Description

I believe that Tessera (TSRA) is a misunderstood stock: it trades at just 9x trailing twelve-month free cash flow but has growing recurring revenue, 99%+ gross margin, 60%+ operating margin, over $7/share in cash, 3% dividend yield, aggressive share repurchase and multiple catalysts ahead.  I think TSRA could be worth over $55 per share, or 75%+ upside, based on 12x EBIT and $300m in recurring revenue in 2017.

TSRA has been posted multiple times on VIC.  The last write-up by 85bears two years ago gives a good background on the company and Starboard’s activist involvement.  TSRA has become an even better story since then.  Rather than re-hash the company’s history, I’ll cover what has happened since the last write-up, why the company is still misunderstood and the catalysts that could drive share price higher.

What has happened since mid-2014?

·        Signed long-term fixed contract with the last of the three major DRAM manufacturers (Micron)

·        Settled with almost all remaining litigation parties (STMicroelectronics, Amkor, UTAC)

·        Grew revenue at its FotoNation unit (imaging technologies for mobile devices) from $10m in 2013 to $30m in 2015; on track to get to $100m in next few years  

·        Grew recurring revenue from $100m in 2013 to over $240m in 2015

·        Spent over $250m in share repurchases since 2013

·        Acquired Ziptronix (advanced semiconductor packaging) for $39m in cash in August 2015

·        Starboard exited its board position and TSRA holdings

Why is the company still misunderstood?

·        Misperception #1: TSRA is a patent troll and not shareholder-oriented.  New investors and existing investors who have not revisited the story since 2013 still hold this perception, which was true prior to Starboard’s involvement and subsequent change in corporate strategy in 2013.

Reality: Starboard replaced the board and management team in 2013 and the new team has executed well on its new strategies: settle vs. litigate, sign new long-term license agreements, unlock hidden gem in FotoNation, shut down money-losing businesses, improve operating margins from negative levels to +60% and return excess cash to shareholders via dividends and buybacks.

·        Misperception #2: TSRA’s recurring revenue will not last as patents expire.  Some investors are uncomfortable that management has not provided the exact length of the three major DRAM agreements (combined 50% of 2015 recurring revenue).

Reality: First, TSRA has a large intellectual property portfolio with over 4,000 patent assets.  The strength of the portfolio is evidenced by TSRA’s history of wins or settlements in its favor in times of patent disputes.  Second, I believe all three DRAM players signed long-term deals with TSRA.  An industry source confirmed to me that Hynix signed an eight-year deal through 2020.  I believe the Samsung and Micron deals could be similar in length.  Management has given sufficient hints that all three DRAM deals could last that long, but they would not confirm this because shareholder pressure during contract renewal discussions could affect negotiations.

·        Misperception #3: TSRA will see revenue decline as the DRAM industry suffers.

Reality: Management has stated that recurring payments from the three major DRAM manufacturers are largely fixed, with further upside if DRAM sales outperform a pre-determined band.  Therefore, the current DRAM industry downturn has minimal impact on TSRA’s DRAM-related revenue.

·        Misperception #4: TSRA is a DRAM-only company.

Reality: DRAM-related revenue fell from 65% of recurring revenue in 2014 to 50% in 2015.  It will go down further as FotoNation expands and new revenue opportunities materialize.  TSRA is starting to assert its patent portfolio outside of DRAM.  The company estimates that of its 4,000 patent assets, more than 90% is outside DRAM packaging – including imaging, 3D-IC, circuitry and non-DRAM packaging.  TSRA is currently in discussion with non-DRAM semiconductor companies, such as Qualcomm and Intel, to license its patents.  TSRA calls these “greenfield” opportunities.

·        Misperception #5: Starboard exiting is a bad sign.

Reality: Starboard’s investment strategy is to go active in underperforming companies, fix them and move on.  Starboard has already done the heavy lifting by turning TSRA around and the investment no longer fits their activist profile.

·        Misperception #6: The stock has no catalysts.  The stock has drifted lower since peaking in the low $40s in early 2015.  Many investors bailed out thinking the Amkor settlement in January 2015 was the last major catalyst. 

Reality: While TSRA has not had any major revenue-driving announcements since Amkor, the company has continued to deliver on its quarterly guidance.  During this time, I believe the company has built up a solid pipeline of revenue opportunities: BVA adoption, FotoNation growth, greenfield licenses, former customers’ re-licensing and Ziptronix growth.

What are the upcoming catalysts?

·        Bond Via Array (BVA) adoption: BVA is a new TSRA mobile packaging technology that addresses small form factor, high bandwidth, low power and low cost in mobile devices. TSRA just announced an agreement with ASE, the world’s largest semiconductor packaging company, to apply BVA in next-generations of application processors for smartphones and tablets.  BVA would be adopted by ASE’s non-DRAM customers such as Qualcomm and MediaTek.  I expect other packaging companies like Amkor and PTI to follow ASE.  TSRA believes annual BVA revenue opportunities could be worth tens of millions based on per unit royalty.

·        FotoNation growth: TSRA continues to see rapid growth and believes annual revenue opportunities around $100m.  FotoNation’s imaging technologies are increasingly being adopted in smartphones for red-eye removal, autofocus, image stabilization, face-tracking, biometrics and many other features.  Phone manufacturers, such as Samsung and LG, pay a per unit royalty to TSRA. A notable aspect about the $100m revenue target is that management believes it can get there on increased royalty rates and the removal of volume caps (vs depending on unit volume growth alone).  TSRA’s prior management team had agreed to royalty rates and volume caps that were extremely low.  Current management believes new royalty rates could be as high as 50x prior rates.  Management also believes FotoNation has new revenue opportunities in drones and automobiles.

·        Greenfield/Non-DRAM Licenses: As mentioned above, another hidden gem is TSRA’s non-DRAM patent portfolio that had been ignored by prior management.  When the current CEO came on board, he made it a priority to begin monetizing these assets.  TSRA is in late stage discussion with two companies and believes a deal will be signed soon.  I believe the potential revenue opportunity is at least in the tens of millions per year.

·        Re-license former customers: Over the past few years, TSRA reached settlements with major semiconductor packaging companies (OSATs) for past contract violations: Amkor for $155m, PTI for $196m and ASE for $27m.  TSRA is negotiating with these same OSATs to license current and future use of its packaging technologies.  For reference, Amkor and UTAC had each paid TSRA tens of millions of dollars per year prior breaking their contracts and getting sued by TSRA.

·        Ziptronix growth:  Ziptronix owns ZiBond and DBI advanced packaging technologies.  Thus far, Sony is its principal customer and uses the new DBI technology in the image sensors supplied in the latest Samsung Galaxy S7 smartphone.  TSRA believes Ziptronix’s technology can be used in other markets and represents over multi-hundred million in revenue opportunity over the next decade.

·        Share buyback: TSRA bought back 2.5% of its shares outstanding in Q1 2016.  I expect TSRA to continue its aggressive buyback plan given the amount of cash on its balance sheet and the cash flow it will generate.

Valuation

I value TSRA based on 12x my 2017 EBIT estimate, which I derive from forecasting 2017 recurring revenue and using management target operating margins for revenue between $250-300m.

TSRA should generate $260m in recurring revenue in 2016, up from $240m in 2015.  The company guided to $255-270m in total revenue in 2016, which included $5m in episodic (one-time) revenue in Q1.  The CFO has been very conservative in his guidance, having beaten consensus estimates every quarter since he joined in early 2014.  TSRA’s CFO has typically guided on revenue he has visibility on, unlike the CFO at peer Rambus.  Given the recently announced UTAC settlement, I believe TSRA’s 2016 guidance is even more achievable.

For my 2017 revenue projection, I have added my assumption on incremental revenue opportunities to my baseline 2016 recurring revenue (see Table 1).   I derive 2017 EBIT by applying 68% operating margin to $300m recurring revenue.  Using 12x EV/EBIT multiple is reasonable because Rambus (RMBS), an underperforming peer that has repeatedly missed estimates, current trades at 11x ttm and 2016 EV/EBIT.  Therefore, I arrive at a price target of $55/share, or 75%+ upside from current price (see Table 2).

Table 1: Bridge to 2017 revenue

Table 2: Valuation Matrix

Note: Target operating margin of 60-70% based on TSRA’s investor presentation

Risks

·        Patent expiration: I see this as a low risk given TSRA’s large portfolio of patent assets and history of success in license renewals and favorable legal settlements.

·        Dilutive acquisition: Management is well aware of this concern.  So far they have made only one tuck-in acquisition while concurrently returning a large amount of cash to shareholders.  I expect them to make a sizable acquisition at some point, but I also expect them to be financially disciplined.

Catalyst

• BVA adoption (new mobile packaging technology)
• FotoNation growth
• Greenfield/Non-DRAM licenses
• Re-license former customers
• Ziptronix growth
• Share buyback