Cirrus Logic: The Apple Problem

Standard

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.