Tessera Technologies Offers Investors The Complete Package

Summary

• My investment thesis is that Tessera Technologies presents a highly appealing investment opportunity as a unique technology innovation and intellectual property licensing firm for semiconductor packaging and image processing solutions.
• Key investment merits include a leading market position, high entry barriers, significant market potential, strong growth opportunities, robust margins, healthy balance sheet, strong cash flows, shareholder-friendly management, and attractive valuation.
• Key investment catalysts include additional sales opportunities (including both recurring and episodic revenues), potential merger and acquisitions, and increased investor awareness.
• Key investment risks seem manageable and include customer concentration, technology displacement, patent obsolescence, potential litigation, and slow uptake of new technologies.
• My analysis of the "thesis tiles" composing the Tessera Technologies "investment mosaic" suggests that it offers equity investors the complete package: High quality, strong growth, and attractive value.

Investment Thesis (the "Elevator Pitch"):

Tessera Technologies (NASDAQ:TSRA) is a unique technology innovation and licensing firm for semiconductor packaging and image processing solutions that presents a compelling investment opportunity. Key investment meritsinclude the following:

(1) dominant market position with technology presence in billions of semiconductor chips and hundreds of millions of mobile devices;

(2) high barriers to entry including over 3,700 patents issued and pending and a highly innovative technical workforce;

(3) significant market potential (targeting the $86B DRAM memory chip market, $120B+ non-DRAM chip market, and $10B imaging sensor market);

(4) strong growth opportunities from licensing additional IP to new and existing customers;

(5) substantial sales visibility from multi-year recurring revenue contracts;

(6) robust margin profile with ~100% gross margin and 58-66% operating margin target;

(7) healthy balance sheet (~$8/share or ~20% of equity capitalization in cash and no debt) and strong cash flows (~$2/share annually or ~5% FCF yield);

(8) shareholder-friendly management focused on capital return via a 2% dividend yield and ~7% share buyback program; and

(9) attractive valuation at only 17x 2015 and 14x 2016 expected recurring earnings.

Key investment catalysts include new revenue opportunities (both recurring and episodic), potential merger and acquisitions (likely "tuck-in" IP purchases), and increased investor awareness (only 4 sell-side firms and 645 Seeking Alpha alert subscribers currently follow TSRA). Key investment risksinclude customer concentration, technology displacement, patent obsolescence, potential litigation, and slow uptake of new technologies. However, these risks seem manageable given TSRA's technology dominance and innovation, long-term licensing contracts, shift from litigation to customer cooperation, and recent bullish management commentary.

Company Background:

TSRA is a technology innovation firm that develops and licenses its semiconductor and imaging intellectual property (IP) patents and knowledge to global hardware producers. TSRA generates IP licensing revenue from two primary markets:

i. Semiconductor packaging solutions: Create mechanical and electrical connections between semiconductor chips and printed circuit boards on hardware devices via its Tessera (legacy) and Invensas (next-generation) subsidiaries.

ii. Image processing solutions: Provide features such as face beautification, "red eye" removal, panorama, and image stabilization for mobile devices such as smartphone, tablet, automotive, and security cameras via its FotoNation subsidiary.

Key Investment Merits (the "Boardroom Presentation"):

1. Leading market position: TSRA has over 20 years of leadership in technology innovation and IP development which have been validated by its industry penetration. TSRA's inventions are found in many of today's smartphones and a broad range of electronic devices (from small wearable devices to large data centers). Over 100 billion (B) semiconductor chipsets (primarily Dynamic Random Access Memory or DRAM chips) have been shipped with TSRA's packaging IP, and over 100 million (M) tablets, 750M smartphones and 1.2B digital still cameras have been shipped with TSRA's FotoNation IP.

2. High entry barriers: TSRA benefits from a "wide competitive moat" due to:

i. Strong IP that includes over 3,700 patents issued and pending worldwide and should gain from a record number of patent applications in recent years. TSRA's patent portfolio consists primarily of non-DRAM advanced packaging (29%), circuitry (20%), next-generation packaging technologies (19%), and imaging (19%). Of note, DRAM advanced packaging accounts for only 7% of TSRA's patents but drives the vast majority of its current revenues. This suggests sizable monetization opportunities for TSRA's other technologies if similar levels of licensing penetration can be achieved.

ii. Innovative workforce as TSRA has ~200 employees in 8 offices worldwide as of year-end 2014, of which ~130 are engineers and scientists and over 80 have advanced degrees. This implies industry-leading sales of ~$0.75M per employee in 2014 that should rise to ~$1.17M per employee in 2015 based on current recurring revenue guidance.

3. Significant market potential: TSRA has collected over $1B in IP licensing revenue since going public in 2003. TSRA is expecting solid growth in the large multi-billion dollar semiconductor and image processing markets. For example, research firm Gartner estimates TSRA's semiconductor focus segments of DRAM and Flash Memory will reach sales of $86B in 2018, while imaging sensors will reach sales of $10B in 2018. TSRA's top DRAM customers (Hynix, Micron, and Samsung) hold 92% DRAM market share, and Gartner forecasts DRAM shipment volumes to experience a 6% compound annual growth rate (CAGR) through 2018. TSRA continues to focus on the memory market with its DRAM and next-generation memory advanced packaging. TSRA also has multiple active engagements to license its IP to greenfield semiconductor customers in the $103B application-specific standard product (ASSP) market and $20B application-specific integrated circuit (ASIC) market. Longer-term, TSRA sees customer unit volumes growing exponentially as computing shifts to mobile devices and to wearables (e.g., the proliferation of the "Internet of Things"). TSRA also sees growing penetration in the automotive and security electronics markets for applications such as driver monitoring (e.g., eye fatigue detection and driver authentication) and biometrics (e.g., facial recognition and iris authentication).

4. Strong growth opportunities: TSRA is focused on large growth opportunities in its core markets, including

1) licensing its legacy and next-generation DRAM advanced packaging IP to semiconductor memory producers;

2) licensing its FotoNation computational imaging IP to camera producers (targeting the 1.2B+ unit smartphone market, 1B+ unit automotive market, and 220M+ unit tablet market); and

3) licensing its non-DRAM (ASSP and ASIC) IP to greenfield customers (targeting the 1.4B+ unit application processor market).

Greater IP bundling under multi-year contracts should drive higher pricing and revenue over time. TSRA currently expects its recurring revenue to rise from a trough of $103M in 2013 to ~$235M (thus far) in 2015, primarily driven by its legacy DRAM semiconductor IP. TSRA also expects its recurring licensing sales of next-generation semiconductor IP to rise from a negligible amount in 2013 to ~$30M in 2018 with a total addressable market greater than $400M, and its recurring revenue from FotoNation to grow ~10x from ~$11M in 2013 to ~$100M over the next several years. The licensing opportunity of non-DRAM (ASSP and ASIC) IP to greenfield customers represents a wild card at present, but could eventually eclipse DRAM license sales due to TSRA's large patent base and untapped market opportunity.

5. Substantial sales visibility: TSRA has built a strong recurring revenue base via multi-year contracts with its key customers for IP licensing, technology transfers, and related software sales. Most of TSRA's recurring revenue derives from license agreements with fixed annual royalty terms and hence does not depend on hardware unit sales. Many of these license agreements continue until 2019. Management has raised its guidance for recurring revenue from $120M to $140M for 2014 (yet delivered $150M), and from $150M to $195M to $235M for 2015 (thus far). TSRA has also generated sizable episodic (non-recurring) revenues from one-time engineering fees, initial license fees, back payments resulting from audits, damages awards from courts or other tribunals, and lump sum settlement payments. However, these are far less predictable and are expected to decrease with reduced litigation expense over time.

6. Robust margin profile and earnings power: TSRA's revenues have near 100% gross margin as its IP licensing model requires no production costs. At a recent investor conference presentation on March 9th, 2015, TSRA raised its already high margin targets once it reaches $240-260M in annual sales. TSRA now targets expense margins of 14-16% for research and development (vs. 17-19% previously), 16% for sales, general, and administrative (vs. 19% previously) and only 4-10% for litigation (vs. 13-14% previously). This suggests a 58-66% operating margin target (vs. 48-60% previously) or up to 1,000 basis points of potential margin improvement which could translate into up to ~$0.30 per share or ~20% greater earnings power. Management further forecast legal expense at the low-end of its guidance range as litigation activity concludes, so its operating margin should be at the mid- to high-end of its target range (62-66%). Based on TSRA's growth prospects and margin targets, I estimate TSRA has an earnings per share (EPS) power range of $1.66-1.83 in 2015 and $1.77-2.09 in 2016 from recurring (non-episodic) revenue alone. By comparison, Street estimates are for an EPS range of $1.88-2.12 in 2015 and $1.58-1.91 in 2016 from total (recurring and episodic) revenue.

7. Healthy balance sheet and cash flows: TSRA's cash balance of ~$8/share as of December 31st, 2014, is equal to ~20% of its equity market capitalization, and the firm has no debt. Furthermore, TSRA should convert nearly all of net income to free cash flow (FCF) since its capital expenditures and working capital needs are minimal under the firm's IP-centric business model. TSRA could therefore generate ~$2/share in FCF per year (~5% FCF yield at the current stock price of ~$40) from recurring revenue alone (before dividend payments). Conservatively assuming no additional share buybacks or dividend increases, TSRA's cash balance should hence rise from ~$8/share at the end of 2014 to over $9/share by the end of 2015 and over $10/share by the end of 2016.

8. Shareholder-friendly management: TSRA's new management is actively engaging with investors and returning substantial capital to shareholders via dividends and buybacks. During its March 9th, 2015, investor presentation management indicated that it currently needs only ~$200M (~$3.67/share) of cash to fund its growth plans, suggesting its "excess cash" of $234M ($4.29/share) could be used for further capital returns. As discussed above, TSRA should also grow its cash balance by over $1/share each year after annual dividend payments.

On its February 10th, 2015, earnings call, TSRA doubled its quarterly dividend from $0.10 per share to $0.20 per share, which implies an annual dividend yield of about 2.0% at the current stock price. In November 2013, TSRA's Board increased its share buyback plan from $100M to $150M, and the Board increased it again by $100M in October 2014. As of December 31st, 2014, TSRA had $145M left on its share buyback, sufficient to retire nearly 7% of its fully diluted shares outstanding at the current share price. TSRA's increased share buyback activity over the past year exceeds all cumulative share repurchases in the firm's history, and management expects to continue executing aggressively on its buyback plan.

9. Attractive valuation: TSRA is attractively priced given its healthy growth prospects, a high-margin recurring revenue model which drives strong cash flows, a robust balance sheet, and a high return on capital (15%+, actually held back by the large net cash position that earns little interest income). Based on TSRA's earnings power estimates above and excluding its growing net cash position, TSRA's stock currently trades at only ~16-18x 2015 recurring earnings and ~13-15x 2016 recurring earnings. I believe TSRA deserves at least a 20x multiple on its recurring earnings base given its high sales visibility and robust margins, in line with its current FCF and earnings yield of 5%. This suggests at least ~20%-40% share price upside at the midpoints of my 2015-16 estimated earnings ranges, and excludes the potential earnings upside from episodic revenue. Of note, published sell-side research price targets for TSRA range from $45 to $57 with a mean/median of ~$51, suggesting at least 13% upside with median expectations of 28% upside and high expectations of 43% upside. Of the four sell-side research analysts covering the stock, two rate it a "strong buy" and two rate it a "buy".

Key Investment Catalysts:

1. Turn-around completion: Historically, many analysts and investors who followed TSRA perceived the firm as a litigious semiconductor-focused IP firm with a history of costly and lengthy patent enforcement lawsuits that delivered mixed financial results.

TSRA now benefits from a new management, strategy, and culture after well-regarded activist investor Starboard (~4.9% owner) forced changes in its Board of Directors and executive team in mid-2013. TSRA's relations with its customers has shifted from adversarial to cooperative with an emphasis on technical collaboration rather than litigation. In the past 18 months, TSRA has settled litigation with over 10 major hardware firms (including Freescale, Hynix, Micron, Qualcomm, Samsung, and Sony) for a total sum well above $300M. This was in sharp contrast to the ~$200M collected over 8 years under prior management with over $240M of related litigation expenses.

TSRA has also discontinued its own manufacturing operations to focus entirely on IP development and licensing, and expanded its innovation efforts in new areas such as next-generation semiconductor packaging (Invensas) and digital mobile imaging (FotoNation). As a result, 2014 was TSRA's first revenue growth year since 2009 for continuing operations, and the firm has returned to profitability with a long-term target of 58-66% operating income margins.

Finally, TSRA is re-engaging with investors (it hosted its first analyst day in years on September 2nd, 2014) and returning substantial value to shareholders via dividends and share buybacks. These changes should lead to a positive inflection in analyst and investor perspectives of the firm.

2. Additional recurring licensing opportunities: TSRA has significant recurring licensing opportunities ahead across its Invensas and FotoNation patent portfolios. These opportunities include relicensing former customers, extending new licenses to existing customers (and hence increasing royalty payments), and licensing greenfield customers in new markets outside DRAM. For example, TSRA is exploring further collaborations with high-volume partners like Qualcomm and Samsung for both portfolios. Of note, management has dedicated and incentivized a sales team specifically to close greenfield non-DRAM deals, and on TSRA's March 9th investor conference presentation, its CEO has indicated that he would be disappointed if TSRA did not sign at least one if not two or three new non-DRAM IP customers throughout 2015.

TSRA also signed a $50M non-exclusive licensing agreement in April 2014 with China-based O-Film which recently closed. Management believes there is substantial upside potential from this licensing deal, as well as from deals with other Chinese and Taiwanese hardware makers. Finally, management is also working to license the remaining DRAM producers that account for the 8% of the DRAM market that is still unlicensed by TSRA.

3. Additional legal and other episodic revenue opportunities: TSRA's strategic shift from adversarial litigation to technical collaboration has driven licensing revenue growth, lowered litigation expense, expanded profit margins, and removed remaining legal overhang. However, TSRA may occasionally engage in litigation and arbitration proceedings to directly or indirectly enforce its IP rights and license agreements which could generate significant revenue from damage awards or lump sum settlement payments. TSRA may also pursue episodic revenue on an opportunistic basis from one-time engineering fees, initial license fees, and back payments resulting from audits.

4. Potential mergers and acquisitions (M&A): Although TSRA's management expects the firm's growth to be primarily organic, the firm has been acquisitive in the past and management remains committed to exploring M&A opportunities across firms, people, technologies, products, and IP ranging from small deals to transformational transactions. Management has indicated that it has a high M&A "hurdle rate" as these deals must involve accretive targets with closely related businesses. I expect to see modest capital used for purchasing "tuck-in" patents to augment TSRA's IP as exemplified by TSRA's acquisition of Smart Sensors Limited in December 2014.

5. Increased investor awareness: TSRA is not widely followed by Wall Street, nor is it well-known to investors given its small size (~$2B equity market capitalization as of 3/13/15). For example, TSRA is currently followed by only ~645 "basic alert" subscribers of Seeking Alpha (the largest online investor community with ~4 million registered users). TSRA is also followed by only four sell-side research analysts, three of whom are from small investment boutiques that have initiated research coverage on TSRA in only the past nine months. Should TSRA continue to execute well and grow along its current trajectory, I would expect more investors to become familiar with and interested in the stock.

Key Investment Risks:

1. Customer concentration: TSRA licenses its technologies to over 90 firms, but Hynix, Micron, and Samsung control over 90% of the DRAM market and account for a significant portion of TSRA's recurring revenue. Samsung and Hynix accounted for 24% and 11% of TSRA's 2014 sales, respectively, with Micron likely to account for over 10% of TSRA sales in 2015 following its recent licensing agreement. Powertech accounted for 34% of TSRA's sales in 2014 following a $196M legal settlement in February 2014, and Amkor will likely account for a sizable amount of TSRA's 2015 sales following its $155M legal settlement in January 2015. TSRA's IP revenues are dependent on its ability to renew contracts and collect royalties from these large customers. However, this risk seems unlikely in the foreseeable future given TSRA's recent signings of multi-year licensing agreements with Hynix (January 2013), Samsung (January 2014), and Micron (July 2014). Many of TSRA's key license agreements continue until 2019.

2. Technology displacement: TSRA's IP royalties could be sharply reduced if alternative semiconductor packaging technologies displace its own in certain applications, especially with DRAM. However, this risk seems unlikely as Hynix and Samsung have already licensed TSRA's IP for the next several years, and TSRA's recent signing in a multi-year licensing agreement with Micron included the Invensas patent portfolio for advanced packaging and cooperation on future production technologies.

3. Patent obsolescence: TSRA's portfolio of issued patents has expiration dates that range from 2015 to 2033. Without new patents either developed internally or purchased, TSRA faces the risk to being unable to monetize its IP as key patents expire. However, this risk seems unlikely as TSRA has filed for a record number of new patents in recent years that extend the life of its IP, and management is frequently reviewing ancillary patent portfolios for acquisition.

4. Potential litigation: TSRA relies on litigation to collect licensing royalties in many instances. As such, IP revenues are dependent on the company legal team's ability to succeed on the courts. In addition, greater than expected litigation expenses can form an overhang on TSRA's stock. However, as previously discussed, TSRA's relations with its customers in recent years have shifted from adversarial to cooperative with an emphasis on technical collaboration rather than litigation, and only one sizable litigation remains outstanding.

5. Slow uptake of new technologies: TSRA's long-term growth depends on timely uptake of new semiconductor packaging and image processing technologies to offset any potential decline in its more mature patents. If industry demand does not develop as quickly as expected, TSRA may not be able to maintain its sales levels. However, recent management commentary (e.g., during its recent analyst day and earnings call) was bullish on emerging technology penetration over the next several years as discussed above.

Contrarian (Bearish) View:

TSRA's turn-around which began in mid-2013 is now largely complete, and sales and earnings have likely peaked after strong 2014 results. Street expectations are for sales to decline from $279M in 2014 by ~6% y/y to $262M in 2015, and another ~5% y/y to $248M. Likewise, Street expectations are for EPS to decline from $2.26 in 2014 by ~12% y/y to $1.99 in 2015, and another ~10% y/y to $1.79 in 2016. Furthermore, activist investor Starboard has sold most of its shares in TSRA after the last two earnings call at stock prices ranging from $34 to $41, and key executives have recently sold shares at similar prices as well. Following its legal settlement with Amkor in January 2014, TSRA has concluded most of its major remaining litigation, and no significant event catalysts are left to drive the shares higher. After 115% appreciation over the past two years and nearly 70% appreciation in the last year alone, the "easy money" in TSRA for investors has already been made.

My Variant (Bullish) View:

TSRA's turn-around may indeed be near completion, but the long-term growth story is still in its initial stages as evidenced by the significant market potential and growth opportunities discussed above. Street sales and EPS estimates are indeed forecast to decline in 2015 and 2016, but this is solely due to the sharp drop expected in episodic revenue from litigation settlements. Episodic revenue is forecast to decline from $129M in 2014 to only $27M in 2015 and to much less than that in 2016. However, this episodic revenue decline masks the strong growth expected in recurring revenue, from $103M in 2013 to $150M in 2014 and $235M (thus far) in 2015. This recurring revenue is higher quality (multi-year rather than one-time) and is TSRA's core growth driver. Recurring revenue growth should continue beyond 2015 as TSRA has hinted at opportunities to relicense unsigned former customers, extend new licenses to existing customers, and license greenfield customers in new markets outside DRAM. Activist investor Starboard's decision to sell its shares is not surprising given the recent sharp appreciation in TSRA's stock price and Starboard's mandate to return investment profits to investors. Starboard has been careful to sell its shares gradually to minimize the stock price impact (it is trading only ~7% below its recent peak). Starboard now owns less than 5% of TSRA's shares, and at its current sale pace it should exit its TSRA stake entirely within a few months. Insiders have also sold TSRA shares recently, but these sales have been mostly under pre-arranged automatic programs (10b-5-1 plans for executives) and typically involved only a modest portion of their holdings. TSRA has partially offset price pressure from activist and insider sales with aggressive corporate share buybacks as discussed above, and management indicated it will continues to purchase shares at current price levels. Plenty of catalysts remain in the form of additional recurring license opportunities, potential M&A, and increased investor awareness of TSRA's strong business model and outlook. While TSRA's shares have appreciated sharply over the past two years, the stock remains attractively valued with significant upside as discussed above.

Additional disclosure: This article was provided for informational purposes only. Nothing contained herein should be construed as an offer, solicitation, or recommendation to buy or sell any investment or security, or to provide you with an investment strategy, mentioned herein. Nor is this intended to be relied upon as the basis for making any purchase, sale or investment decision regarding any security. Rather, this merely expresses Lee Kronzon's opinion, which is based on information obtained from sources believed to be accurate and reliable and has included references where practical and available. However, such information is presented "as is", without warranty of any kind, whether express or implied. Lee Kronzon makes no representation as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use should anything be taken as a recommendation for any security, portfolio of securities, or an investment strategy that may be suitable for you. Gator Capital Management, LLC, including its members, partners, affiliates, employees, and/or consultants, (collectively, "Gator Capital") along with its clients and/or investors may transact in the securities covered herein and may be long, short, or neutral at any time hereafter regardless of the initial recommendation. All expressions of opinion are subject to change without notice, and Gator Capital does not undertake to update or supplement this report or any of the information contained herein. Before making any investment decision you should conduct thorough personal research and due diligence, including, but not limited to, the suitability of any transaction to your risk tolerance and investment objectives and you should consult your own tax, financial and legal experts as warranted.

Disclosure: The author is long TSRA. (More...)

By Lee Kronzon, CFA

Source : http://seekingalpha.com/article/3014086-tessera-technologies-offers-investors-the-complete-package