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JeffryClarke (34.10)

Zen and the Art of the Easy Buy: Silicom (SILC)



April 27, 2014 – Comments (3) | RELATED TICKERS: SILC

Much like you, and kung-fu masters from the 1970’s, I strive for earnestness, clarity and simplicity of thought.  I try to avoid cheap cynicism, sarcasm and annoying teenage rhetorical devices like air quotes and quotation marks.  But then sometimes I can’t help myself, such as when the market punishes an amazing company like Silicom by nearly 20% in two days for reporting a “bad” quarter. 

This terrible, shyte-kicking, throw-the-old-folks-and-chickens-in-the-storm-cellar quarter from Silicom featured YOY revenue growth of 26%, operating income growth of 37% and exceeding analysts’ EPS expectations by 8%.  And mind you, this was a company with an outrageous, “high flying” forward P/E ratio of 18x before the market puked all over it.  It’s now trading at less than 15x forward P/E and so, yeah, I gladly opened a position last week.

And now back to our usual zen-like state of investment analysis.  Silicom is a network equipment company based out of Israel.  It was founded in 1987 and has traded on US exchanges since 1994.  It currently has 7M shares outstanding, 1.5M of which are owned by Zohar Zisapel, the co-founder of the highly successful RAD group.   For most of its existence, Silicom has been firmly in the micro-cap penalty box with no research coverage and very little trading volume. 

Silicom has been quietly reporting amazing results for several years now, including annual revenue and operating income growth of 38% and 69% on average since 2009.  In fact, it has been profitable for 37 straight quarters including when the world was falling apart in 2008 and 2009.  In 2013, the company reported organic revenue growth of 50%.  In January 2014, Needham & Co picked up research coverage and the stock firmly shot out of the micro-cap penalty box.   The stock soared to $73/share in March, drifted down to $57/share early last week and then got slaughtered on the “bad” Q1 earnings announcement.  It’s currently at $47/share, which as mentioned above, is an incredibly reasonable forward P/E ratio of 14x.

The Silicom business model that has produced these amazing results is entirely sustainable and may in fact be accelerating.   Silicom is the unquestioned market leader in the niche category of hardware that enhances and optimizes server performance.  Its products include multi-port adapters, which add ports to a server; bypass adapters, which allow a system to keep running in case of a server failure; intelligent bypass switches; and smart adapters, which improve server CPU performance for demanding functions like encryption, time stamping and virtualization. 

Silicom sells these products to OEMs such as Cisco, Juniper, Citrix and Riverbed.  The company has indicated it has about 100 OEM customers.  Over time, they have added new OEMs and deepened their relationships with current OEM customers by offering new products, such as SETACs (server to appliance converters).  The company has three major new products in the pipeline right now, including a virtualization off-load engine and an encryption and compression product that positions it to benefit from the building trend towards virtualization, cloud and big data computing.   On the Q1 conference call, the CEO mentioned that the encryption and compression product would perfectly serve the Hadoop market segment, which is expected to grow from $2B currently to $50B by 2020.

But if explosive top-line growth is not good enough, consider that Silicom’s business model is massively scaleable.  Because they have only 100 customers, its sales, marketing and administrative staff is small and rarely in need of expansion.  From 2009 to 2013, its operating margin expanded from 11% to 25%, completely as a result of how the business model is designed.

All of this, and the market is assigning a forward P/E multiple that is actually lower than the forward multiple on the S&P 500.  That is outrageous.  And the management team at Silicom is working hard to change that.  They started paying a dividend last year that is now $1.00/share annually, and they have committed to paying out 50% of earnings on an ongoing basis.  The CEO mentioned a potential stock split on the earnings call, which could presumably increase trading volume and attract more research attention.  And next week the management team will be in three US cities (Chicago, New York and Minneapolis) meeting with potential investors. 

So why did the market puke all over this company last week?  I think there were three main factors, none of which bother me. 

First, sales decelerated versus last year, from 50% to 26%.  Humans have a tendency to over-extrapolate trends and so there is a fear that 50% goes to 26% goes to 1%.  But the revenue growth of Silicom has always been lumpy with recent good years of 50% growth (e.g. 2010) and “bad” years of 20% growth (e.g. 2012).   As I understand it, that is because they have long lead times on product introductions and are subject to replacement cycles in the networking industry.  Regardless, if 20% is a “bad” year, at 14x forward P/E I am not worried, in fact, I am ecstatic to be buying at these levels.

Second, the tax rate increased from 4% to 15%.  The Israeli government rolled back tax benefits in 2011 that were helping Silicom and the effects are now finally being realized.  Again, I can’t imagine this is part of a trend and I wouldn’t expect the tax rate to go to 26% next year.

Finally, the company filed an F-3 in March that would allow it to issue another $80M in stock.  Nothing freaks the market out these days like a growth company doing a follow-on.  And because this company has $55M in cash and no debt, it is somewhat confusing.  The CEO did his best to clear up the confusion on the conference call saying:  “Our growth strategy is based on our continuous organic growth while taking advantage of external opportunities through potential acquisitions especially as we increase our addressable markets. While our current cash levels are more than adequate for our ongoing working capital and organic growth needs our shelf filing provides us with the flexibility and resources to act should the right opportunity present itself.”

That statement is pretty clear – they are giving themselves financial flexibility to do an acquisition by issuing stock.  For a company with only 7M shares outstanding, an accretive acquisition could be a triple win:  EPS accretion, increased market capitalization (more funds able to purchase) and increased trading volume (more research coverage and better liquidity).

The only two target prices from the research community on Silicom right now are $72/share and $60/share from Needham and Zacks, respectively, and both of those shops are being exceedingly conservative in the assumptions they are using.  Silicom is an easy, easy buy right now at $47/share, but I don’t think it will last long.  Happy hunting everyone!  

3 Comments – Post Your Own

#1) On April 27, 2014 at 2:29 PM, HarryCaraysGhost (66.06) wrote:

Finally, the company filed an F-3 in March that would allow it to issue another $80M in stock.

That's usually a red flag in my book. Dilutes existing shareholders. 

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#2) On April 27, 2014 at 4:04 PM, JeffryClarke (34.10) wrote:

Well, by definition it dilutes percentage ownership, but whether it dilutes EPS depends on how it's used.  This management team has been a very responsible steward of shareholder capital, and they report to Zisapel who does not appear to be a wasteful person.  So I'd be shocked if they did anything goofy, but the fun part is that everyone gets to judge these things for themselves.

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#3) On April 29, 2014 at 4:52 AM, rickdplumr1 (< 20) wrote:

I've followed this company for almost 5yrs and I'm buying all I can afford esp. at this super unwarranted price drop-Their 1st qrtr has always been the smallest in revenues and progresses every qrtr and the 4th is always SUPER SWEET!  Thanks for this buying opportunity.

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