Description

Thesis: Spansion Inc. (CODE) is an undervalued company with a stable core business, significant growth opportunities, strong FCF conversion, and a management team focused on generating shareholder value. CODE trades at 4.2x EV / 2013 EBITDA, and after adjusting for NOLs and the sale of its headquarters, trades at 3.0x despite its strong FCF conversion, leading position in a stable market, and diversified customer base across geographies and end markets. We believe CODE offers an attractive risk-return, with 39% - 92% upside to the current share price.

Business Description: CODE is the market leader in embedded NOR applications, with a 37% market share, and is beginning to move into the embedded NAND market. CODE produces specialty memory products, which are generally higher performance, lower volume, and have longer life cycles (at least 5 years) relative to commodity memory products. CODE is able to differentiate on service, features and capabilities, and product quality with an asset-light business model.

CODE has a diffuse and diversified customer base across various geographies and end markets including consumer, communications and gaming, and transportation and industrial. No single customer represents more than 3% of sales.

Competitive Environment: CODE’s main competitors are not currently focused on its core segment in embedded NOR. Micron Technology (MU) is focused on acquiring Elpida Memory, a DRAM company, out of bankruptcy rather than building its high-end embedded NOR business, which competes directly with CODE. The two lower end players, Macronix and Winbond (both based in Taiwan), are trying to improve their embedded NOR density, but are still far behind CODE, and CODE continues to innovate with higher density products.

CODE trades at a discount due to the perception that the NOR market is declining. While this is true for the market as a whole, the decline has been driven by the wireless segment. Conversely, the embedded NOR sub-segment of the market, that CODE focuses on, is growing in the mid to high single digits (page 63 from 2012 analyst day presentation).CODE no longer has material exposure to the declining wireless NOR market. In 2011, chipset suppliers for mobile phones in China and other parts of Asia transitioned away from embedded NOR, creating a rapid decline in the wireless NOR end market. CODE was forced to exit and restructure the wireless business as a result of this. In response to the wireless exit management aggressively reduced costs, resulting in manufacturing expense declining in Q3-12 year over year by 27% on a 7% revenue decline. The wireless transition is now behind CODE and is fully baked in to current and projected financials. Embedded NOR ex wireless, which is now the vast majority of CODE’s business, has not declined and remains a steady grower with higher gross margins than legacy wireless.

Growth Opportunities:

CODE identifies a $6.5Bn addressable market in its core embedded NOR market, embedded NAND, and Programmable System Solutions (PSS). CODE is planning to roll out new products in its core parallel and serial NOR markets, as well as SLC NAND and PSS. In the past 20 months, CODE has introduced 20 new products.

Although the entire NOR market is declining, CODE’s embedded NOR segment is growing steadily in the mid to high single digits, across a variety of end markets and geographies. CODE’s remaining NOR business has higher and more stable gross margins than the legacy wireless business, with opportunities for additional margin expansion and growth:

-       Technology Improvements in Core NOR market: CODE is shifting from 110nm technology to 65nm and below over the next several years, providing a tailwind for gross margins, opportunities to gain share, and increased internal capacity. As the density increases and the physical size of the embedded memory declines, margins naturally expand as physical input costs fall more quickly than pricing. CODE has current capacity to grow 30% in 65nm or below technology

-       Embedded NAND market: Embedded NAND is inferior in quality to NOR but for many applications this is “good enough” at lower price points. CODE is ramping up in 2013 as they receive accreditation from customers (current pipeline of 200 customers). This segment represents $25mm of revenues in 2012 and is expected to generate $75mm - $100mm of revenues in 2013 (per recent analyst day presentation). This is a niche market that CODE has identified that others are not likely to focus on

-       Royalties: CODE is currently in discussions with third parties that they believe are infringing on their IP. In the past, CODE did not have the financial resources to defend its IP, after spending more than $1Bn pre-bankruptcy in R&D. Licensing revenue will have close to 100% flow through to FCF and earnings, given NOLs, and should drive increased revenues and margins in 2013 and beyond

Management: Management is focused on creating shareholder value and provides significant transparency on its historical financial and operating results and detailed forward-looking guidance. CODE announced on Nov. 20th the sale of its headquarters and surrounding land for $65mm to Prometheus Real Estate Group, who will lease back the space starting in 2013 to CODE, with the first 6 months rent-free. Assuming $25mm of the sale was for the 24.5k acres, this implies $40mm sale price for the headquarters. A 7% cap rate implies annual rent expense of $2.8mm, following the initial 6 month rent-free period.

Valuation / Price Target: CODE trades at a substantial discount to peers, at EV / 2013 EBITDA of 4.2x and a 2013 FCF Yield of 12.0%. CODE’s asset-light business model and $1Bn of NOLs enable it to efficiently convert EBITDA into FCF, and provides substantial cash flow leverage on its revenue growth. Management low-end guidance of 8% revenue growth in 2013 would lead to Adj EBITDA growth of 18%, FCF growth of 40%, and Adj EPS growth of 44%. We are comfortable with management’s guidance for the core business, however we believe the IP licensing discussions currently in progress could provide incremental upside to these projections.

Please see below for annual projected financials based on CODE’s long-term guidance provided at the 2012 analyst day, which excludes the impact from any additional royalty agreements.

CODE trades in line with its closest competitor, MU, despite its superior cash flow profile, which is more similar to its financial competitors.

A valuation range of 4.5x – 6.5x Adj EV / EBITDA implies 39% - 92% upside to the closing share price on 11/30/12. Adj EV includes $170mm of present value for the NOLs and includes the sale of its headquarters and the surrounding land for $65mm, as previously announced. EBITDA and FCF are adjusted for estimated annual rent expense of $2.8mm for the corporate headquarters.

Risks:

1. Consumer electronics, automotive or other end markets slowing growth or opting for lower cost/quality solutions
2. Uptake of embedded NAND in 200 customers in pipeline
3. IP infringement risks if licensing negotiations are not successful
4. Liquidity overhang / concentrated ownership (Silver Lake owns 11.4mm shares)
5. Competitors narrowing the technology / quality / service gaps

Catalyst