Actions Semiconductor ACTS
January 07, 2007 - 8:23pm EST by
fiftycent501
2007 2008
Price: 8.21 EPS
Shares Out. (in M): 0 P/E
Market Cap (in M): 708 P/FCF
Net Debt (in M): 0 EBIT 0 0
TEV: 0 TEV/EBIT

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Description

Actions Semiconductor is a cheap (20% free cash yield in ’07 and 14% LTM), high growth, high ROIC company, with minimal capital requirements that conservatively offers 50% upside.
 
Background
ACTS is a fabless semiconductor company based in China. It is the dominant provider of low end systems on a chip (SoC) solutions to the MP3 and personal media player (PMP) market.  Being fabless, its main focus is on R&D/product development, so it has virtually no capex.  ACTS has great customer relationships because it is known for hand holding with the lower end OEM’s that are not that technologically sophisticated, so that the OEM’s can add more functionality and get their product to market quicker.  ACTS accomplishes this with a flexible architecture, using digital signal processors (DSP), which allows customers to port new applications and software quickly and easily.  The competition for the most part use application specific integrated circuits (ASIC), which usually require the entire semiconductor to be redesigned to add any functionality.
 
ACTS does very little business in the US where brand name products dominate the marketplace.  In the rest of the world, where ACTS focuses, more generic type MP3 players are prevalent.  Some of ACTS major customers are Aigo, Tomy, Lenovo, Zarva, Thomson, Hyundai, NEC.
 
I realize that this website isn’t called Growth Investors Club, but the secular growth is compelling and who doesn’t like getting growth for free?  Market forecasts for NAND Flash based MP3 players are for 20-25% growth through ’09 to 231 million units, and that the PMP market will grow from 18 million in ‘06 to 88 million units in ’10.
 
ACTS is predominantly an MP3 SoC provider at this point.  It is currently making inroads in higher end areas, like the PMP market, by offering SoC’s with better video functionality.  It will also be developing solutions for MP3 player phones, as well.  ACTS management realizes that they have to broaden their product portfolio to maintain their margins and growth rate.
 
Having a dominant position and a fabless business model results in great economics.  ‘05’s ROIC was 56% and LTM 39%.   In ’05 ACTS converted 97% of net income into free cash.  Not bad considering that net income and revenue grew 178% and 161%, respectively. 
 
Competitive position
ACTS should ship almost 77 million units in ’06, which is 40-43% market share, based on industry projections of 180-190 million units.  This is substantial, considering that the iPod (which ACTS is not designed into) makes up about 20% of the MP3 market, so of everything else ACTS controls more than ½ of the non iPod market.  Within China it is estimated to have 70-80% market share.
 
ACTS is the low cost producer.  Engineering costs in China are 1/10 of what they are in the US and 1/3 of what they are in Taiwan.  All manufacturing is outsourced, predominantly to Hejian Technology.  ACTS is also driving down costs through line width shrinks with its foundry partner and is transitioning from .25 micron to .18.  About 50% output is at .18 now, which should help support margins.  As a result, ACTS’s operating margins are about 20% better than its peers.
 
Projections and Valuation
 

Price
$8.32
 
 
SO
86
 
 
MC
716
 
 
 
 
 
 
Cash
261
 
 
Debt
77
 
 
EV
532
 
 
 
 
 
 
NetCash/Share
 $   2.14
 
 
 
 
 
 
 
2005
2006E
2007E
Units
    48,866
    76,783
114,301
ASP
 $   3.00
 $   2.22
 $   1.80
 
 
 
 
Rev
149.6
170.1
206.1
GP
89
97.1
114.1
Op Inc
70.9
79.2
102.9
NI
73.6
78.4
99.9
 
 
 
 
dil SO
80.5
86
86
EPS
 $   0.91
 $   0.91
 $   1.16
 
 
 
 
P/E 
9.1
9.1
7.2
P/E ex-cash
6.8
6.8
5.3

 
ACTS currently enjoys a very low tax rate at 7.5% since the Chinese government was trying to encourage technology investment.  Eventually its tax rate will rise, but the timing and level are uncertain.  It is possible that in ’08 and beyond the tax rate could rise to the mid-teens to 30%.
 
Also keep in mind that ACTS will generate roughly $100 million of free cash flow in ’07, so there will be another $100 million on the balance sheet.
 
Longer term, ACTS expects 30% industry unit growth and 20-25% ASP erosion per year for the foreseeable future.  Due to product innovation it expects to be able to grow units at 35-40% with lower ASP declines.
 
Asian consumer electronics semi stocks (Mediatek, Sunplus, Sonix, Silicon Motion, Novatek, Himax) trade anywhere from 11-19x ’07 EPS, with the average about 15x.  One could argue that ACTS deserves a premium since none of these competitors enjoys as strong margins or competitive position, and ACTS trades in the US.  ACTS should trade at the low end of the peer range at the very least, which would equate to $12.75.
 
 
Upside to consensus
I don’t normally invest in stocks just because they are going to “beat” earnings, but I think that a strong case can be made for ACTS results to be considerably better than the current consensus in ’07.
 
New distribution deals will increase market share in ‘07.  ACTS has been picking up more and more distributors, which an integral part of its strategy to take share globally.  ACTS had been using many smaller distributors, but recently has announced agreements with 2 large distributors, World Peace Industrial and GMI Technology.  GMI Technology named ACTS its sole supplier of SoC’s, which is a major blow to SGTL, which did roughly 18% of its revenue through GMI.  World Peace Industrial is the #1 distributor in Asia and #3 globally.  It was also an important distribution channel for SGTL.  It ships about 1 million MP3 SoC’s per month, so in the back half of ’07 this could potentially add $20 million or revenue on a run rate basis.  Both of these distributors give ACTS access to new geographies and new, larger customers. 
 
New products will also provide upside to consensus estimates.  The 13 series will offer a higher end product for the PMP market than ACTS already offers, which equates to higher margins.  It will support storage of over 2GB of flash and will use be compatible with the prevalent open standards of software for video in usage today, so it will open new markets to ACTS.  The 13 series is already beta testing with customers and should be in volume by the second half.
 
ACTS was subject to an exclusionary order by the ITC that barred it from selling one of its product lines in the US (I will address this in more detail in the “Risk” section), but the introduction of its 7500 and 9 series will allow it to re-enter the US market, which would be additive to projections.
 
SNDK is trialing ACTS SoC’s.  Not only would a customer win like this boost numbers significantly, but it would validate ACTS’s technology and value proposition through a win with a tier 1 OEM.
 
Pricing in the NAND Flash market has been weak and is expected to deteriorate further.  Cheaper flash means cheaper MP3 players, which should catalyze demand for ACTS’s products.
 
Risks
The industry is highly competitive and ACTS relies predominantly one end market at this point.  Any company that boasts ROIC and growth rates like this is bound to attract attention and invite competition.  ASP erosion is a fact of life in all segments of the semiconductor industry.  The successful competitors are the ones that engineer costs out of the product the quickest.  As I mentioned earlier, ACTS is the low cost producer.  SGTL, PLAY, Samsung, and Telechips are ACTS’s main competitors.  SGTL is on the ropes.  PLAY is losing share.  Samsung is a formidable competitor though. 
 
Hejian Technology is ACTS’s primary foundry, so ACTS relies on Hejian for the vast majority of its product supply.
 
ACTS has been involved in patent litigation in the past.  On 9/15/06 the ITC ruled that ACTS’s 207X, 208X, and 209X infringed on SGTL patents.  As a result, the ITC barred ACTS from selling these products in the US.  There were no damages awarded and the exclusion order has not had much impact on ACTS’s top line.  US sales are probably 5-10% of total and the product lines in question are being phased out.  The risk is that SGTL tries to pursue a similar outcome in Europe.  However, as I mentioned before SGTL is troubled and going through a management transition, and ACTS is migrating to newer products that do not infringe, so I do not think it is likely that SGTL will bother, especially because by the time anything could be done in Europe the 207X, 208X, and 209X would be basically obsolete anyway.  In a shrewd bit of strategery, ACTS actually sued SGTL for patent infringement in China, so litigation could actually turn out to be a positive.
 
ACTS shareholders include many esteemed value investors.  Just take a look at the top 3 holders: 1) Janus 2) Stratix Asset Mgmt 3) SAC.  Uh… ok so these guys aren’t exactly value investors.  Some of you snarkier VIC members might not consider them investors at all.  Nonetheless, these are smart guys (Janus aside) who know their stuff, but I would caution that if they decide to exit en masse, it could end up looking like the 3 stooges trying to walk through a doorway at the same time, so I’d be remiss if I didn’t mention this as a risk, even though it does not relate to the fundamentals.
 
 

Catalyst

New product launches
New distributor/customer relationships
Resolution to litigation
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    Description

    Actions Semiconductor is a cheap (20% free cash yield in ’07 and 14% LTM), high growth, high ROIC company, with minimal capital requirements that conservatively offers 50% upside.
     
    Background
    ACTS is a fabless semiconductor company based in China. It is the dominant provider of low end systems on a chip (SoC) solutions to the MP3 and personal media player (PMP) market.  Being fabless, its main focus is on R&D/product development, so it has virtually no capex.  ACTS has great customer relationships because it is known for hand holding with the lower end OEM’s that are not that technologically sophisticated, so that the OEM’s can add more functionality and get their product to market quicker.  ACTS accomplishes this with a flexible architecture, using digital signal processors (DSP), which allows customers to port new applications and software quickly and easily.  The competition for the most part use application specific integrated circuits (ASIC), which usually require the entire semiconductor to be redesigned to add any functionality.
     
    ACTS does very little business in the US where brand name products dominate the marketplace.  In the rest of the world, where ACTS focuses, more generic type MP3 players are prevalent.  Some of ACTS major customers are Aigo, Tomy, Lenovo, Zarva, Thomson, Hyundai, NEC.
     
    I realize that this website isn’t called Growth Investors Club, but the secular growth is compelling and who doesn’t like getting growth for free?  Market forecasts for NAND Flash based MP3 players are for 20-25% growth through ’09 to 231 million units, and that the PMP market will grow from 18 million in ‘06 to 88 million units in ’10.
     
    ACTS is predominantly an MP3 SoC provider at this point.  It is currently making inroads in higher end areas, like the PMP market, by offering SoC’s with better video functionality.  It will also be developing solutions for MP3 player phones, as well.  ACTS management realizes that they have to broaden their product portfolio to maintain their margins and growth rate.
     
    Having a dominant position and a fabless business model results in great economics.  ‘05’s ROIC was 56% and LTM 39%.   In ’05 ACTS converted 97% of net income into free cash.  Not bad considering that net income and revenue grew 178% and 161%, respectively. 
     
    Competitive position
    ACTS should ship almost 77 million units in ’06, which is 40-43% market share, based on industry projections of 180-190 million units.  This is substantial, considering that the iPod (which ACTS is not designed into) makes up about 20% of the MP3 market, so of everything else ACTS controls more than ½ of the non iPod market.  Within China it is estimated to have 70-80% market share.
     
    ACTS is the low cost producer.  Engineering costs in China are 1/10 of what they are in the US and 1/3 of what they are in Taiwan.  All manufacturing is outsourced, predominantly to Hejian Technology.  ACTS is also driving down costs through line width shrinks with its foundry partner and is transitioning from .25 micron to .18.  About 50% output is at .18 now, which should help support margins.  As a result, ACTS’s operating margins are about 20% better than its peers.
     
    Projections and Valuation
     

    Price
    $8.32
     
     
    SO
    86
     
     
    MC
    716
     
     
     
     
     
     
    Cash
    261
     
     
    Debt
    77
     
     
    EV
    532
     
     
     
     
     
     
    NetCash/Share
     $   2.14
     
     
     
     
     
     
     
    2005
    2006E
    2007E
    Units
        48,866
        76,783
    114,301
    ASP
     $   3.00
     $   2.22
     $   1.80
     
     
     
     
    Rev
    149.6
    170.1
    206.1
    GP
    89
    97.1
    114.1
    Op Inc
    70.9
    79.2
    102.9
    NI
    73.6
    78.4
    99.9
     
     
     
     
    dil SO
    80.5
    86
    86
    EPS
     $   0.91
     $   0.91
     $   1.16
     
     
     
     
    P/E 
    9.1
    9.1
    7.2
    P/E ex-cash
    6.8
    6.8
    5.3

     
    ACTS currently enjoys a very low tax rate at 7.5% since the Chinese government was trying to encourage technology investment.  Eventually its tax rate will rise, but the timing and level are uncertain.  It is possible that in ’08 and beyond the tax rate could rise to the mid-teens to 30%.
     
    Also keep in mind that ACTS will generate roughly $100 million of free cash flow in ’07, so there will be another $100 million on the balance sheet.
     
    Longer term, ACTS expects 30% industry unit growth and 20-25% ASP erosion per year for the foreseeable future.  Due to product innovation it expects to be able to grow units at 35-40% with lower ASP declines.
     
    Asian consumer electronics semi stocks (Mediatek, Sunplus, Sonix, Silicon Motion, Novatek, Himax) trade anywhere from 11-19x ’07 EPS, with the average about 15x.  One could argue that ACTS deserves a premium since none of these competitors enjoys as strong margins or competitive position, and ACTS trades in the US.  ACTS should trade at the low end of the peer range at the very least, which would equate to $12.75.
     
     
    Upside to consensus
    I don’t normally invest in stocks just because they are going to “beat” earnings, but I think that a strong case can be made for ACTS results to be considerably better than the current consensus in ’07.
     
    New distribution deals will increase market share in ‘07.  ACTS has been picking up more and more distributors, which an integral part of its strategy to take share globally.  ACTS had been using many smaller distributors, but recently has announced agreements with 2 large distributors, World Peace Industrial and GMI Technology.  GMI Technology named ACTS its sole supplier of SoC’s, which is a major blow to SGTL, which did roughly 18% of its revenue through GMI.  World Peace Industrial is the #1 distributor in Asia and #3 globally.  It was also an important distribution channel for SGTL.  It ships about 1 million MP3 SoC’s per month, so in the back half of ’07 this could potentially add $20 million or revenue on a run rate basis.  Both of these distributors give ACTS access to new geographies and new, larger customers. 
     
    New products will also provide upside to consensus estimates.  The 13 series will offer a higher end product for the PMP market than ACTS already offers, which equates to higher margins.  It will support storage of over 2GB of flash and will use be compatible with the prevalent open standards of software for video in usage today, so it will open new markets to ACTS.  The 13 series is already beta testing with customers and should be in volume by the second half.
     
    ACTS was subject to an exclusionary order by the ITC that barred it from selling one of its product lines in the US (I will address this in more detail in the “Risk” section), but the introduction of its 7500 and 9 series will allow it to re-enter the US market, which would be additive to projections.
     
    SNDK is trialing ACTS SoC’s.  Not only would a customer win like this boost numbers significantly, but it would validate ACTS’s technology and value proposition through a win with a tier 1 OEM.
     
    Pricing in the NAND Flash market has been weak and is expected to deteriorate further.  Cheaper flash means cheaper MP3 players, which should catalyze demand for ACTS’s products.
     
    Risks
    The industry is highly competitive and ACTS relies predominantly one end market at this point.  Any company that boasts ROIC and growth rates like this is bound to attract attention and invite competition.  ASP erosion is a fact of life in all segments of the semiconductor industry.  The successful competitors are the ones that engineer costs out of the product the quickest.  As I mentioned earlier, ACTS is the low cost producer.  SGTL, PLAY, Samsung, and Telechips are ACTS’s main competitors.  SGTL is on the ropes.  PLAY is losing share.  Samsung is a formidable competitor though. 
     
    Hejian Technology is ACTS’s primary foundry, so ACTS relies on Hejian for the vast majority of its product supply.
     
    ACTS has been involved in patent litigation in the past.  On 9/15/06 the ITC ruled that ACTS’s 207X, 208X, and 209X infringed on SGTL patents.  As a result, the ITC barred ACTS from selling these products in the US.  There were no damages awarded and the exclusion order has not had much impact on ACTS’s top line.  US sales are probably 5-10% of total and the product lines in question are being phased out.  The risk is that SGTL tries to pursue a similar outcome in Europe.  However, as I mentioned before SGTL is troubled and going through a management transition, and ACTS is migrating to newer products that do not infringe, so I do not think it is likely that SGTL will bother, especially because by the time anything could be done in Europe the 207X, 208X, and 209X would be basically obsolete anyway.  In a shrewd bit of strategery, ACTS actually sued SGTL for patent infringement in China, so litigation could actually turn out to be a positive.
     
    ACTS shareholders include many esteemed value investors.  Just take a look at the top 3 holders: 1) Janus 2) Stratix Asset Mgmt 3) SAC.  Uh… ok so these guys aren’t exactly value investors.  Some of you snarkier VIC members might not consider them investors at all.  Nonetheless, these are smart guys (Janus aside) who know their stuff, but I would caution that if they decide to exit en masse, it could end up looking like the 3 stooges trying to walk through a doorway at the same time, so I’d be remiss if I didn’t mention this as a risk, even though it does not relate to the fundamentals.
     
     

    Catalyst

    New product launches
    New distributor/customer relationships
    Resolution to litigation

    Messages


    Subjectquestions
    Entry01/07/2007 09:50 PM
    Memberroc924
    Can you address why the stock is at such a low multiple of earnings? i.e. what's the bear case and why is it wrong?

    Why are ASPs declining so rapidly? Can they not add more functionality to the SOC to moderate the decline? Does this suggest that we are already at the tail end of this company enjoying high ROICs?

    ACTS's top 5 customers represent 80% of sales. Is there something that can give us confidence they won't get designed out of a major customer in the next year?

    How do you get comfortable with management and the corporate structure? I noticed the chairman sold a third of his holdings on the recent secondary.

    I noticed that incremental GM% is 39% in 2006, much lower than overal GM% of 57%. Why is that? You model a big improvement in incremental GM% in 2007.

    Thanks for the write up.




    Subjectroc answers
    Entry01/09/2007 01:04 PM
    Memberfiftycent501
    Hey Roc, good questions.

    "Can you address why the stock is at such a low multiple of earnings? i.e. what's the bear case and why is it wrong?"

    My main concern is competition. As I wrote, many of the pure play competitors are struggling, but I am concerned about Samsung and the potential for other new entrants, either large integrated manufacturers or the potential for new upstarts to enter the market. It is understandable for a stock in a competitive space with basically one end market to trade at a discount, but I think that even with a bearish outlook the valuation disparity with its peers is too great. I think the main reason the stock is so cheap is that there is a misunderstanding about the severity of the impact from the ITC ruling in the US and the possibility of something similar happening in the EU. The exclusion from the US has not had a material impact on their unit shipments and I do not think there will be a negative event in regard to the EU. I have been told by industry sources that the 207X, 208X, and 209X are less than 10% of rev, so even if SGTL were to achieve some kind of legal win in Europe, I think the impact would be minimal. I have not been able to completely verify those numbers, but I have no reason to doubt the sources. These products are being phased out also. They are all .25 micron product, and the company is rapidly shifting to .18, so these products will probably not even be produced in the near future. I think the secondary also probably gave investors pause.

    "Why are ASPs declining so rapidly? Can they not add more functionality to the SOC to moderate the decline? Does this suggest that we are already at the tail end of this company enjoying high ROICs?"

    Competition causes ASP erosion. These types of declines are often seen in the industry. Previously, ACTS was focused on lower end product. New product introductions should slow the decline. As ASP’s decline, demand increases and the market grows, so gaining economies of scale in production is a big part of a successful semi business model. Over the longer term I do not view ACTS’s margins as sustainable. I would expect competition to eventually whittle them down. I do think they can maintain them for the foreseeable future though and that even with lower margins they can earn an attractive ROIC. So I do not think they are necessarily at the tail end, but it is reasonable to assume that it will decline at some point. At this valuation, they are not getting credit for earning well in excess of their cost of capital.

    "ACTS's top 5 customers represent 80% of sales. Is there something that can give us confidence they won't get designed out of a major customer in the next year?"

    I have nothing concrete, but all of my research shows that these customers are happy. They all seem to be positive on the new product launches as well, which should provide some comfort in the coming years. The addition of new distributors will add new customers, so customer concentration should diminish with time.

    "How do you get comfortable with management and the corporate structure? I noticed the chairman sold a third of his holdings on the recent secondary. "

    Corporate governance outside of the US, and particularly China, Mauritius, Cayman Islands, is not as good as the US, so there is less shareholder protection. This is unfortunately part of investing in emerging markets.

    It is also always disconcerting to see insider selling, especially at this valuation, but the company was founded in ’01 and has been extremely successful in a short period of time, so I think it is natural for the founders and early investors to take some off the table.

    "I noticed that incremental GM% is 39% in 2006, much lower than overal GM% of 57%. Why is that? You model a big improvement in incremental GM% in 2007."

    As the transition to smaller process geometries continues, from .25 to .18, incremental gross margins will improve in ’07.


    Mgmt is presenting at the Needham conf this week, so if I get any clarifications I’ll post a follow up.

    Subjectupdate?
    Entry05/19/2007 08:22 AM
    Memberjay912
    Roc, Thanks for the writeup. I've started looking at this name recently and was wondering if you had any new thoughts since your original post. Clearly with the updated outlook from management the upside may not be the same for the business, but the enterprise value is off quite a bit and it may still offer a very compelling investment.

    Subjectjay
    Entry05/23/2007 03:36 PM
    Memberfiftycent501
    Clearly I got this one wrong so far. I actually averaged down though on the last leg down. Basically, my revenue projections were too aggressive.

    Unit volume came in lower in 1Q than I was expecting. 1Q is always seasonally slow, but this was exacerbated this year by dramatic declines in NAND flash prices that caused low end MP3 manufacturers to hold off on purchasing IC's from ACTS. NAND flash pricing has stabilized and unit volume is back on track.

    Pricing is a different story. ASP degradation in 1Q was also worse than I expected for several reasons. Competition is very intense and having the unit volume slow did not help. ACTS ASP’s were also negatively impacted by them clearing some older inventory. the inventory situation is better, but competition is still very tough. That said ASP erosion should return to more normal mid single digit levels for the current product throughout the rest of the year. The new higher end product launch (Series 13) is happening now. They have won about 30 design wins already and it should be shipping in volume in 3Q. Series 13 could be 10% of units in 2H at an ASP of $3.50-4.50, which is much higher than the current ASP, so there could be an inflection point in 4Q.

    ACTS continues to maintain its gross margin through migrating to smaller geometries. 90% of production in 2Q will be at .18.

    And yes the balance sheet still looks great with $2.44/share of cash. they announced an 8mil ADS buy back, but some of that will offset options grants. They have talked of doing acquisitions, but it looks like they are being conservative as I know of large deals that they have passed up. They appear content to make investments in start ups for now.

    So it is trading at about 6x FCF on ’07 estimates. Still looks cheap to me, but ASP’s remain the wild card here.
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