understand but suggest keeping Cirrus Logic on the radar with the possibility of taking advantage of any pullbacks.  For investors that consider valuation, looking to put some money to work in the technology sector, we think Cirrus is a logical choice that will provide satisfactory returns in the years to come.