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A Chipmaker Gets Ready
To Join the Big Leagues

Besides adding Ulta Beauty (NASDAQ: ULTA) to Growth Portfolio and selling Twenty-First Century Fox (NASDAQ: FOXA), we’re making two other Portfolio changes. Cypress Semiconductor (NASDAQ: CY) joins Eastern Fireworks. And an old favorite, Eli Lilly (NYSE: LLY), moves from Income/Value to Growth Portfolio.

For the past 35 years Cypress, headquartered in San Jose, California, has been producing cutting-edge semiconductors. But it has been less adept at leveraging its superior technology to financial results.

That has been changing since the company’s founder, T.J. Rodgers, stepped down as chairman in 2016. Rodgers was a brilliant inventor with a prescient grasp of industry trends. But he was less talented as a manager. His departure left Cypress, still a relatively small company, with the ability and searing motivation to join the big leagues.

Cypress is smack in the middle of some IT’s fastest-growing areas. That plus its strong presence in Asia make it a strong fit for our aggressive Eastern Fireworks collection of stocks. Nearly two-thirds of the company’s revenue comes from Asia, with China accounting for around 43%.

Before stepping down, Rodgers took two steps that firmly positioned the company for stronger growth. One was merging with Spansion, a leader in automotive electronics. The other was purchasing the Internet of Things (IOT) portfolio of Broadcom (NASDAQ: AVGO) (Growth Portfolio). The acquisitions have combined with company-originated products to propel Cypress to the forefront of critical IT areas, particularly in the automotive market.

Wireless connectors and electronics are essential to cars’ infotainment systems and to connecting to outside services like GPS, traffic reports, and the Internet. Over the next five years the electronic content of automobiles is expected to double, driven in part by rising sales of electric vehicles, which are heavily dependent on electronic components. The top eight automobile equipment manufacturers are integrating Cypress connectivity products into their automotive hardware and software.

The most widely recognized connector is the universal serial bus, or USB, which allows different devices to easily connect to one another. Cypress dominates the newest technology, USB-C, which is more versatile and far faster than previous versions. Over the next five years USB-C growth is projected to surge more than 20-fold.

Microcontrollers are dedicated integrated circuits that act as sensors to trigger connectivity among particular devices. A legacy of the Rodgers era is programmable systems on a chip (PSoC). These “smart” microcontrollers can be easily adapted for different devices, in contrast to microcontrollers dedicated to a particular set of devices. PSoCs also can be programmed to ward off cyberattacks.

Cypress also provides proprietary software that makes it possible to link together a broad assortment of connected devices and services from companies like Amazon (NASDAQ: AMZN) and Microsoft (NASDAQ: MSFT) (both in Growth Portfolio) and Alibaba.

Compounded revenue growth for most Cypress product lines should be 10% a year or greater, easily offsetting any declines in the company’s memory divisions. The result should be compounded revenue growth just shy of double digits.


But profit growth should be considerably faster, thanks to greater scale and greater attention to operating efficiencies than in the Rodgers era. Five-year profit growth could approach 20% a year.

Rodgers’s legacy could be a company whose size matches the founder’s brilliance. The balance sheet is solid. Exceptional growth prospects and the modest projected 2018 P/E result in an exceptionally low PEG of about 0.6. The projected 2018 free cash flow yield is over 7%. This is an exciting company whose upside potential sharply exceeds the risks.

BROADCOM’S LATEST TACTIC

Semiconductor company Broadcom hasn’t given up efforts to acquire mobile chipmaker Qualcomm, even after Qualcomm’s board of directors unanimously rejected its initial unsolicited $105 billion ($130 if counting debt).

Broadcom has proposed a group of 11 candidates to replace Qualcomm’s entire board, setting up a po-tential proxy fight where Qualcomm shareholders could determine the fate of the bid. Qualcomm’s annual shareholder meeting is scheduled for March 6.

Qualcomm dismissed Broadcom’s offer, which values Qualcomm shares at $70 a share, to be paid mostly in cash with the balance in Broadcom shares, as too low even as a starting point for negotiations. Rather than upping its offer, Broadcom wants to pressure Qualcomm’s board members to negotiate. The message is simple: Work with us or shareholders may make the decision for you. 
An added wrinkle is that Qualcomm is now immersed in a legal battle with Apple (NASDAQ: AAPL) (Income/Value Portfolio), a major customer for both Qualcomm and Broadcom. Apple is suing Qualcomm for allegedly overcharging royalties on the chips used in iPhones; Qualcomm has countersued that Apple is infringing on its patents.
Broadcom’s friendlier relationship with Apple might make Qualcomm more disposed to consider the merger. A combined Broadcom and Qualcomm could choose to reduce licensing fees and possibly eliminate the legal dispute. In a further complication, Qualcomm has run into regulatory flak in its own bid to take over NXP Semiconductors.

If the NXP deal does go through, Broadcom projects that the three companies together –Qualcomm, NXP, and Broadcom – would generate annual sales of $51 billion, triple Broadcom’s current annual revenue.

The combined entity also could generate an estimated $30 billion or so in free cash flow over the next two years. That would cover a good chunk of the purchase price for Qualcomm, although Broadcom still would probably need to take on additional debt. But the earning power of the combined entity should ensure the debt would not be debilitating. 
To improve its chances of winning regulatory approval if a deal is struck, Broadcom is relocating to the U.S. from Singapore. As a U.S. company, Broadcom might ease regulatory concerns about handing sensitive U.S. technology to a foreign company. Still, regulatory approval figures to be a formidable hurdle to overcome. 
The prospective deal with Qualcomm is clearly not dead and given the industry-shaking potential of a merger, it’s a situation we will be monitoring very closely.

Shortly after announcing its intention of replacing Qualcomm’s board, Broadcom reported good results for its fiscal fourth quarter (ended October 29). Revenue grew 16.8% and net income increased by 14.5%. Revenue grew across all four of its operating segments.
The wireless segment was particularly strong as revenue growth accelerated to 37.1% compared to 32.5% in the year-ago quarter. Broadcom credits this to the recent iPhone 8 launch. With the iPhone X’s subsequent launch on November 3, the company expects the strength to carry over into the current quarter. In fact, Broadcom’s announcement helped lift Apple’s share price as well. The company also increased its quarterly dividend to $1.75 per share, from $1.02.

PORTFOLIO SHIFT

Acknowledging its prospects for faster growth, we’ve moved Eli Lilly (NYSE: LLY) from Income/Value to Growth Portfolio. Lilly’s impressive and well-diversified portfolio of drugs includes six that already contribute at least $1 billion in annual revenue, with four more close to doing the same. Its pipeline is rich in drugs under development. We offer further details in the following article.

Stock Talk

Freddie

Freddie

Do you have some sort of target price on CY for over the next year or so?

Scott Chan

Scott Chan

Dear Freddie,

Our suggested buy up to price is $18. It’s not quite the same as a target price, but it does give guidance in terms of the price at which we feel CY is a buy.

We don’t like target prices because the situation is constantly shifting and we feel a buy-up-to price (or a “limit price”, if you prefer) is a better gauge. If you must have a target, when we recommended CY at $15.24, we were forecasting a 25% twelve-month gain, which would put CY at about $19.

Freddie

Freddie

Thank you

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