Cirrus Logic: The Apple Problem

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Summary

  • An Earnings Power Valuation indicates that CRUS is trading at a discount.
  • Massive investments in R&D have stimulated growth.
  • Revenues have doubled since 2013.
  • Unfortunately, dependence upon Apple raises red flags.

Cirrus Logic (NASDAQ:CRUS) dropped nearly 3% in Wednesday’s trading, and the price decline inspired me to investigate a potential buying opportunity.

Cirrus Logic certainly looks like a cheap stock cast adrift from frothy NASDAQ shores. The PE ratio for the Austin, Texas, company stands at 13 times 2017 earnings. The $3.26 billion market cap represents 2.72 times book value. CRUS has no debt and $329 million of cash on the books. There aren’t many high-quality technology companies that sport such reasonable metrics.

Two schools of thought have taken shape among recent discussions on Seeking Alpha: The¬†bullish story¬†emphasizes the company’s cutting edge semiconductor technology that provides the heavy lifting for audio and voice applications. The proliferation of sophisticated mobile devices has propelled growth at CRUS from $800 million in sales during 2013 to over $1.6 billion today. Operating profit margins have jumped from 25% to over 40% in three years. Returns on capital exceed 30%.

The¬†skeptics¬†believe that CRUS is far too dependent on a major customer: Apple (AAPL). The electronics giant accounts for nearly 80% of sales. There is probably no finer horse to hitch your wagon to than Apple. But Apple is no Clydesdale. It’s a thoroughbred. And even the finest champions have been known to change jockeys from race to race.

Although I am attracted to Cirrus Logic, I ultimately side with the skeptics. The Apple dependence is too much of a concern. I look at it in a very simplistic way: why would I own a company that has specialization in a critical segment of the market but is dependent upon a single customer when I can buy the customer itself? In Apple, I would be buying the thoroughbred with a far more diversified stable of products, millions of loyal customers, and perhaps the finest brand name in the world. Just buy Apple is my verdict.

Earnings Power Valuation

Nevertheless, attractive metrics merit further exploration. For my valuation exercise, I decided to employ the Earnings Power Valuation (EPV) model, championed by Bruce Greenwald at Columbia University. Greenwald’s method is fairly straightforward: Identify the stable free cash flow of the business and divide the number by the weighted average cost of capital to arrive at a value.

The company will produce revenues of over $1.6 billion in the fiscal year, which ends in March of 2018. Gross profits should come in around $830 million. Operating income was $317 million in 2017 and will likely exceed $366 million in FY 2018.

Research and Development: Hidden Assets

One number caught my eye: the company spends over $300 million per year on research and development. This amounts to over 49% of gross profit.

Accountants treat R&D as an expense. However, research and development is a critical driver of growth and is more closely akin to capital investment. The continuous enhancement of voice and audio technologies through large investments in R&D explains why the world’s most famous mobile device company partners with CRUS.

I capitalized recent research and development expenses at CRUS to produce an additional $750 million in assets. In the process of adjusting free cash flows for R&D, the annual expenditure is added back and a portion of amortization is subtracted. I gave the R&D asset a straight-line amortization of four years. The net effect is a $100 million boost to free cash flow. The amount of research and development invested by CRUS is a strong vote in the bullish column.

Share-Based Compensation is a Concern

Meanwhile, share-based compensation (SBC) posed a challenge for me. Like most tech companies, CRUS offers a large portion of compensation in the form of restricted stock units and options. The number paid in the form of non-cash stock benefits will exceed $40 million in 2018, or just over 10% of operating expenses. The customary process in the Greenwald model is to add back SBC because it is a non-cash expense. This effectively raises the value of the business. The model treats the value of the options and restricted stock much in the same way as debt, and it gets subtracted after the value is determined.

Buffett is a famous naysayer against the practice of removing share-based compensation when valuing a business. Compensation is an expense, pure and simple. I tend to agree, but I decided to add back SBC since grants and options are such a traditional means of paying employees in the technology industry.

So, if large share awards to employees are such a common occurrence, then why does it bother me? Probably because management has touted its recent share purchases of about $100 million. It indicated another $80 million in buybacks were forthcoming. Unfortunately, this amount merely seems to be keeping pace with the issuance of shares for options and grants. The share count has barely budged despite recent buybacks. In this case, the argument that share-based compensation is a non-cash item loses its validity. Real cash is being expended to keep the float from increasing.

WACC is a Tough Nut to Crack

Turning my attentions to the weighted average cost of capital was much more difficult. Greenwald prefers a calculation that takes an equity risk premium above the company’s cost of debt. Most other models employ beta to measure the risk associated with a particular stock. Greenwald argues that beta is a better measure of volatility than risk. In other words, just because a stock price fluctuates, it doesn’t necessarily mean the underlying business is riskier.

Cirrus Logic, however, has no debt. I reluctantly decided to calculate the cost of equity using the capital asset pricing model which employs beta. In the case of CRUS, the beta is .85 vs. a market beta of 1.0. This has the overall effect of reducing the company’s cost of equity to 6.84%. This results in an earnings power value of $78 per share. Cirrus Logic appears to be selling for a discount of 34% to its current market price.

But wait – not so fast. It made no sense to me that CRUS should have a lower cost of equity than the customer that makes up 80% of its revenues. What is the beta for Apple? 1.21. Applying Apple’s beta to the cost of equity raises the cost of capital for CRUS to 8.67%. The result is a share value of $62. A share price of $62 is more sensible on a P/E multiple basis than the $78 value I initially modeled. If the company earns $4.30 on a diluted basis in FY 2018, the P/E will be 14.4. The $78 per share number produced by the .85 beta pushes the P/E to the dubious level of 18. Yet, $62 does indicate that there is potential for 17% upside. Is that enough of a discount to entice me into the water?

I am tempted to purchase CRUS, but the dependence on Apple is far too heavy. In fact, one could easily argue that the cost of equity for Cirrus Logic should be much higher than Apple. If I saw that CRUS was available below $45, I would purchase shares. I desire a 30% discount to the earnings power valuation to provide a sufficient margin of safety.

A Final Thought on Profit Margins

I have painted a picture of some kind of giant axe emblazoned with the Apple logo poised to strike. This fear is overblown. Cirrus Logic has proven technology and investments for the future are consistently growing. The balance sheet is pristine, and management is not complacent.

As much as Cirrus depends on Apple, Apple needs Cirrus and its robust audio and microphone technology. Barring a catastrophic failure, it seems unlikely that Apple would dump Cirrus in one fell swoop. A day of reckoning is probably years in the distance. In the meantime, leaders at Cirrus can focus their energy on increasing the quality of their wares, diversifying the customer base, and making skillful acquisitions. With $0 debt and over $400 million in annual cash flow, CRUS has a lot of strengths to work with.

My concern is therefore less about the sudden death of a customer relationship than the slow loss of breath from such a tight embrace.

I recall those famous stories of Wal-Mart (NYSE:WMT) when they would invite all of their suppliers to an arena in Bentonville for a big showroom display and price negotiation. They would literally turn up the heat in the building while negotiating the contracts. Wal-Mart always had the leverage. The beads of sweat on the brows of the suppliers just hastened their capitulation.

What seems more likely to me is that, in the event of a slowdown in handset sales, Apple could hungrily eye Cirrus Logic’s 40% operating margins, fat share compensation packages, and a paucity of other customers as an opportunity to negotiate price concessions.

If there’s a slowdown in the handset market, CRUS will start to sweat.

Appendix:

Exhibit 1, Weighted Average Cost of Capital

Exhibit 2, Balance Sheet Adjusted for R&D and Leases

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: As always, the author has presented his own opinions and analysis. You should conduct your own due diligence before investing. I welcome feedback and discussion and I am happy to correct any errors or add any pertinent information to the article.

Tredegar: Plastic Surgery

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Summary

  • Tredegar has recovered from lows, but upside is limited.
  • Family owners have returned to management and steadied the ship.
  • Plastic hygiene products are under competitive pressure.
  • Aluminum extrusion is growing but cyclical.
  • An earnings power valuation places the stock price in the low teens.

Tredegar (TG) is a Richmond, Va.-based company that operates in two major business segments: plastics used for consumer products and aluminum extrusion deployed in the construction and automotive sectors. The company was badly shaken by Procter & Gamble’s (NYSE:PG) decision to diversify its sources of hygienic plastic films used primarily for sanitary products like diapers. Tredegar forecasts net sales could decline in the plastics business related to personal hygiene for the next several years by $5 million to $10 million annually.

The stock plummeted to $14.65 in July from an all-time high of $30 per share in 2013. TG has recently rebounded to $17. Unfortunately, my analysis shows Tredegar to be fairly valued with limited upside. My earnings power valuation yields a stock price below the $15 level.

Tredegar has a market capitalization of $560 million and a debt balance of $187 million. Revenues have fallen from $961 million in 2013 to $830 million in 2016. Enthusiasm for TG revived after second quarter results showed revenues stabilizing in the plastics segment and growing in the aluminum extrusion business.

Note: The balance sheet for June 2017 has been adjusted by capitalizing R&D investments and operating leases.

Family Pride

There is much to like about Tredegar. Family owners Bill and John Gottwald returned to leadership positions in the company after the customer defections during 2015. They have 22% ownership and a clear desire to restore growth. They have recognized the need for urgent transformation. The plastics business is consolidating redundant facilities, and significant dollars have been invested in capital improvements and research and development.

The aluminum extrusion business, Bonnell Aluminum, is more promising. The production of specialty products and components for the construction and automotive industry has grown as demand for lightweight materials increases. The recent acquisition of Futura Industries will be accretive to earnings in 2017.

Yet, reading of the 2016 CEO letter by John Gottwald leaves one feeling underwhelmed. The CEO admitted his struggle to outline a clear vision for the company. Is this humble candidness or a shell-shocked owner grasping for a future in a family business that was believed to be in transition to a new generation of leadership?

Revenues have started growing again, but beware the fine print

Tredegar has posted revenue declines for the past three years ended December 2016. Gross profit peaked in 2012 at $187 million but slumped to $162 million in 2016. Operating income hit $32 million last year, a decline of over half from 2012. Earnings per share were 75 cents for 2016. At $16.75 per share, the P/E stands at 22. With a dividend of 11 cents, the yield is north of 2.6%. Tredegar had $29.5 million in cash at YE 2016 with $95 million borrowed on a line of credit.

The second quarter of 2017 brought better news. Revenues expanded by over $90 million from the prior period in 2016. Operating income expanded by $50 million. Unfortunately, $38 million in revenue growth is attributable to one-off recognition of increased values of ownership stakes in subsidiary businesses. The value of Kaleo, a specialty pharmaceutical company was boosted by about $25 million. Although the re-valuation is welcome, it begs the question of why Tredegar owns part of a pharma company. The results at Kaleo seem to justify the value increase as revenues for the business increased by over $75 million for the first six months of 2017. Another one-time boost came from an $11 million escrow adjustment related to the Terphane acquisition of 2011.

Futura

The remainder of the revenue increase does hold merit as a sign of growth at Tredegar. The acquisition of Futura Industries, a Utah-based aluminum extrusion company, closed in February. Futura generated revenues of $53 million since February and $6.6 million in operating profit through¬†June 30. Unfortunately, growth didn’t come for free. Debt expanded from $95 million to $187 million during the first half of 2017 due to the $92 million Futura acquisition.

Although returns on capital have been in the mid-single digits for several years, TG is committed to research and development that may boost sales in the future. R&D expenditures have been ramped up from $16 million in 2015 to $19 million in 2016. R&D is expected to be the same in 2017. Capital expenditures for plant closings and upgrades are welcome, but they have forced TG into negative free cash flow during recent quarters. The dividend may be at risk.

Unfortunately, it is also worth noting that Tredegar has pension liabilities of over $90 million.

Evaluating Tredegar is difficult without in-depth knowledge of the thin-film plastic market and aluminum extrusion industries. The author lacks this education and is, therefore, limited to parsing numbers and corporate risk factors. I have assembled an earnings power valuation using the method advocated by Bruce Greenwald. The results are presented below. Think of this article as a ‚Äúfirst pass‚ÄĚ look at Tredegar. If there is appeal beyond the numbers as presented, then investigate further. Your comments are welcome, and I am happy to revise my analysis if better information is available.

Certainly, the world of thin film plastics has potential. Food safety is a big opportunity as people worldwide choose more convenient packaged options. But the business seems highly competitive. The Procter & Gamble loss shows that a search for cost effective suppliers is well under way as brand name profits come under increasing pressure. Investments in technology will help, but can they drive growth or merely prolong a business facing secular headwinds? Aluminum extrusion has much potential, but the reliance on highly cyclical businesses raises significant concerns. It is late in this economic expansion, and headwinds have appeared in vehicle manufacturing.

For me, Tredegar shall remain on the sidelines. The stock appears to be fully valued at this time. A sustainable growth trajectory in the plastics business would need to appear before I consider an investment.

Earnings Power Valuation: $14.20 per share



Notes: 
Revenues РThe valuation writeup in Kaleo as well as the Terphane adjustment have been excluded from revenues. However, the value of Kaleo (cited in the 10-Q) has been added to the net value computation. Beta has been used to calculate the cost of equity. Many would consider the use of beta as distorting the typical Greenwald methodology. However, the author believes a weighted cost of capital at 10.68% is reasonable. Due to one-time tax write-offs, the effective tax rate for 2017 is only 9.9% vs. 29.8% in 2016. For purposes of valuation, a tax rate of 30% is assumed. R&D as an adjusted balance sheet item with expenses reflecting a reimbursement of current expenditures less an allowance for amortization over a four-year period.

Appendix: Tredegar Income Statements

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: As always, the author has presented his own opinions and analysis. You should conduct your own due diligence before investing. I welcome feedback and discussion and I am happy to correct any errors or add any pertinent information to the article.