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Will Embedded Flash Provide Zilog a New Future?

Posted on February 27, 2007

Background:

ZiLOG (Nasdaq: ZILG, current price: $4.20) is a brand name in the semiconductor market, having been founded in 1974 by Federico Faggin, a co-inventor of the microprocessor.

The company, saddled with debt after a Texas Pacific Group LBO in 1998, and facing plummeting semiconductor prices in subsequent years, reorganized under Chapter 11 bankruptcy protection in 2002. Following its emergence from bankruptcy, ZiLOG has since refocused its business by eliminating manufacturing facilities and becoming a fabless semiconductor supplier of 8-bit microcontroller semiconductor devices. In particular, the company has refurbished its product portfolio to focus on opportunities presented by the fast-growing embedded Flash microcontroller market.

A microcontroller (MCU) is a computer-on-a-chip that is optimized to control electronic devices such as motors, remote controllers and user interfaces on appliances. Such a device typically comprises a central processing unit, non-volatile program memory, random access memory for data storage and various peripheral capabilities. Analysts estimate the 8-bit MCU market to be approximately $4 billion per year.

For additional information on ZiLOG’s colorful history, you can follow this link:

http://www.fundinguniverse.com/company-histories/ZiLOG-Inc-Company-History.html

For additional information on the MCU market, please use this link:

http://en.wikipedia.org/wiki/Microcontrollers

Capitalization:

Approximate Shares Outstanding: 17 million

Current Stock Price: $4.20

Cash: $21 million

Debt: $0

Enterprise Value: $50 million

Estimated Fiscal 2007 Sales: $80 million

Cash-Burn: $2 million to $4 million a year. Company is actually at EBITDA breakeven.

Comments:

The quality of ZILG’s balance sheet is offset, in part, by the fact that ZiLOG’s legacy business is rapidly deteriorating. In each of the past three years net sales have declined significantly, i.e. net sales were $78.8 million for the twelve months ended March 31, 2006, $95.6 million for the calendar year ended December 31, 2004, and $103.6 million for the calendar year ended December 31, 2003.

So while our EV/Sales calculation suggests a significant discount to industry multiples, as we’ll show below, whether the discount is warranted or not depends entirely on the company’s potential to stabilize revenue, and more importantly reignite growth in the coming years. Our investment thesis hinges on the company’s probability of realizing that potential.

Significant Financial and Personnel Changes

ZiLOG has undergone countless changes over the years, as can be seen by reading the historical link referenced above. In this section, we’ll just focus on the recent changes that we deem to be important.

• Recent Financial Changes: Revenue Growth and EBITDA Positive Results

One of the things that caught our attention about ZiLOG (ZILG) was that despite a decline in revenues in recent years, the last few quarters have demonstrated a stabilization of the revenue stream, as well as some glimmer of renewed top-line growth and EBITDA profitability. All of this reflects initial success with new product lines.

For instance, in the last quarter, as reported by the company:

“Sales for the quarter were $20.7 million, an 18 percent increase over sales of $17.6 million for the comparable period a year ago and a decrease from sales of $21.2 million for the immediately preceding quarter. The increase in sales from a year ago reflects continued growth in new product sales including embedded flash MCU and Universal remote control solutions. Embedded flash sales were $3.6 million for the quarter, an increase of 89 percent from the comparable quarter a year ago, reflecting growth in the health & fitness and digital communications markets. Additionally, net sales of universal remote control solutions including the CRIMZON family of solutions increased 38 percent as compared to the third fiscal quarter a year ago, reflecting growth in the home entertainment and consumer gaming markets. The Company reported adjusted EBITDA (as defined below) of positive $0.3 million in the quarter as compared to positive $0.2 million in the preceding quarter and negative $1.8 million in the third fiscal quarter a year ago.”

As can be seen above, it would appear as if the company is approaching a major inflection point in the business, wherein new product growth could lead to substantial top- and bottom-line gains. As evidenced by past examples, i.e. RBAK or INAP, this type of financial situation is the best time to get invested in these types of tech turnarounds, assuming, of course, that the valuation is still reasonable.

• Recent Management Changes: Growing the Flash Business

In addition to seemingly improving its operations, ZiLOG has also started to beef up its management ranks. Recently, the company hired Darin Billerbeck as CEO.

An Intel veteran, Mr. Billerbeck was co-head of Intel’s $2B Flash division. His experience in that role makes us optimistic about his potential to ignite ZiLOG’s sales in the promising area of embedded flash MCUs. You can read up extensively on Mr. Billerbeck by Googling him. From what we have read, he characterizes the ZILG opportunity as a once a lifetime opportunity to help substantially grow a start-up operation.Our feeling is that Mr. Billerbeck clearly has the skill set and people connections to greatly expand ZILG’s flash business, which is miniscule compared to what he managed over at Intel.
As for incentives: Mr. Billerbeck received 400,000 option shares at a strike price of $4.30 per share.

Risk Control and Downside Scenarios

On the one hand, the downside of an investment here is limited due to two key factors:

• Debt-Free Balance Sheet

The company sports a clean balance sheet, with a decent amount of cash. While we don’t view ZILG’s cash balances as extremely healthy, they do seem sufficient to support the company’s current growth plans and profitability objectives.

• Extremely Low Relative Valuation

One of ZILG’s much larger competitors is Microchip Technologies (NasdaqGS: MCHP). MCHP currently trades at an EV/Sales ratio of nearly 6.5, while ZILG’s is at about 0.65. Of course, it is important to note that MCHP has over $1 billion in sales, nearly $1.3 billion in cash, and has a long history of top-line growth and strong profitability. Nevertheless, it should be clear from the comparison to MCHP that ZILG’s valuation is depressed.

However, the above positives must be weighed against the following negatives:

• Non-Stable Revenue Base

The clearest downside risk at ZILG is the continual deterioration of legacy product lines at ZiLOG. The company certainly has a much less stable revenue base than that of many other companies we have recommended, and this is reflected in the extremely depressed valuation of the stock.

Somewhat encouragingly, the implementation of a leaner cost structure has been quite effective in minimizing cash burn at the company over the past few years. Were it not for the costly defense of a patent infringement lawsuit launched by rival Microchip Technologies, it appears that ZILG would be at approximately cash-flow breakeven. Therefore, with even a modest up-tick in sales, driven by strong uptake of new product offerings in the flash MCU segment, the company would start throwing off cash. At present, flash products comprise about 10% of company sales, and we expect that figure to expand significantly over the next few years as Mr. Billerbeck catalyzes growth in that area.

• Lawsuit with Microchip

ZiLOG is currently in patent litigation with Microchip. The company will incur substantial expenses in defense against these claims. In the event of a determination adverse to ZILG, the company’s business may be harmed.

However, to put this risk in perspective, we believe that if ZILG’s sales continue to improve, the company would become a likely buyout target for MCHP, since it would probably be cheaper for MCHP to just buy ZILG than to waste time and financial resources fighting them in court.

• Extremely Competitive Industry Environment

The semiconductor industry is intensely competitive and is characterized by price erosion, rapid technological change and heightened competition in many markets. The industry consists of major domestic and international semiconductor companies, many of which have substantially greater financial and other resources than ZILG.

The one factor working in ZILG’s favor, even considering the competitive risk, is that ZiLOG is a major brand name in the semiconductor industry.

Upside Scenarios

Why might Wall Street get on the ZILG bandwagon? The potential, of course, lies in the rapid widespread adoption of flash-based reprogrammable MCUs.

Traditional ROM-based MCUs have to be programmed by the semi supplier, resulting in significant lead times and consequently, possible inventory obsolescence. The cost of flash-based MCUs is just now becoming competitive with ROM-based MCUs, so the segment is reaching a major inflection point. The attractiveness of flash is borne out by the fact that reprogrammable MCUs are the fastest-growing segment of the MCU market. Microchip Technologies is itself having great success with flash MCUs, sales of which were up 42% YoY as of the quarter ended Sept 30, 2006.

IF ZILG continues to make permanent inroads in the flash MCU space, its sales will increase significantly and the company’s valuation could also take a nice jump.

Upside and Downside Targets

A good comp for determining the upside in ZILG is its aforementioned rival, Microchip Technologies. For obvious reasons, one cannot casually apply MCHP’s multiples to ZILG to generate an upside target, because ZiLOG has a lot of work to do before it can ignite its top-line and perform even remotely as well as Microchip. However, it is clear that ZILG’s multiple can expand from here many times over, assuming modest sales growth. Over a two to three year time horizon, we think an attainable multiple would be 1.5x-2x EV/Sales, on $90 million in sales. This would place the stock’s value in the $10-$12 range.

On the downside, one can easily envision a complete erosion of legacy product revenue, a small share of the flash MCU market, and a little cash. Assuming continued erosion of the revenue base, we put the downside around $3/share. However, we should note that the CEO’s recent options were given at $4.30 per share, so we consider this scenario to be less likely than the potential upside.

Assuming a 60% chance of the upside scenario and a 40% chance for the downside case gives us an expected value of about $7/share, or about 60% upside.

There is, of course, still some question as to whether our probability weightings are justified, but another way of looking at this valuation is that we think the shares have about 30% downside and over 100% upside. This type of risk/reward is definitely something we would bet on, every single time.

The key thing to watch here is the continuation of company announcements surrounding the rollout of the Flash business.

Please Note: We hold a position in ZILG. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Special thanks to Toby Shute for helping to prepare this write-up.

Additional Notes:

Here are some additional facts that we wanted to add to our initial report on ZILG:

• Before the TPG takeover, ZILG had a peak revenue year in 1996, when it reported nearly $300 million in sales and EBITDA of about $90 million, for margins of 30%. The company , at that time, reached a peak market cap of nearly $800 million.

• TPG acquired ZILG on July 21, 1997 for $25 per share, or about a $420 million Enterprise Value. This would equate to about $23 per share using the current capitalization. At the time, ZILG’s sales were about $280 million.

As you can see from the above, when times are good, ZILG has almost never traded at an EV/Sales ratio of less than 1. So with some growth, we definately see the current ZILG trading at 2X EV/Sales ratio or about $11 per share.

• One of ZILG’s largest shareholders is LiteSpeed Management LLC, run by Jamie Zimmerman. This hedge fund specializes in restructuring, bankruptcies etc. and has an excellent track record. Seemingly, Litespeed picked up their shares in ZILG during the bankruptcy. For an interesting interview with Mrs. Zimmerman, please click here. Having such a fund invested here, gives us confidence that ZILG will pursue shareholder-friendly strategies.

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Disclaimer:
This site may include market analysis and we may own shares in the stocks mentioned in our reports. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

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