"We do not tolerate losing." - Cypress Semiconductor Core Value No. 1
It is my belief that the recent drop in shares of Cypress Semiconductor(CY) in the wake of its FQ3/FQ4 warning represents a very compelling entry point for investors. While it is likely that the story will remain challenging in the near term, the downside risk at current levels is significantly mitigated by the fact that there is very little room for negative surprise for FQ4 coupled with a dividend yield of 4.83%. In addition to what looks to be very limited downside, there is room for upside surprise to the tempered FQ4 estimates. Finally, even if FQ4 plays out in-line with current pessimistic expectations, I do not see Cypress' issues as structural, and expect that by the end of FQ4 (when guide for FQ1 of the following year will be issued) sentiment will reverse and the shares will trade at least 30% above the most recent close of $9.05.
A Brief Overview of Cypress's Business
Cypress also has what it calls its "Programmable Systems Division" which focuses on the design and sale of products based on its "PSoC" product lineup (used for digital cameras, appliances, notebooks, medical devices, and so forth), as well as its suite of touch sensing products (which are really specialized PSoC products) for smartphones, tablets, autos, and more. In addition, the company has been targeting higher end laptop trackpads. While 2012 saw a revenue decline (and it looks as though from the recent FQ3/FQ4 warnings, 2013 will be down) in this segment, the business should generally be a growth one over the next several years.
The next is its data communications division which focuses solely on USB controllers. In particular, one will find products from this operating segment in printers, cameras, gamepads, smartphones, mice, and more. It is of note that Cypress is the market share leader in this space. Finally, the company runs an "Emerging Technologies" business that includes a few majority-owned subsidiaries (AgigA Tech and Deca Technologies), foundry services, and "certain corporate expenses."
With that out of the way, it's time to get to the thesis. To understand the upside potential, it's important to understand why we have the opportunity in the first place.
Management Alignment With Shareholders Is Unique, Downside Limited
Cypress issued a warning that its FQ3 revenue would come in at $184M - $187M, well below consensus of about $204.7M. The company also painted a pretty bleak picture for Q4, giving preliminary estimates of revenues down 9% to 11% from FQ3 (revenue range of $164M - $170M, well below the consensus of ~$207M). The shares dropped in wake of this warning, as would be expected.
The interesting thing to me whenever a company pre-announces a "disastrous" quarter is just why it did so. In Cypress's case, it looks as though the Q3 miss is largely driven by weak Asian mobile orders and a pushout of certain handset programs to Q1 next year. The Q4 weakness is driven by seasonal declines in touch, customer program delays, and end of life actions. This certainly isn't pretty, but this type of warning is one that seems very "recoverable."
The shares have already priced in a lousy Q3 and an even worse Q4, and given that the dividend yields of ~4.83% is already among the highest in the semiconductor/tech sector, I see very limited downside in a "worst case" scenario. But the real question that investors need to ask is, "what if things don't turn out as badly as expected?"
See, the interesting thing about Cypress is that its CEO, T.J. Rodgers, is very well known for his ability to interact with the sell-side/investors. Further, Rodgers holds ~8.4M shares or roughly 5.6% of the company's outstanding share count and in the annual reports is very upfront about caring about his company's stock performance. This suggests that while the revised Q3 guide is likely to prove to be no surprise at the official Q3 earnings release, I'm not so sure that the current Q4 "guide" will turn out as badly as expected - management is likely sandbagging.
Also keep in mind that Cypress has $83M left on its existing $400M buyback authorization, and I would not be surprised if at the coming earnings call, management announces that its board has authorized a new, much larger buyback program. In short, I believe that Cypress is unique in the semiconductor space in just how aligned management is with its shareholders, and I'm expecting that despite what looks to be a quarter or two of "dead money" at worst, the company will pull the necessary levers to keep investors interested.
Okay, But Why Should I Own The Shares?
While the "financial engineering" part of the equation (dividend + likely new buyback announcement) is unique, I am betting that this weakness only lasts a quarter. That is, we know FQ3 is ugly and we're expecting that FQ4 should be even worse, so there's not much room for things to get much worse.
However, I do expect that quite a few of the difficulties that the business is seeing in the near-term will subside by the time we get to the end of FQ4 and the company issues the guidance for FQ1 of the following year. In particular, while the consensus estimates for FY2014 now call for just 3.6% top line growth (from a now lowered base for FY2013 that is expected to be a ~6.10% Y/Y decline), I believe that these estimates err on the side of caution and in the case of a better-than-feared FQ4 and FQ1 guide, have ample room for upward revision. Indeed, I expect revenue growth more in the range of 7-10% as the orders that were pushed out from this year materialize next year, which keeps the operational leverage story mostly intact (as Cypress's bottom line is heavily influenced by the utilization of its semiconductor factory).
In particular, while I'm confident that the trend in SRAM of lower TAM/greater share will continue (Samsung just exited the business, so its share will be distributed among Renesas, Cypress, and GSI Technology(GSIT)), and while the other parts of the business don't look all that interesting (as they are fairly negligible and not exciting from a growth perspective), I am still very bullish on the firm's PSoC/touch products. Notably, despite a slowdown in broader handset growth, Cypress's touch products look competitive and still have room to gain share. I would also like to point out that the "miss" was due to push-outs and inventory management on the part of Cypress's customers, not due to material share gain. I expect this revenue to be recognized during FY2014.
Further, with the company's PSoC 3.0 and PSoC 5.0 products, Cypress is actually aiming to expand its TAM into the upper end of the embedded/microcontroller market. The value proposition that the company claims to offer is a software-driven solution that greatly simplifies the hardware (which means that customers save significantly upfront). While execution problems have marred the sales earlier versions of Cypress's PSoC line (particularly on the software side), management has projected that the underlying issues there have been resolved.
The Bottom Line
All told, I feel comfortable calling for FY2014 EPS of $0.62 (above $0.55 consensus), and even with moderate 10% EPS CAGR over the next three years with a long-term growth rate of 5%, and noting that the company has ~$0.84/share in net debt, shares look to be worth $12.70 today, implying about 37% upside from current levels. While Cypress really needs a "great" quarter for the shares to become fully valued, I believe that given the strength of the management team and the superb dividend yield cushion, the odds are stacked in favor of a long position.
Additional disclosure: I plan to add to my position should the shares remain depressed as funds become available.
By Ashraf Eassa
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