On Tuesday, Power Integrations (POWI) announced a new quick charge device (CHY103D) compatible with Qualcomm's (QCOM) new Quick Charge 3.0 protocol (announced on Monday). We view the Power Integrations' announcement to be an incremental positive, expanding upon the firm's existing growth opportunities and adding to its positive fundamental trajectory. Power Integrations already generates a significant amount of free cash flow, has no long-term debt, has a reasonably strong customer base, a variety of patents, and pays a decent dividend. Using a discounted cash flow analysis, we value the company at $69.45 per share, significantly more than its current stock price.
Power Integrations creates electronic components used to convert power for all kinds of electronic devices such as cell phones, refrigerators and power tools, to name a few. Per the company's investor presentation, POWI considers itself a leader in energy efficiency as well as a clean-tech enabler. The company has generated a double-digit compound annual revenue growth rate since 2001 and believes it has more significant growth opportunities ahead.
Power Integrations believes it is set to benefit from a secular growth trend in which power converters are upgraded to less complicated and more energy-efficient technologies. The opportunity exists across the spectrum of power converters, but the company sees specific opportunities with higher-power products as well as rapid-charging for mobile devices (e.g. CHY103D). In the company's second quarter news release, president and CEO Balu Balakrishnan commented:
We anticipate sequential revenue growth in the third quarter, led by adoption of our new InnoSwitch product family, which continues to ramp into the mobile-device market and is now gaining adoption by customers in our other end-markets as well."
For reference, POWI's investor presentation describes the InnoSwitch IC (pictured below) as the first integrated circuit (IC) to integrate primary and secondary sides of the power supply across the safety barrier. The firm explains that it enables a drastic reduction in component count and complexity, and it is also "highly energy-efficient."
The new CHY103D device (pictured below) works alongside the InnoSwitch IC to improve charging efficiency and reduce heat dissipation by enabling more granular voltage increments.
The following chart shows Power Integrations' leadership position with regards to integrated circuits.
Also, the company is not afraid to defend its leadership position by pursuing infringement charges via its ~734 patents. For example, Power Integrations continues to pursue infringement findings against competitor Fairchild Semiconductor (FCS).
Also worth noting, the company describes itself as a "recognized leader in clean technology." For example, POWI believes its InnoSwitch product family is highly energy efficient relative to the competition. This may prove to be a significant competitive advantage as industry energy specifications continue to tighten. For example, the US Department of Energy is tightening federal standards for external power supplies effective in 2016. And European standby power limitations were tightened to 0.5 W in 2013. A quick look at POWI's website reveals the firm's keen interest in a variety of energy efficiency priorities including topics like the Environmental Protection Agency's (EPA) electric vehicle charging expectations, the EPA's promotion of more energy-efficient products, and the Department of Energy's amended rules for testing power supplies, to name a few. The following graphic displays some of the company's credentials with regards to clean technology.
Power Integrations generates lots of cash from operations. For example, over the last two years, the company has generated enough cash from operations to cover its total two-year capital expenditures about five times over. The company also has zero long-term debt. We use a discounted free cash flow model to value the company at $69.45 per share. We assume a 15% free cash flow growth rate in 2016-2020 followed by a more normal 3% growth rate thereafter. We also assume a 12.25% required rate of return (WACC, CAPM derived). If we drop our 2016-2020 growth rate to a conservative 3% (and continue this 3% into perpetuity), then the valuation drops to $43.50 per share, which is still slightly above its current market price. However, we believe the higher growth scenario is more likely. And according to Yahoo!Finance, the four analysts covering the stock agree with higher growth; in fact, they believe the company can grow earnings by 30% (per annum) over the next five years.
As another rough check of the company's valuation, we use a valuation formula first published in the 1940s by Warren Buffett's mentor, Benjamin Graham: EPS x (8.5 + (2 x growth)). However, in this case, we assume the company can grow earnings at 30% (per annum) over the next five years (as mentioned above) before reverting to a more market normal 3% earnings growth rate thereafter. In this five-year higher growth scenario, the company is worth around $71.38 per share, well above its current market price.
Uses of Cash
The company generates more cash than it needs, and returns some of the extra cash to shareholders through dividends and share repurchase. The 1.2% dividend yield is decent, and it has been growing (from $0.08 per share in 2013, to $0.10 in 2014, to $0.12 in 2015). Also, the company has a history of buying back shares. And despite the share repurchases that were already authorized, the company announced during the most recent quarterly call an additional $30 million share repurchase plan. Further, the company has around $170 million of cash and short-term investments sitting on its balance sheet. To put POWI's cash in some perspective, the company's balance sheet cash and future free cash flows may easily exceed its $1.2 billion market cap over the next ten years.
A significant percentage of POWI's net revenues come from a limited number of applications of the company's products, such as cellphone chargers, LED lights, desktop PCs and home appliances (annual report). This is a significant risk because if the company's products do not eventually penetrate additional markets, then the business will not grow as expected.
Power Integrations' top ten customers accounted for 59%, 59% and 64% of net revenues in 2014, 2013 and 2012, respectively. This creates risk because if larger customers leave, it will have a significant negative impact on the firm's results. For example, Avnet accounted for 19%, 19% and 20% of the company's total net revenues in 2014, 2013 and 2012, respectively. Also, ATM Electronic Corporation accounted for 12% of total net revenues in 2012 (but was less than 10% in 2013 and 2014).
Foreign jurisdiction risks are also significant for Power Integrations. Most of the company's manufacturing and customers are located outside the US, even though the company is headquartered in San Jose, California. For color, only 5% of net revenues in 2014, 2013 and 2012 were generated in the United States. Operating in foreign jurisdictions subjects the company to potentially weaker intellectual property rights and the challenge of complying with foreign laws. The company is also exposed to foreign-currency exchange risks. Power Integrations has agreements with two of its major suppliers to allow for mutual sharing of the impact of exchange rate fluctuations between Japanese yen and US dollar. However, the company still estimates a decline in value of the US dollar of 10% versus the euro or Swiss franc, which will detract approximately one quarter-million dollars from pre-tax income (for reference, the company's total net income in 2014 was around $59.5 million).
Volatility in quarterly results is another risk to the firm's stock price. As the company notes in its annual report: "Our quarterly operating results are volatile and difficult to predict. If we fail to meet the expectations of public market analysts or investors, the market price of our common stock may decrease significantly." To add some context, Power Integrations' quarterly earnings have deviated from consensus estimates by around 5% per quarter over the last two years.
Power Integrations already generates lots of free cash flow, but has opportunities to grow this cash flow significantly. If the firm is sitting on the leading edge of a secular trend towards less complicated, more efficient, electronic components (e.g. CHY103D and InnoSwitch), then the growth opportunities are vast. However, even without the secular growth, Power Integrations is already worth slightly more than its current stock price suggests. Of course, there are risks to the company's ability to sustain its current level of business, and the widespread growth and adoption are yet to be seen. However, as Warren Buffett says, if you wait for the robins, spring will be over.