Strong Signals from Elantec
By Markos Kaminis
Standard & Poor's Focus Stock of the Week is Elantec Semiconductor (ELNT ), a leading provider of analog integrated circuits for niche markets. The shares carry S&P's highest investment ranking, 5 STARS (buy). S&P believes that the shares will benefit in the near-term from the company's leading share of the market for niche IC components in high-growth end-markets.
Elantec designs and manufactures high-performance analog integrated circuits primarily for the video, optical storage, communication, and power management markets. It focuses on high-growth markets where customer requirements include: high speed, high precision, low distortion, low power consumption, and analog intensive integration.
The aggregate market size of the segments Elantec serves is approximately $2.6 billion, and is anticipated to grow at an average annual rate of 16% through 2004. The company's average annual growth expectations through 2004, for each of its markets, are: video (13.5%); optical storage (19%); communications (19%); power management (19%). Concentration in high-performance analog chips, where differentiation is important, allows Elantec to seek wide margins.
GETTING A FOOTHOLD.
The company provides both standard products and application specific standard products (ASSPs). With design level expertise gained through experience, Elantec has gained the opportunity to partner with customers in designing ASSPs that can easily integrate into a customer's product. Once integrated circuits are designed into a customer's product, Elantec has been able to maintain a strong position to be considered for the customer's next generation product.
While Elantec's ASSP operation is a lower-margin business, it helps the company build strong relationships with customers that often need standard products as well. The company also designs ASSPs to the requirements of particular applications; by not designing for a specific customer in these instances, it can develop products that are highly scalable and cost-efficient, meeting the needs of a broader customer base. In each of Elantec's target markets, the company offers a suite of standard products and ASSPs.
One of Elantec's most exciting markets is optical storage, where the company provides products for applications including CD rewritable drives, DVD rewritable drives, DVD read-only drives, optical camcorders and video digital recorders. Elantec believes it holds about a 65% share of the market for the driver for the laser diode used in CD read/write technology, and an even greater share of the market for a similar component used to drive DVD read/write technology. During the first fiscal quarter of 2002 ended December, the company reported that optical storage revenue had grown 9% from the previous year's quarter, and encompassed 32% of total revenue.
In the growing, $1.55 billion video market Elantec serves, the company provides products for applications including: cathode ray tube, flat panel displays, overhead displays, set top converters, special effects generators, video cameras, and video distribution networks. The company believes it holds an approximate 33% share in certain components it provides for liquid crystal displays. During the quarter ended December 31, 2001, video revenue represented 40% of the company's total, but it decreased 2%. However, sales of liquid crystal display buffers grew 15%.
PC sales are important to Elantec's growth, and on the face of it, an expected 8% decrease in 2001 global PC unit sales would be disconcerting to us. However, flat panel displays, CD rewritable and DVD rewritable and read-only drives are relatively new options to the PC purchaser. The key driver for Elantec's growth in this market is the degree to which these drives are incorporated in PCs sold, and that is increasing rapidly. Consumers are demanding the technology and more and more PCs are being sold with the drives included, so despite relatively stale PC market growth, growth for these drive products is healthy. Also, Elantec's optical products are not limited to the PC market, and reach consumers through various other consumer electronics products.
Elantec's offerings in the communications market, target applications including ADSL, HDSL, and VDSL. The U.S. DSL market has not been too lively of late, but Elantec experienced what it described as substantial growth in its DSL related revenue in the December quarter. The company reported significant demand for its products in Japan, Korea, Taiwan, and China. Revenue from the communications segment made up 24% of total revenue during the December quarter, and the company anticipates modest growth in the fiscal second quarter.
Standard & Poor's is forecasting a revenue decline for Elantec of 21% in fiscal 2002 (ending September), as a weak economy crimps demand. However, we believe revenues will improve, and that has been confirmed by management's comments following the first quarter earning release, indicating that demand remained strong into January. Management also reiterated confidence in its forecast for 3%-5% sequential revenue growth in the second quarter. We found it noteworthy that Elantec's book-to-bill ratio surpassed 1:1, indicating that demand had increased; bookings soared 48% on a sequential quarter basis. We expect optical storage product sales to benefit from rising attach rates to PCs and other consumer products. Near-term sales growth will be driven by the video and communications product segments.
Although gross margin may weaken nearly 200 basis points, to about 56% in fiscal 2002, S&P expects sequential improvement thereafter due to increased volume. Cost cuts will likely not be enough to offset the costs of continued R&D investment and the lower sales volume, and thus, we expect the operating margin to narrow to the low-teens. Aided by a lower effective tax rate, we project fiscal 2002 EPS at $0.44, and expect strong end-market demand to drive EPS to $0.95 in fiscal 2003.
WHY A BUY?
It is worth noting that Elantec captured 300 design wins and introduced 17 new products in its first quarter, compared to 1,050 and 40, respectively, in all of fiscal 2001. Design wins are critical for chip companies, because they lead to the use of that company's device in prototyping of an electronic product and, potentially, in volume production. Once a chip company's product is regularly designed into an important customer's end product, it is often difficult for a rival firm to challenge it. We would note, that though small in market capitalization, Elantec's customer list includes a who's who of electronics and technology providers.
Elantec's shares recently traded at approximately 4.4 times book value, which is discounted to the level of semiconductor providers and analog peers. At 10.3 times trailing sales, the shares trade at a premium to those of the company's peers based on this measure, but we believe Elant's growth prospects and market position justify the current multiple.
With negligible debt, greater than $7 a share in cash, equivalents and short-term investments, and early improving operational trends, we think the shares are appealing for semiconductor exposure in diversified portfolios. S&P believes the shares warrant a 7.4 price-to-book multiple, based on the company's relatively strong finances and prospects, implying a target value of $65. S&P's discounted cash flow analysis bolsters our price target, as it supports a fair value range of $63 to $67.
Kaminis is an equity analyst covering small-cap and emerging growth issues for Standard & Poor's