|Shares Out. (in M):||52||P/E||0.0x||0.0x|
|Market Cap (in $M):||750||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||-475||EBIT||0||0|
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Tessera Technologies (TSRA) is a holding company with two operating subsidiaries: Intellectual Property and DigitalOptics. We believe the market has overestimated the downside risk in Tessera’s IP licensing business and underestimated the upside in DigitalOptics. In the context of TSRA ‘s mountain of cash ($9/share) and the high probability of an imminent cash infusion from a settlement with Amkor(between $2-4$/ share) , TSRA provides solid downside protection in cash with the potential to make multiples on your investment with the successful commercialization of its DigitalOptics platform.
Intellectual Property (IP)
Since the early 1990s TSRA has licensed almost the entire DRAM industry for use of its various IP. Tessera is most famous for inventing chip-scale-packaging which has become a standard in the semiconductor industry for attaching chips to circuit boards. The vast majority of Tessera’s IP has been created in-house. Only in recent years has Tessera acquired IP to supplement its portfolio.
As might be expected, IP licensing is a very litigious area, which creates uncertainty, especially when licensees come up for renewal. On the one hand, renewals should be less risky because the licensees have already validated the IP by paying royalties, making non-infringement and other defenses less likely. On the other hand, licensees hate paying royalties and will sometimes attempt to use renewals as an opportunity to play games. It is important to note that because Tessera’s technology is so fundamental to semiconductors, it has proven effectively impossible to design around.
In late 2011 Tessera won a major victory when Samsung and Hynix, the #1 and #2 DRAM manufacturers, renewed their licenses for 5 years. However, Micron and by extension Powertech (now part of Micron with the acquisition of Elpida) did not announce a renewal (it is not as if they unilaterally said “no” but they opted for what has become a protracted negotiation). This is the biggest overhang/ risk in the Tessera story given that Powertech and Micron represented 25% and 19% of 2011 revenue, respectively. Management is very confident that the Micron/Powertech renewal will be resolved favorably and there are a few details about the situation that give us confidence:
At the end of the day there is no way for outsiders to know with certainty what will happen in this situation. For the above stated reasons we are confident in our base case scenario, which we think is the most likely scenario, that Micron and Powertech renew at a royalty rate lower than their previous rate but not less than 50% of the previous rate. We understand that’s a big range but given the limited publicly available information we think our range is reasonable.
In public, Tessera management has said that they expect their core licensing business to grow slowly off it its current base of ~$200mm. A skeptic might observe, as many on Wall Street who have given up on Tessera have, that royalty revenue has been in decline over the past several years. We don’t think it makes sense to discount one-time settlements from the core royalty stream. When Amkor paid Tessera $65mm a few years back, for example, it could have been seen as a one time payment which in reality was the delayed recognition of the $5mm/ quarter Amkor should have been paying for that time period. In other words, it makes more sense to look at the royalty stream as a regression line slowly going up and to the right with bumps along the way. In this context we take a conservative approach valuing this business. Off a base of revenues of $200mm solely from existing technologies and customers, the IP operating segment incurs $81mm in operating expense. Valuing the business at 5x EBIT, below comparative multiples for other IP royalty streams, gets you to $600mm or ~$10/share. For whatever it is worth in their corporate presentation (http://files.shareholder.com/downloads/TSRA/1973242276x0x571981/D06BE1D3-581D-4B12-A35A-539B34EC504A/TSRA_Presentation_May_2012.pdf) management projects that the licensing business will grow to several times its current levels by 2022 which gives us assurance that their royalty stream is durable with no immininet patents cliffs.
DigitalOptics is a product-focused business developing high level mobile camera technology which we believe is on the cusp of a dramatic ramp in growth. Over the last several years Tessera has built out a supply chain and purchased a camera module manufacturing facility from Flextronics (the head of DigitalOptics, Bob Roohparvar, was previously in charge of the acquired Flextronics division). Tessera’s digital optics technology is already used in 90% of Digital Still Cameras (think Canon ,Panasonic, etc) but the biggest opportunity for further commercialization is smartphones . DigitalOptics’s first product is a MEMS autofocus actuator which displaces the voice coil motor which has been around for decades and has reached its performance limits. MEMS refers to a microelectromechanical system which basically means a very small mechanical device embedded in an integrated circuit (silicon). Another notable example of a MEMS-based technology is the gyroscope found in many smartphones that allows users to flip the screen around. Tessera’s MEMS actuator is smaller, faster, generates no heat, and uses 1/300th the power of a voice coil and generates better image quality. In fact MEMS autofocus is 10x faster than the auto focus found in digital still cameras. The market for actuators is $1 billion. Tessera’s cost, especially before they ramp at their foundries with the resulting economies of scale, will be comparable to legacy voice coil purveyors so their product should be priced competitively and Tessera thinks they can dominate the market. As of their Q2 conference call, Tessera confirmed that they are engaged with an integrator that sells camera modules to Tier 1 OEMS and expects to ship its first actuators in Q4 2012.
DigitalOptics’s ultimate ambition is to become a vertically integrated camera module supplier that would supply the $9 billion camera module market. Currently there is no camera module manufacturer with greater than 10% market share. It seems highly likely that TSRA, with its patented technology, can take share from the commodity players. After all, this a highly fragmented and commodity industry and DigitalOptics will own the only actuator that meets the industry’s demanding thinness requirements (z height). More than that, DigitalOptics’s fully assembled camera module will add shutter, image stabilization, and optical zoom. Yes, you might be wondering current high end smartphones offer many of these features but only after adding 7-10 millimeters to the z height. By using MEMS technology DigitalOptics can add all the functionality of a digital still camera and only add a couple microns to the z height.
Until Tessera recognizes revenue from its first actuator or camera module, our conviction is primarily informed by what we hear from the company which describes its interaction with OEM’s as a “pull” more than a “push” and that there are 5-6 Tier 1 OEMs that have requested thousand of samples. All this leads us to believe that this is more an execution than technology bet, i.e., getting dual-sourced Tier 1 qualified manufacturing capacity that can reliably produce tens of millions of units per month. On the Q2 Conference call CEO Bob Young somewhat spooked the market when he announced that Tessera would no longer give forward looking guidance as DigitalOptics begins to ramp given the difficulty in trying to predict the magnitude and trajectory of the ramp but he did stick to his prediction that DigitalOptics on a standalone basis would be profitable by Q42013. In very rough numbers DigitalOptics is currently burning $90mm in cash on an annual basis and industry-wide gross margins for camera modules / voice coils are around 40%, suggesting that he expects the business to be generating at least $240 million of revenue by the fourth quarter of 2013. The best comp we have for DigitalOptics at this stage would be InvenSense (INVN), another mobile MEMS supplier, which trades at 4.5x next year’s revenue which gives DigitalOptics at a breakeven run rate revenue of level of ~$240mm a valuation of $1 billion or $19/ share. We ultimately believe the opportunity is much bigger and DigitalOptics will earn better gross margins than the industry but our point is to show the value of even a minimal penetration of the actuator market. Once DigitalOptics begins selling fully integrated camera modules in the first half of next year we expect the market to give DigitalOptics the value it deserves.
As of June 30.2012 Tessera reported $475mm in cash ($9/share) and its market cap at $14.40 is $750 so the EV is ~$275mm. On July 9, 2012 Tessera announced that the International Court of Arbitration issued an interim award in favor of Tessera for a minimum of $125mm ($2.50/ share) but Amkor said in a later press release that the amount could be as much as $400mm. Adding the current $9/share to the $2.50/ share from Amkor gets you to $11.50 vs today’s share price of $14.40. If Amkor surprises on the upside you could be getting IP Licensing and DigitalOptics for free. We feel downside in Tessera is limited and Tessera is worth at least $40/ share if DigitalOptics gets traction ($10/ share for IP Licensing + $20/share for DigitalOptics + $11.50/ share in cash post Amkor = $41.50). In a scenario where DigitalOptics wins 10% of the camera module / actuator market, DigitalOptics can generate close to a billion dollars in revenue. At that point we expect Tessera to spin DigitalOptics, as Tessera’s CEO has already made reference to his desire to separate the two companies. Tessera is a shareholder friendly company (they actually pay a dividend) with huge option value for those that are willing to hold through the various uncertainties.
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