|Shares Out. (in M):||28||P/E||NM||NM|
|Market Cap (in $M):||114||P/FCF||NM||19|
|Net Debt (in $M):||-57||EBIT||-7||1|
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Emcore was written up in detail last February by Go2bl93, so I will refer readers to his note for much of the background on the pieces of the business and instead focus this note on what has changed over the last year and why Emcore is a compelling long today, even more so than when it was first written up.
As a brief refresher, Emcore is a vertically integrated producer of mixed signal optics, including chips (made in its California-based Indium Phosphide fab), lasers, receivers, transmitters, and optical switches. Historically the Company’s core focus has been on the cable TV (CATV) industry, supplying components and subsystems primarily to Arris and Cisco who in turn incorporate them into the headend transmission equipment they sell to cable MSOs. Over the last several years, Emcore has repurposed its core technology to tackle problems in several other markets, including aerospace/defense, teleco/datacenter, and wireless. Those efforts, though nascent, are beginning to show real traction, lessoning the company’s dependence on CATV and setting the stage for meaningful growth. We believe this transition will result in substantial earnings growth for Emcore over the next 24 months, setting the stage for a doubling of the stock from current levels at a time when downside is minimal. While this may sounds very similar to Go2bl93’s thesis, two important things have changed over the last year: first, Emcore’s shares have fallen to a level that gives reasonable value to neither its existing CATV offering nor its several sizeable growth opportunities; and second, the company has announced a number of design wins in its navigation gyro business that give us confidence in the revenue opportunity to come; and third, the CATV business is finally improving following a difficult 2018. Given these material developments, we believe the stock warrants a new look.
The CATV business is improving following a terrible 2018
2018 was a difficult year for Emcore. Entering the year, the CATV business (80% of revenue) faced two known headwinds: Emcore was discontinuing its low-margin RF on Glass (“RFoG”) product line ($18m of revenue in 2017); and Comcast was moderating its spending following an unusually strong 2017. This second piece is harder to quantify explicitly, but management has said it was a large contributor in the jump in CATV revenue from $66m in 2016 to $99m in 2017. These two factors alone caused the stock to fall from over $11 per share in July of 2017 to $7 by January 2018. Unfortunately for Emcore shareholders, there was more pain to come. In early February, Emcore disclosed an inventory correction at Arris, its largest customer, as they internalized certain manufacturing operations. Arris simply stopped ordering a particular part for roughly six months.
The result of these three issues was that CATV revenue fell from $99.1m in 2017 to $59m in 2018, with a 3Q nadir of $11.7m. But with these issues behind it, CATV revenues, led by the newly-introduced linear externally modulated laser (“L-EML”) product line, are beginning to recover, jumping to $17.9m in 4Q18 and posting a solid (but seasonally lower) $14.9m in 1Q19. Management is guiding CATV revenue of $60m to $80m in 2019. Even if CATV comes in toward the lower end of the range, the business should show modest growth this year, and possibly more.
Emcore has announced multiple navigation design wins
Throughout the second half of FY17 (ended Sept. 30th) and into the first half of 2018, much of the investor fatigue in Emcore’s stock was a function of the company’s failure to sign a long-term agreement to supply Raytheon with navigation gyros for its multi-spectral targeting system (“MTS-B”) platform. Though Emcore had received a commitment for the first year of a contemplated 5-year agreement, Raytheon dragged its feet on signing the 4-year extension, leading some investors to question the future of the navigation business. In early September, Emcore finally announced the 4-year extension with contemplated revenue of $4m to $5m a year over the life of the contract. Beyond this much anticipated announcement, over the last year Emcore has announced:
- An agreement with a top-3 defense contractor to provide a custom IMU for airborne stabilization and navigation, initially in fighter aircraft and tactical jets, and eventually in a wider range of applications. Though less focused on by analysts than the Raytheon agreement, this deal has the potential to be much larger, potentially generating as much as $15m a year in revenue.
- An award from a large DoD contractor to design and deliver inertial measurement units (“IMUs”) for a custom inertial navigation system; the initial units are expected to be a precursor to production orders in 2019.
- A $4m contract to design and manufacture inertial measurement systems for a maritime systems application.
While the company doesn’t disclose much detail about specific contracts, and getting third-party diligence checks on these agreement has proven unfruitful, management has confirmed that that the existing design wins amount to $20m to $40m a year in revenue, once ramped, compared to just $8.6m of navigation revenue for the LTM period ended 12/31/18. Further, we believe these initial wins are just beginning for Emcore. Now that it has started to find acceptance among tier-1 customers, we believe the company is likely to continue taking share from incumbents Northrop Grumman and Lockheed Martin given the favorable performance, size, weight, and power characteristics of Emcore’s offering, at comparable or better price points. While the timing and size of future design wins is inherently uncertain, our understanding is that some of the opportunities in Emcore’s pipeline today are worth upwards of $30m a piece, far larger than anything they’ve historically bid for.
As these projects ramp, this business will provide not only incremental revenue and higher-than-corporate-average gross margins, it will provide a degree of consistency and visibility to earnings that Emcore has been lacking in recent years. Additionally, we think that as it scale, it could make Emcore an acquisition target for one of the defense primes who is either being beaten in the market by Emcore, or is looking to reduce its reliance on the competitors from whom it currently sources navigation gyros.
Other Growth Avenues
There are two additional revenue opportunities worth mentioning. The first is the Chips business. Historically Emcore has used excess capacity in its fab to produce merchant chips that it sells to optical components and subsystems manufacturers such as NeoPhotonics (ticker: NPTN). This is a high volume, low ASP business, but it helps to maintain high throughput at Emcore’s fab to keep costs down in its other businesses. Emcore did $10m of revenue in 2018 essentially only selling into the PON market. The company is now starting to sample with datacenter customers, which will add another leg to the business. Management thinks this business can do $15m to $20m in the near term, and vastly more over the next few years.
The second opportunity, which management has described to us as the biggest call option on the company, is in the distributed antenna system (“DAS”) market. This is a play on 5G. The idea behind EMKR’s offering is as follows: on a typical cell site, the fiber servicing the site carries a digital signal. Normally, the fiber extends up to the antenna, at which point it is converted into analog and broadcast over radio waves to mobile devices. The challenge with having the digital-to-RF conversion happen at the top of the cell tower is that it requires having more equipment on the tower. EMKR’s solution entails doing the conversion from fiber-to-RF at the base of the tower and using an EMKR laser to send the analog data up to the antenna, thus saving on size, weight, and power. According to management, the company is in “full blown” trials with two of the largest equipment suppliers and is “catching the attention of all the others.” Given the potential size of this market, if Emcore gets any traction here it will be a game changer for the company. These lasers will carry an ASP of around $75, and each tower would need 5 to 8 lasers, for total content per tower of $375 to $600. Today, China alone has 3m 4G base stations, and the number of stations needed under 5g is expected to multiply, to say nothing of the rest of the opportunity in the rest of the world. If successful here, this could result in hundreds of millions of dollars of revenue for Emcore over multiple years. We estimate Emcore receives $5m of incremental revenue from DAS in 2020.
The chart below lays out our revenue expectations for the different pieces of the business:
Margins are set to improve
From 2015 when Emcore finalized the divestiture of the last of a series of non-core assets, through the end of 2017, Emcore’s gross margins (ex. stock-based comp), averaged approximately 35% (see the chart below). However, for the last four quarters, they’ve been meaningfully lower, reaching a trough of 7.3% in 3Q18. The primary reason for the fall-off was the steep reduction in revenue resulting from the Arris issues. With less revenue, EMKR failed to efficiently leverage the fixed costs of its fab. Beyond this obvious headwind, margins have also been hampered by several other transitory issues. The first is the ramp of Emcore’s new L-EML product line. As with any new product, it has taken some time for Emcore to work down the cost curve to normalized margins, which should be in the mid-30s.
The second issue is more complicated. Because the L-EML product line has ramped far faster than management had ever expected, the company was forced to write-down the value of some of its legacy DFB lasers. These are non-cash write-offs and don’t reflect any change in the actual value or selling price of the inventory. The inventory at question here isn’t fashion apparel or fresh produce. These DFB lasers have incredibly long lives. The only reason they are being written off is because demand is shifting from the older DFB lasers to Emcore’s new L-EML products, forcing the company to change its assumptions about how quickly it will work through the inventory.
Lastly, there are some miscellaneous one-time costs baked into recent results including legal expenses, expedited shipping costs for a large order to Cisco, and L-EML ramp-up expenses.
If we back out these transitory costs (see the chart below), recent results start to make a lot more sense, and we can see that in the most recent quarter (1Q19) Emcore had already returned to normalized margins in excess of 32%, Though the March quarter, which will be reported in May, is likely to still have some noise in the numbers, we expect margins to see a meaningful lift in the second half as L-EML starts to approach normalized margins and the Company begins to ramp its navigation business, which carriers margins well above the company average. Even with the first half drag, 2019 margins should exceed those of 2018 by nearly 400bps, even if we normalize the 2018 figures for the non-recurring costs. Ultimately, we see no reason why margins can’t return to levels in excess of 35%, though for conservatism sake, we only model 33% in 2020.
The stock has gotten too cheap
As of today’s close, shares of Emcore trade at just $4.12, giving the company a market cap of $114m. Subtracting out $57.3m in net cash yields an enterprise value of just $57m. This compares to:
- 2019 revenue of $103m (0.6x) and $121m of revenues in 2020 (0.5x)
- 2020 Adj. EBITDA of $10m (5.6x) (we look at 2020 because 2019 EBITDA ($2.8m) is weighed down by several transitory issues, which we discuss below.
- Federal NOLs of $436.4m
- Tangible Book of $101.6m ($3.67 per share)
- Current Assets less ALL Liabilities of $80.9m ($2.93 per share).
Put simply, the valuation doesn’t make sense on any level. If all Emcore had were its $65m to $70m in CATV revenue, the company would be able to generate a modest profit and the business should reasonably be worth 0.8x to 1.0x, or between $52m and $56m at the low end and $65m to $70m at the high end (i.e, the entire current enterprise value).
We think Navigation and the remaining businesses should generate $18.5m and $36.1m, respectively, in revenue in 2020. Applying a 1.5x to 2xx multiple to Navigation and 1.25x to 1.75x to the revenue results in additional value of $73m to $100m. Said differently, the growth pieces alone could be worth 130% to 175% of the current enterprise value.
Adding up the values, and docking EMKR for some modest cash burn this year (something that is only happening because the company is essentially rebuilding its Alhambra production facilities in its existing footprint), we believe shares are conservative worth $6.30 to $7.80 per share, for upside of 50% to 90%. In a scenario where the company truly hits on the opportunity set before it in Navigation or 5G, we can easily justify a share price closer to $10. And importantly, none of these figures give any value to the NOLs, which if valued at even 5% of face value, yields another $0.80 per share in value.
Excess cash creates optionality
The last point worth touching on is that in addition to providing downside protection, Emcore’s big cash balance provides investors with a free option on them one day using it to actually create value. The cash has sat largely untouched since 2015 when the company tendered for $45m of stock. Until last June, using the cash to buy back additional stock would have resulted in some of the NOLs being invalidated. That restriction has eased now that we are 3 years past the tender. For this reason, in October the company declined to renew the poison pill it had had in place since the tender. No announcement has been made about any new buyback, but we could easily imagine a scenario in which the company buys back $10m to $15m of stock around current levels. Such a buy would be highly accretive in that they currently earn next to nothing on the cash.
Alternatively, the company could use the cash to pursue some type of M&A deal. This isn’t an acquisitive management team, but they have expressed a desire to more quickly get to scale in their Navigation business. Should they find the right opportunity, it could accelerate earnings growth and serve as a catalyst for improving investor sentiment.
- Further disruption in the CATV business.
- Execution issues in ramping up to production levels in Navigation.
- Return to normalized gross margins in coming quarters
- Additional navigation design wins
- Initiation of a buyback or other material value-added use of cash
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