Description

Year         2010 2011 2012 2013

Revenue    30.4  39.6  46.2  55.3

EBIT           6.0    8.9   10.4   13.3

EPS         $0.84 $1.24 $1.44 $1.69

Silicom is a company trading cheaply on its core business and undergoing new product cycles that give it the potential for significant incremental revenue growth.  The company currently trades at $14.00, equaling a $100 million market cap with $51 million in net cash.  The company should earn $1.44 in 2012 and $1.69 in 2013.  After stripping out the $7.40 per share in net cash this results in an adjusted P/E of 4.4x for 2012 and 3.8x for 2013.  The company has been profitable for the past five years with 20%+ operating margins most recently.  Silicom dominates its markets with nearly 100% market share in the WAN Optimization NIC market (see below) and high market share in the security NIC market as well.

What is SILC's core business?  The company makes Network Interface Cards (NICs) for servers and for server based appliances.  These cards connect the servers and appliances to the surrounding network.  Silicom's cards add input / output (IO) ports to the servers they are installed in and take some of the burden for processing incoming packets off the the core processor.  The cards allow the server manufacturers flexibility in the number of IO ports they offer in their devices.  Silicom's NICs come with anywhere from one to six ports, and can either have copper or fiber based interfaces.  The port speeds can range from 100M/s to the newer 10G/s cards.  Some of Silicom's cards also come with bypass functionality, which allows the server to be bypassed if it malfunctions and not bring down the entire network.

The two main types of appliances that Silicom NICs are currently used in are WAN Optimization devices and security (firewall and Intrusion Prevention) devices.  WAN Optimization makes up about half of Silicom's revenue, security a third, and the rest is a variety of smaller things.  WAN Optimization appliances compress and accelerate network traffic between offices of businesses that use them.  It is a growing market (probably 15% growth going forward) and had been a super hot 100% grower a few years ago.  The main players in that market are Riverbed, BlueCoat, and Cisco.  Security devices protect networks by spotting dangerous traffic and taking steps to eliminate it.  This market is more fragmented than WAN Optimization and SILC has many customers here.  This market is also growing and should remain healthy even in a down market as security is a high priority for CIOs.  Recently Silicom announced a large win at a traffic management and policy control vendor.  This is another type of equipment with bypass requirements and is a rapidly growing category.

Silicom maintains its dominance in the NIC market due to two factors.  The first is the vast gap in product breadth between Silicom's portfolio and its closest competitor's.  Silicom has over 200 different NICs in its portfolio, including 1G, 10G, copper, fiber, bypass, encryption cards, etc.  Interface Masters, the #2 player has only 40 different NICs.  Second, Silicom is fanatical about customer service and I have only heard good things from their customers about them.  They have never lost a customer once they have won them originally.   

What are Silcom's new products?  The first are external bypass boxes.  Some server appliance manufacturers do not like putting internal bypass cards into their boxes.  What they do instead is put a seperate box with bypass functionality ahead of their box in the network.  Thus, if their box goes down traffic is bypassed and the network stays up.  This market is probably as large as the internal bypass market and represents a 100% new opportunity for Silicom.  The second new type of product for the company is intelligent cards.  These cards fully offload packet processing from the main CPU and enable much fast packet capture on the device.  This is also a new market for the company and a sizable one as well.  The third product, and by far most important, is the company's SErver To Appliance Converter device.  This is a combination of a few components that converts a regular server to a server appliance.  This is a new concept in the industry (SILC recently received a U.S. patent on it) and represents a market opportunity many times the size of SILC's current opportunity. 

So why does a company that grew revenue 30% last year trade at 4.4x earnings when cash is netted out?  First off, growth has slowed recently as the company hit some tougher comparisons in Q4 and Q1 and only grew revenue 10% in Q1.  Silicom's revenues can be lumpy and there was a lack of lumps in Q1, leading to the slowdown.  Based on my work some of this revenue should start hitting again in Q2 leading to revenue acceleration the rest of the year.  Second Silicom's stock is pretty illiquid, a combination of few shares outstanding, lack of analyst coverage, and few shareholders being willing to sell at these prices.  As illiquid stocks currently are VERY out of favor, SILC's share price has suffered recently.  Another issue is management's use (or lack thereof) of their significant cash hoard.  The $51m currently on their balance sheet is far in excess of the needs of their business, yet management has so far not returned cash to shareholders.  Management has looked into a dividend, both a one time and an ongoing one, but Israeli tax law would levy a significant tax on such a dividend so the company decided not to go ahead with it.  Management has not initiated a share buyback due to their fear that their stock would become even more illiquid if they took shares out of circulation.  They are currently looking at small acquisitions but are being quite careful about it and haven't done any over the last five years. 

The company's largest shareholder is Zohar Zisapel, who owns 22% of the stock.  Zohar is well known amongst investors in Israeli technology stocks as his company, the RAD Group, gave seed money to many successful Israeli tech companies.  Other current public companies stemming from the RAD Group included Radware, Radvision, Radcom, and Ceragon Networks.  Zohar and his brother Yehuda have shown themselves to be long-term patient investors and while they have sold a few of their portfolio companies, they seem to be willing to let their companies develop and grow over time.

Catalyst