ALPHA & OMEGA SEMICONDUCTOR LTD AOSL
February 15, 2011 - 4:12pm EST by
specialk992
2011 2012
Price: 13.54 EPS $1.71 $1.76
Shares Out. (in M): 26 P/E 7.9x 7.7x
Market Cap (in M): 349 P/FCF 21.9x 13.5x
Net Debt (in M): -101 EBIT 33 37
TEV: 248 TEV/EBIT 7.5x 6.6x

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Description

Introduction
There is currently a bifurcation in the market for publicly traded technology stocks. Some businesses are afforded multiples that seem to assume robust growth and margin expansion for decades in the future while at the same time, participants in unfashionable sectors such as the PC supply chain are trading at what I consider deep value levels. MSFT is one example. I own some MSFT, but its case has already been made by some prominent value investors. I am writing about Alpha & Omega Semiconductor Ltd. (AOSL), a broken IPO that went public at $18.00 per share in April 2010. As a PC supply chain participant, AOSL had the misfortune to go public right before the introduction the iPad and a minor correction in the PC supply chain. Despite good execution through these headwinds, IPO investors have dumped the stock, giving opportunistic investors a chance to buy a stake in a promising growth business at a discounted price. Overall, I believe that the stock was a decent deal at its IPO and a screaming bargain at today's prices. Under what I consider a reasonable set of assumptions I think AOSL could double in the next 18 months.
 
Business Description
AOSL is a supplier of power semiconductors, primarily power MOSFETs and power management ICs, largely to the global PC and consumer electronics industry. The company's primary customers include virtually all the major PC ODMs and OEMs: ASUSTeK, Dell, HP and Samsung as well as Compal, Hon Hai, Foxconn, Quanta, TPV Technology/AOC and Wistron. Although AOSL's headquarters are in Silicon Valley, the company has an unusual trans-national structure where a Bermuda holding company owns a Cayman Islands subsidiary which in turns owns subsidiaries in the U.S. (R&D, HQ), Taiwan (primarily sales & marketing, field engineering) and China (manufacturing and in-house packaging and test). AOSL is a fabless company, which means it contracts out the fabrication of its wafers to 3rd party wafer foundries, but does own its own packaging and test capacity. This structure enables AOSL to leverage world-class U.S. design talent and ultra-efficient Chinese manufacturing, packaging and test while servicing the PC island kingdom of Taiwan with an aggressive local presence. Importantly, this structure also allows the company to pay a tax rate of 10-15%.
From talking to the company and our industry contacts I believe that AOSL has a competitive advantage that lies in their design prowess, ability to do business with all of the major PC ODMs as a pseudo-local Taiwanese company and efficient fabless operations. These advantages are not as easy to explain in a 30 minute IPO roadshow meeting but should not go away overnight. Since its founding in 2000, AOSL has consistently outgrown its primary competition such as Fairchild Semiconductor, International Rectifier and Vishay. AOSL's competitors largely own their own manufacturing capacity, and the industry is generally considered to be a slow growth, cyclical commodity business. Fortunately for AOSL, its Chinese foundry partners have been more willing to invest in new capacity than its U.S.-based integrated competitors, enabling AOSL to outgrow its competition in a capital efficient manner while maintaining a cost advantage. FCS, IRF and VSH have increasingly used their capacity for higher margin industrial high voltage business, ceding much of the low voltage PC and consumer electronics market to AOSL and other competitors such as DIOD. In fact, AOSL appears to be following a very similar strategy to DIOD, which has been successful as both an operating company as an investment.

As for the industry backdrop, AOSL is primarily tied to the global PC market and to a lesser extent the consumer electronics market. The strength of the PC semiconductor market is currently questioned by investors because of weak economic growth and tablet cannibalization. However, the economic re-acceleration, corporate IT upgrades and secular drivers such as Windows 7 should keep PCs growing at a moderate pace at least. AOSL has a clear history of growing faster than the market by taking share. My research sources indicate that AOSL continues to take share in the power MOSFET and power management IC markets with strong design win activity, so I expect the above-market growth to continue for the foreseeable future. Additionally, AOSL has maintained a rapid pace of new product introductions and successfully increased gross margins in part by expanding into the higher-margin Power IC market. On its last conference call, AOSL indicated it was temporarily limiting operating margin operating expansion by investing the R&D necessary to enter the higher margin high voltage MOSFET market. High voltage MOSFETs tend to be designed into much longer product cycles in the industrial and communications markets. Based on the company's track record of success in low voltage MOSFETs and power ICs, I would expect this effort to yield fruit for investors.
 
History and Current Situation
In retrospect, April 2010 was not a great time for AOSL to go public. The iPad was released the month before, and investors started to question the future of the PC market. The June 2010 fiscal year had produced blistering 63% growth as the market came back from the depths of the Great Recession, but as AOSL sat in the quiet period after its IPO and fiscal year end the economy seemed to slow and the PC supply chain underwent a minor inventory correction, causing the SOX to sell off violently. IPO investors hoping for a quick aftermarket pop dumped their shares when it didn't materialize. AOSL disappointed investors in its first report as a public company in early August, not because of a sales shortfall but because strong demand had enabled its foundry supplier to raise prices, crimping AOSL's margin forecast. The stock tanked after its Q4 FY 2010 report, briefly touching $10 per share. Ironically, when AOSL reported its September 2010 quarter it actually reported an increase in gross margins because of strong power IC sales, but by that point most investors were no longer paying attention and the analysts whose firms had underwritten the IPO disliked the stock. AOSL also reported a strong December 2010 quarter with continued gross margin expansion- and importantly notified the investment community that the minor inventory correction that began in the summer of 2010 appeared to be over with above-seasonal demand forecast for calendar Q1- but the myopic Wall St. analysts instead focused on the fact that the company was limiting near-term margin expansion by investing R&D in a new product category. The big knock on AOSL is that it is in a cyclical business, and it looks like Y on Y organic revenue growth is going to bottom at 10% in Q1 2011 for this mini-cycle. In my opinion that is cyclicality I can live with. But there poor AOSL sits, unloved and under-followed.
 
At current prices, AOSL appears to offer investors a rare trifecta: rapid growth, a clear path to margin expansion and a valuation (4.4x EV/FYE June 2011 EBITDA, almost $4.00 per share in net cash) Benjamin Graham could love. Although power MOSFETs are generally considered to be a low margin, commodity business, the company has managed to enter the market from scratch and rapidly gain share, posting a five year revenue CAGR (for the year ending 6/30/10) of 23.8% compared to the much weaker growth of Fairchild (2.3% for the five years ending 12/31/10), International Rectifier (-5.3% for the five years ending 6/30/10) and Vishay (4.4% for the five years ending 12/31/10). Operating margins also expanded from virtually nil in FY 2008 to 11% in FY 2010. Keep in mind this period of time included the industry's worst downturn since the dot com bubble collapsed. Gross margins should naturally grow as higher margin power ICs become a larger part of the business. As mentioned above, AOSL recently indicated it was going to limit margin expansion for calendar 2011 as it invests the R&D needed to enter high voltage MOSFETs, but operating margins should stay around 10% before resuming growth in calendar 2012. AOSL also has a history of capital efficiency. The company raised $30M in a venture capital round led by blue-chip venture firm Sequoia Capital in 2006, and basically never touched the money. Sequoia did not sell any shares in the IPO, and continues to serve on the board of directors. Investors today can buy the stock at only about 40% more than Sequoia's $10.00 per share basis, an investment made five years ago when AOSL was a much smaller, private, unprofitable company.
 
Valuation and Return Potential
Because of the poor timing of its IPO and the current investor disdain for the PC market, AOSL now trades at a valuation more befitting a slow or negative growth company, not one with AOSL's kind of revenue growth (I'm modeling 20% for the June 2011 fiscal year) and balance sheet (around $3.90 of net cash and increasing on a $14ish stock). Although it may take a while, AOSL should appreciate as the market recognizes its above-industry growth and dirt cheap valuation. I am hoping that AOSL performs like DIOD (another commodity semiconductor supplier who rapidly gained market share) performed from 2004 to 2007. During this period DIOD appreciated from around $10 to around $30 per share while remaining cheap enough for value investors to own the entire time. I estimate AOSL will do $58M in EBITDA and $24M in free cash  flow in fiscal 2011, followed by $72M of EBITDA and $44M of FCF in fiscal 2012. The company's EV is around $260M today, and should generate around $54M of FCF in the next six quarters, bringing its EV down to about $217M after some share creep. That would be a cool 3x trailing FY 2012 EBITDA at current prices. DIOD currently trades at 7.5x trailing EBITDA, applying the same multiple in June of 2012 gives a $26-$27 share price. For the Pro Forma EPS minded I model $1.76 for FY 2011, $1.93 for FY 2012 and $2.48 for FY 2013. $28 (100% appreciation) would be less than 10x 2013 earnings per share after backing out the almost $6.00 per share in cash the company will have in 18 months. Higher multiples in semiconductors have certainly been observed. A link to a valuation table in Google spreadsheets is below so you can play with valuations at different prices and earnings levels below.
 
https://spreadsheets.google.com/ccc?key=0AsmeNePhbcCtdFJ5MEpldnJaSmQxNW82dmpsd0JsTnc&hl=en&authkey=CKWAsuEL
 
Risks
The global semiconductor market is notoriously cyclical. If we are on the cusp of an economic downturn (or if there is an incipient supply chain correction) my forecasts for AOSL's earnings could look silly. I don't see it happening immediately given that we just went through a minor inventory correction and economic growth seems to be picking up, but you never know.
 
Tablet cannibalization of the PC market is a negative for AOSL. Tablets do use power MOSFETs and ICs, but at a lower $ content level than PCs. So every tablet that is purchased in lieu of a PC is an incremental negative for AOSL.
 
AOSL is a transnational entity that has most of its operations and employees in China and Taiwan. While I don't think it presents the same level of risks as a Chinese reverse merger, it is something to be cognizant of. Culturally, AOSL management may favor growth over margins and return of capital to shareholders.
 
AOSL is a recent IPO with significant insider and VC ownership that may come to market in the future, although I am pretty confident they are not interested at today's prices.
 
Disclosure
I am long AOSL. I may buy or sell AOSL at any time without notice, and this is not an offer to purchase or sale securities. Please do your own due diligence. In fact, if you can explain to me why AOSL deserves to trades where it does I would love to hear it.

Catalyst

Continued strong execution should increase the confidence public markets investors have in the company.

The company guided to above-seasonal strength in calendar Q1. If this strength continues revenue and earnings estimates should come up. The PC supply chain correction seems to be over. Notably, an item in today's Digitimes indicated that Taiwanese notebook ODMs could have 15-20% sequential shipment growth in Q2. Wall St. currently expects 6.5% calendar Q2 sequential growth for AOSL. http://www.digitimes.com/NewsShow/MailHome.asp?datePublish=2011/2/14&pages=PD&seq=224

AOSL is one of the few unequivocally cheap growth companies in the increasingly picked over technology and small cap markets. It has a lot of appreciation to go before it catches up to the performance and valuation of its best comps, DIOD, FCS and VSH.

Resumption of margin expansion in calendar 2012 as investments in high voltage MOSFET R&D pay off.
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    Description

    Introduction
    There is currently a bifurcation in the market for publicly traded technology stocks. Some businesses are afforded multiples that seem to assume robust growth and margin expansion for decades in the future while at the same time, participants in unfashionable sectors such as the PC supply chain are trading at what I consider deep value levels. MSFT is one example. I own some MSFT, but its case has already been made by some prominent value investors. I am writing about Alpha & Omega Semiconductor Ltd. (AOSL), a broken IPO that went public at $18.00 per share in April 2010. As a PC supply chain participant, AOSL had the misfortune to go public right before the introduction the iPad and a minor correction in the PC supply chain. Despite good execution through these headwinds, IPO investors have dumped the stock, giving opportunistic investors a chance to buy a stake in a promising growth business at a discounted price. Overall, I believe that the stock was a decent deal at its IPO and a screaming bargain at today's prices. Under what I consider a reasonable set of assumptions I think AOSL could double in the next 18 months.
     
    Business Description
    AOSL is a supplier of power semiconductors, primarily power MOSFETs and power management ICs, largely to the global PC and consumer electronics industry. The company's primary customers include virtually all the major PC ODMs and OEMs: ASUSTeK, Dell, HP and Samsung as well as Compal, Hon Hai, Foxconn, Quanta, TPV Technology/AOC and Wistron. Although AOSL's headquarters are in Silicon Valley, the company has an unusual trans-national structure where a Bermuda holding company owns a Cayman Islands subsidiary which in turns owns subsidiaries in the U.S. (R&D, HQ), Taiwan (primarily sales & marketing, field engineering) and China (manufacturing and in-house packaging and test). AOSL is a fabless company, which means it contracts out the fabrication of its wafers to 3rd party wafer foundries, but does own its own packaging and test capacity. This structure enables AOSL to leverage world-class U.S. design talent and ultra-efficient Chinese manufacturing, packaging and test while servicing the PC island kingdom of Taiwan with an aggressive local presence. Importantly, this structure also allows the company to pay a tax rate of 10-15%.
    From talking to the company and our industry contacts I believe that AOSL has a competitive advantage that lies in their design prowess, ability to do business with all of the major PC ODMs as a pseudo-local Taiwanese company and efficient fabless operations. These advantages are not as easy to explain in a 30 minute IPO roadshow meeting but should not go away overnight. Since its founding in 2000, AOSL has consistently outgrown its primary competition such as Fairchild Semiconductor, International Rectifier and Vishay. AOSL's competitors largely own their own manufacturing capacity, and the industry is generally considered to be a slow growth, cyclical commodity business. Fortunately for AOSL, its Chinese foundry partners have been more willing to invest in new capacity than its U.S.-based integrated competitors, enabling AOSL to outgrow its competition in a capital efficient manner while maintaining a cost advantage. FCS, IRF and VSH have increasingly used their capacity for higher margin industrial high voltage business, ceding much of the low voltage PC and consumer electronics market to AOSL and other competitors such as DIOD. In fact, AOSL appears to be following a very similar strategy to DIOD, which has been successful as both an operating company as an investment.

    As for the industry backdrop, AOSL is primarily tied to the global PC market and to a lesser extent the consumer electronics market. The strength of the PC semiconductor market is currently questioned by investors because of weak economic growth and tablet cannibalization. However, the economic re-acceleration, corporate IT upgrades and secular drivers such as Windows 7 should keep PCs growing at a moderate pace at least. AOSL has a clear history of growing faster than the market by taking share. My research sources indicate that AOSL continues to take share in the power MOSFET and power management IC markets with strong design win activity, so I expect the above-market growth to continue for the foreseeable future. Additionally, AOSL has maintained a rapid pace of new product introductions and successfully increased gross margins in part by expanding into the higher-margin Power IC market. On its last conference call, AOSL indicated it was temporarily limiting operating margin operating expansion by investing the R&D necessary to enter the higher margin high voltage MOSFET market. High voltage MOSFETs tend to be designed into much longer product cycles in the industrial and communications markets. Based on the company's track record of success in low voltage MOSFETs and power ICs, I would expect this effort to yield fruit for investors.
     
    History and Current Situation
    In retrospect, April 2010 was not a great time for AOSL to go public. The iPad was released the month before, and investors started to question the future of the PC market. The June 2010 fiscal year had produced blistering 63% growth as the market came back from the depths of the Great Recession, but as AOSL sat in the quiet period after its IPO and fiscal year end the economy seemed to slow and the PC supply chain underwent a minor inventory correction, causing the SOX to sell off violently. IPO investors hoping for a quick aftermarket pop dumped their shares when it didn't materialize. AOSL disappointed investors in its first report as a public company in early August, not because of a sales shortfall but because strong demand had enabled its foundry supplier to raise prices, crimping AOSL's margin forecast. The stock tanked after its Q4 FY 2010 report, briefly touching $10 per share. Ironically, when AOSL reported its September 2010 quarter it actually reported an increase in gross margins because of strong power IC sales, but by that point most investors were no longer paying attention and the analysts whose firms had underwritten the IPO disliked the stock. AOSL also reported a strong December 2010 quarter with continued gross margin expansion- and importantly notified the investment community that the minor inventory correction that began in the summer of 2010 appeared to be over with above-seasonal demand forecast for calendar Q1- but the myopic Wall St. analysts instead focused on the fact that the company was limiting near-term margin expansion by investing R&D in a new product category. The big knock on AOSL is that it is in a cyclical business, and it looks like Y on Y organic revenue growth is going to bottom at 10% in Q1 2011 for this mini-cycle. In my opinion that is cyclicality I can live with. But there poor AOSL sits, unloved and under-followed.
     
    At current prices, AOSL appears to offer investors a rare trifecta: rapid growth, a clear path to margin expansion and a valuation (4.4x EV/FYE June 2011 EBITDA, almost $4.00 per share in net cash) Benjamin Graham could love. Although power MOSFETs are generally considered to be a low margin, commodity business, the company has managed to enter the market from scratch and rapidly gain share, posting a five year revenue CAGR (for the year ending 6/30/10) of 23.8% compared to the much weaker growth of Fairchild (2.3% for the five years ending 12/31/10), International Rectifier (-5.3% for the five years ending 6/30/10) and Vishay (4.4% for the five years ending 12/31/10). Operating margins also expanded from virtually nil in FY 2008 to 11% in FY 2010. Keep in mind this period of time included the industry's worst downturn since the dot com bubble collapsed. Gross margins should naturally grow as higher margin power ICs become a larger part of the business. As mentioned above, AOSL recently indicated it was going to limit margin expansion for calendar 2011 as it invests the R&D needed to enter high voltage MOSFETs, but operating margins should stay around 10% before resuming growth in calendar 2012. AOSL also has a history of capital efficiency. The company raised $30M in a venture capital round led by blue-chip venture firm Sequoia Capital in 2006, and basically never touched the money. Sequoia did not sell any shares in the IPO, and continues to serve on the board of directors. Investors today can buy the stock at only about 40% more than Sequoia's $10.00 per share basis, an investment made five years ago when AOSL was a much smaller, private, unprofitable company.
     
    Valuation and Return Potential
    Because of the poor timing of its IPO and the current investor disdain for the PC market, AOSL now trades at a valuation more befitting a slow or negative growth company, not one with AOSL's kind of revenue growth (I'm modeling 20% for the June 2011 fiscal year) and balance sheet (around $3.90 of net cash and increasing on a $14ish stock). Although it may take a while, AOSL should appreciate as the market recognizes its above-industry growth and dirt cheap valuation. I am hoping that AOSL performs like DIOD (another commodity semiconductor supplier who rapidly gained market share) performed from 2004 to 2007. During this period DIOD appreciated from around $10 to around $30 per share while remaining cheap enough for value investors to own the entire time. I estimate AOSL will do $58M in EBITDA and $24M in free cash  flow in fiscal 2011, followed by $72M of EBITDA and $44M of FCF in fiscal 2012. The company's EV is around $260M today, and should generate around $54M of FCF in the next six quarters, bringing its EV down to about $217M after some share creep. That would be a cool 3x trailing FY 2012 EBITDA at current prices. DIOD currently trades at 7.5x trailing EBITDA, applying the same multiple in June of 2012 gives a $26-$27 share price. For the Pro Forma EPS minded I model $1.76 for FY 2011, $1.93 for FY 2012 and $2.48 for FY 2013. $28 (100% appreciation) would be less than 10x 2013 earnings per share after backing out the almost $6.00 per share in cash the company will have in 18 months. Higher multiples in semiconductors have certainly been observed. A link to a valuation table in Google spreadsheets is below so you can play with valuations at different prices and earnings levels below.
     
    https://spreadsheets.google.com/ccc?key=0AsmeNePhbcCtdFJ5MEpldnJaSmQxNW82dmpsd0JsTnc&hl=en&authkey=CKWAsuEL
     
    Risks
    The global semiconductor market is notoriously cyclical. If we are on the cusp of an economic downturn (or if there is an incipient supply chain correction) my forecasts for AOSL's earnings could look silly. I don't see it happening immediately given that we just went through a minor inventory correction and economic growth seems to be picking up, but you never know.
     
    Tablet cannibalization of the PC market is a negative for AOSL. Tablets do use power MOSFETs and ICs, but at a lower $ content level than PCs. So every tablet that is purchased in lieu of a PC is an incremental negative for AOSL.
     
    AOSL is a transnational entity that has most of its operations and employees in China and Taiwan. While I don't think it presents the same level of risks as a Chinese reverse merger, it is something to be cognizant of. Culturally, AOSL management may favor growth over margins and return of capital to shareholders.
     
    AOSL is a recent IPO with significant insider and VC ownership that may come to market in the future, although I am pretty confident they are not interested at today's prices.
     
    Disclosure
    I am long AOSL. I may buy or sell AOSL at any time without notice, and this is not an offer to purchase or sale securities. Please do your own due diligence. In fact, if you can explain to me why AOSL deserves to trades where it does I would love to hear it.

    Catalyst

    Continued strong execution should increase the confidence public markets investors have in the company.

    The company guided to above-seasonal strength in calendar Q1. If this strength continues revenue and earnings estimates should come up. The PC supply chain correction seems to be over. Notably, an item in today's Digitimes indicated that Taiwanese notebook ODMs could have 15-20% sequential shipment growth in Q2. Wall St. currently expects 6.5% calendar Q2 sequential growth for AOSL. http://www.digitimes.com/NewsShow/MailHome.asp?datePublish=2011/2/14&pages=PD&seq=224

    AOSL is one of the few unequivocally cheap growth companies in the increasingly picked over technology and small cap markets. It has a lot of appreciation to go before it catches up to the performance and valuation of its best comps, DIOD, FCS and VSH.

    Resumption of margin expansion in calendar 2012 as investments in high voltage MOSFET R&D pay off.

    Messages


    SubjectRE: timing of IPO upon ipad boom
    Entry02/16/2011 04:39 PM
    Memberspecialk992
    Thanks for the question- My sense on the timing of AOSL's IPO is just that they wanted to go public when there was strong momentum and visibility in their business, and they probably didn't realize (and I didn't either at the time) that the iPad would cause investors to question the future of the PC business. You have to keep in mind that the timing of the IPO was such that they were going to report their first public quarter as a company that had just wrapped up a fiscal year with 63% revenue growth off. Up until late this summer, the PC supply chain was worried about whether it could get enough discrete semiconductors since demand was coming back and the AOSL competitors I mentioned had actually reduced capacity during the downturn and have not added much since. So AOSL had strong revenue momentum, substantial backlog and long lead times when it went public. This is why they could go through the recent PC slowdown and inventory correction without dipping below double digit growth. When AOSL reported its June 2010 quarter, the problem was actually that strong demand had caused its foundry to raise prices. Growth was a little sub-seasonal in September and December but OK overall. Usually a company like AOSL going through an inventory correction would have declines in revenue and big hits to profitability. Currently my impression is supply and demand is more in balance but growth seems to be coming back.
     
    The timing is tough- I expected AOSL to trade up substantially after its last two quarterly reports but the stock just sat there while the SOX and its competitors have been going straight up.
     
    My personal belief is that the tablet market is bending down the growth curve on PCs but not causing the category to go into an absolute decline. In that case AOSL should be able to keep growing as it introduces new products, enters new markets and continues to take share. A non-recession absolute decline in the PC market would be a problem for them. I personally also believe that STX and WDC are gong to be fine in the long term, and will both participate in the SSD market (including by making hybrid SSD/HDDs).

    SubjectUpdate?
    Entry08/01/2012 11:06 AM
    Memberaagold
    specialk,
     
    Do you still own AOSL?  What do you think now?  A lot has happened since you first wrote this up.  If it was a "screaming bargain" at $13.54, what is it at $7.40?  Certainly seems to be some value here...
     
    Thanks,
    aagold
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