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Pixelworks Darkside Valuation

Well, it's been a little too long, but here is my attempt at a Valuation for Pixelworks (PXLW).

For a description of the business, please refer to KitKat's excellent writeup: http://boards.fool.com/Message.asp?mid=20131236

Pixelworks has just recently turned profitable, with brand new positive earnings (very small, but positive).

It has (a trailing 12 month) PE of 130.
Normally I would run away screaming at this point but given the Earnings are very small, this large PE is just noise.

Due to the very small earnings and cashflows, I chose a "darkside" valuation as opposed to using a very small and noisy cash flow as the base multiplied by a growth factor in a traditional DCF.

Calculating a trailing 12 month FCFE yields a negative number, I could use normalized earnings but I thought I would try one of Damordaran's darkside valutions.
I thought I would "show my work" so my assumptions and choices would be apparent to any wishing to modify this valution exercise.

This uses FCFF coupled with the use of Sales/Capital ratio.

The Inputs:

From the conference call, targeted Operation Margin will be in the 15% - 20% range.
Tax rate is 34% - 36% range.
The Semi industry median Sales / Capital ratio = 3.91 (Derived using a stock screener and Excel).
Pixelworks Sales/Capital ratio = 8.5.

I will gradually transition Pixelworks Sales/Capital ratio from 8.5 to 3.91.

For a recap on how this works;
FCFF[i] = EBIT[i]*(1-t) + (Revenue[i] - Revenue[i-1]) / (sales/capital[i])
(At least according to my Dam lecture notes)

The sales/capital ratio is not the only way to do a darkside valution, but it seemed a simple place to start.

Revenue[i] = Revenue[i-1] * (1+Grev) ,Grev = revenue growth rate
EBIT[i] = Revenue[i] * OpMargin[i]

Step 1: Bottom Up Beta

Well, I don't normally like Beta, but since I am using the Dam method I will give it a try.
The Semi group's bottom up Beta = 2.45 (median of the semis in my spreadsheet)

Step 2: Interest Coverage Ratio

This is used to determine a synthetic rating for Cost of Debt.
ICR = EBIT / (5 yr forward interest payments)
ICR = 34.6 / 11.4 = 3.03
I used \$ 11.4 Million as the first 5 years of the coupon payments for the \$150 M convertable offering issued recently.

This gives a synthetic rating of BB, which implies a default spread of 3.5%.

Step 3: Estimate Cost of Capital

Debt = Risk Free Rate + Default Spread

For the risk free rate, I will use the 30 yr TBond as 5.34%
The Cost of Debt is then = Risk free rate + default spread = 5.34% + 3.5% = 8.84%
There is virtually no debt on the balance sheet, so lets look off the balance sheet
For debt, I use the Present Value of the Convertable offering (2 offerings totaling \$150 Million) + Present Value of the coupon payments + Leases and commitments.
The Convertable(s) have a Present Value of Coupon payements of \$45 million,
Leases and Commitmens = \$24 Million

Adjusted Debt = \$150 + \$45 + \$24 = \$219 Million

To calcuate the book value of Equity, I remove GoodWill as well as other liabilities.
Equity = Total Liabilities and Equty - Good Will - Total Liabilities
Equity = \$254 - \$84 - \$21 = \$149 Million

Cost of Equity = Risk Free Rate + Bottom up Beta * Equity Risk Premium
I use an equity risk premium of 4.5%, and an intial Beta of 2.45 (bottom up) so
Cost of Equity = 5.34 + 2.45 * 4.5 = 16.4%
[Wow!, I am not a big believer in Beta, but it is a young risky company, so I will decrease beta over time to 1].

Cost of Captial (WACC) = Cost of Debt * D/(D+E) + Cost of Equity * E/(D+E) = 11.9%

Step 4 Estimate Base Cash Flow

The Trailing 12 Month revenue = \$154.2 million.

Step 5 Other Inputs

From the conference all:
Tax Rate: 34-36% (I use 36%)
Operating Margin: 15-20% (I use 15%, last 2 quarters have Operating Margin of 15.3%)
Gross Margin: 47-49%
Revenue Growth Rate = 15% (for 5 years, gradually declining to 4% steady growth rate after that)

I gradually reduce Debt to 0 over a 10 year time frame.
I gradually reduce Beta from 2.45 (bottom up Beta) to 1 over a 10 year time frame.
I gradually reduce the WACC from 11.9% to about 9% to reflect reduced Debt and increase in Equity.
I gradually reduce the Sales / Capital ratio from its current 8.5 to the industry median of 4.

Employee Stock Options:
6.3 Million shares with a value of \$11.53 Million, divided by 53 Million shares outstanding yields \$1.37 per share reduction in value.
(I used Black-Shoals method, specifically Dam's Warrant spreadsheet).

This results in a \$19.45 Fair value.

As the stock is currently trading around \$15.25, this represents a 21% discount.

Step 7 Vary the Assumptions

Let's see what happens when we change the revenue Growth rates (I use EPS growth estimates)
The Low is 15% (see above), consensus is 26% and the high is 40% (I always throw out the high estimate).

Lets use 15% revenue growth and 20% Operating Margin, then FV = \$25, (40% discount)

Lets use the concensus EPS Growth as the Revenue growth rate of 26% (and 15% operating margin), then FV = \$37.82 (60% discount)

Conclusions

Me, I will stick to the Operation Margin of 15% and the lower Sales Growth rate of 15%.

There are several factors affecting Pixelworks, first the whole semiconductor sector is at at 52 week low, institutional investors are exiting this sector.

There are concerns that demand for HDTV's will drop significantly as soon as the Olympics are over.

With all the cash raised by 2 convertable bond issues (totaling \$150 million) PXLW is bound to use to buy something.
The market rarely likes acquistions, and the acquistions often fail.
Pixelworks has made past acquistions, and it has a lot of goodwill on the books to show for those acquistions.

Semis is an unloved sector, but HDTV is a hyped growth sector.

I will consider buying at a larger margin of safety (more than 20%, perhaps 40%), which given the current love-hate environment, could happen.

Risks

This is my first attempt at a darkside valuation using the Sales/Capital ratio, I could have mis-applied the technique yielding "reasonable" but wrong results.

If there is interest, the spreadsheet is posted here: http://tinyurl.com/243ak

ee

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