Emcore: Activism, Sum-Of-Parts Analysis Suggest Significant Upside

Executive summary:

• Investors extrapolating past issues into the future are failing to realize both EMCORE's turnaround potential and EMCORE's strong positioning in Solar PV and mirco-ITLA markets.


• Activist firm Becker Drapkin Management, with an impressive turnaround track record, has gained three Board seats.


• SOTP analysis produces FY15 PT near $11, upside potential greater than 120%.

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COMPANY OVERVIEW

EMCORE Corporation (EMKR) offers a vast portfolio of compound semiconductor-based products for the broadband, fiber optics, satellite, and solar power markets. Operations are split into two reporting segments: Fiber Optics (~60% of revenue) and Solar Photovoltaics (~40% of revenue). The Fiber Optics segment is further divided into Digital (telecom) and Broadband (majority cable TV), thus experiencing high competition, high volatility, and annually declining ASPs. The Solar Photovoltaics segment mainly serves government-backed space programs and commercial satellite vendors, which allows for higher visibility of revenue. The business model is part internal, vertically integrated, and part external through Fabrinet, a contract manufacturer.

At the time when EMCORE seemed to be shifting to higher gears from the '08 crisis (stock price touched $13), disaster struck again, the Thailand flood. Fabrinet's Thailand facilities were greatly impacted by the flood in late July of 2011, and consequently, EMCORE's Fiber Optics division took a direct hit, as revenues dropped nearly 25%. Management was forced to move operations back to the U.S., suffering major restructuring costs and lower margins. After a lengthy process to normalize operations, EMCORE is beginning to exit the catch-up phase with a few well-positioned products in attractive markets. However, most investors seem to be waiting for results, as EMKR's share price is still bouncing around $5. We say most investors because there is now one investor that recognizes the opportunity in EMKR, activist firm Becker Drapkin Management.

INVESTMENT SUMMARY

Riding the coattails of activist Becker Drapkin Management. Following another investor's idea is no reason to make an investment decision, though in this case, we do appreciate Becker Drapkin's past work and take great notice of the firm's success. Steven Becker and Matthew Drapkin have a well-respected track record of activism (outside Ruby Tuesday's), and might be best known for the turnaround of Hot Topic. The firm's expertise is found in business services, semiconductors, and consumer. Prior to the 13D for EMKR, Becker Drapkin filed seven 13Ds, seeking and landing positions on the Boards of four companies. Thus far, the average holding period is 18-24 months before realizing value. Excluding PULS (where management massively diluted shareholders subsequent to BD Mgmt.'s interest), the average ROI is 2x to 3x the initial buy-in:

Stock	Enter	Avg. price	Exit	Exit price/current position	Current price	Board seats	Return
(HOTT)	3Q10	~$5	1Q13	Acquired Q213 $14	N/A	2	180%
(RT)	2Q11	~$10	4Q13	~$6.50	~$5.5	2	-35%
(PXLW)	4Q11	~$2	still in	trimming in Q4	~$5	3	150%
(TUES)	1Q12	~3.50	still in	trimming in Q4	~$14	3	300%
(PULS)	2Q12	~$20	3Q11	~$9	~$3	0	> -50%
(CSCD)	1Q12	~$3.75	still in	trimming in Q4	~$9	0	140%
(PACR)	1Q13	~$4.50	still in	acquired Q114	~$9	0	100%
EMKR	3Q13	~$4.50	still in	adding in Q4	~$4.75	3

Since EMKR is a position in which BD Mgmt. gained three Board seats, we pay special attention to the four prior companies with Board involvement. As directors, BD Mgmt. was not hesitant to carve out new strategies, including relieving top executives and implementing major cost-cutting initiatives. To that tune, in a short span, EMCORE has already replaced the COO with an outsider, Dr. Chiu, with emphasis on fixing the Fiber Optic issues. Furthermore, we take comfort in BD Mgmt.'s knowledge of the semiconductor arena with previous success in PXLW and CSCD, and that the firm's top ten holdings are routinely littered with semiconductor stocks. With that said, we believe Becker Drapkin's knack for discovering opportunities and succeeding at unlocking/creating shareholder value could be an indicator of EMKR's future stock price. Based on the evidence above, there is an above-average probability that EMKR could double to triple within roughly 2 years. And this leads us to dig in further.

Time to narrow growth strategy, cut excess. The most frustrating area of operations is the production of tunable XFPs. Initial projections of capacity for this product was $15 million in revenue per quarter, within a TAM of $250-$400 million annually. However, management has been a broken record for at least the past six quarters, citing primarily yield issues that disappointed and the inability to fix the problems in a timely manner. As issues persisted, EMKR lost a piece of the potential TXFP market in which heavy-weights Finisar (FNSR) and JDS Uniphase (JDSU) now dominate. Combing through previous quarterly calls, we noted in Q213 management cited 15 customer commitments; by Q114, management states, "we managed to keep a few key accounts … the revenue contribution for tunable XFP is from a major customer." This suggests the low-yield issues scared away about 12 of the 15 prior committed customers and the majority, or all, of TXFP revenue comes from only one customer. Since Q113, (ending Dec. 31, 2012) our calculations show EMKR's tunable XFP line generated ~$1 million in revenue per quarter, as management consistently cited ~$4 million in losses from TXFPs; management's breakeven is $5 million on projected 30% gross margins. This results in -$16 million to FY13's bottom line:

(millions)	Q113	Q213	Q313	Q413	FY13
breakeven	$5	$5	$5	$5	$20
TXFP rev.	$1	$1	$1	$1	$4
loss	($4)	($4)	($4)	($4)	($16)

Had the tunable XFP line not existed, EMKR's non-GAAP EBITDA would have stayed positive, >$10 million. For that reason it would make sense for EMKR to salvage the TXFP lines, plus the following reasons: inability to compete with larger, solidified incumbents FNSR and JDSU; Infonetics reporting overall TXFP growth slowed in 1H13 for the first time; there is only one major customer, suggesting an easier exit; and TXFPs run on the same assembly line as the more promising, higher-margin micro-ITLAs. We would be concerned if TXFPs cut into even one day of micro-ITLA production. Thus, we believe it is time to narrow the strategy and focus efforts on proven areas.

As for the possibility of cutting excess, we note EMKR's SG&A expenses as a percent of revenue. The table below shows the impact on 2012's revenue from the Thailand flood; and we applaud management's 2013 right-sizing, reducing this expense line by $7.5 million:

(millions)	2011	2012	2013	2014E	2015E
Revenue	200.9	163.8	168.1	186.3	222.8
SG&A exp.	35.6	34.9	27.4	22.4	22.3
% of rev.	17.7%	21.3%	16.3%	12.0%	10.0%

With the ball already rolling in the right direction, and with our confidence in Becker Drapkin's added influence, we believe the SG&A line could look more like top competitor Finisar's 8%-9% of revenue. We expect Becker Drapkin to enforce further executive turnover and assume restructuring increases with the possibility of facility consolidations and staff layoffs. Based on our 2014 and 2015 projected revenue levels, reasonable cost controls could save EMKR ~$9.5 million and ~$15.5 million, respectively, vs. the previous SG&A expenses of 16%-18%.

Increasing leadership positions in Solar PV and micro-ITLA markets. We believe any R&D for tunable XFPs should be redirected towards Solar PV and micro-ITLAs. EMCORE currently sits atop a niche Solar PV market with only one viable competitor, SpectroLab, a subsidiary of Boeing. The primary source of revenue comes from multi-junction solar cells that power spacecraft and satellites in orbit. These solar cells set a world record for performance, with 34.8% efficiency. A typical project plays out over 2-3 years, and the 12-month order backlog currently sits at $55.3 million, nearly 75% of annual segment revenue. Over the past four to five quarters, management has cited contract wins totaling >$100 million, most of which is currently sitting off-balance sheet as long-term commitments. During the Q114 call, management unveiled two aggressive moves: to increase penetration of existing customers by offering new solar panels integrated with the solar cells (expects incremental $15-$20 million in annual revenue); and to expand EMKR's customer base by pursuing accretive margins in the adjacent market of high-end mobile power for defense applications. All together, we enjoy this market mainly because it is boring, has somewhat high barriers to entry and pricing power, and thus, the ~20% non-GAAP EBITDA margins should be fairly protected.

(millions)	2013	2014E	2015E
Solar PV revenue	$71.2	$80.5	$102.0
non-GAAP EBITDA %	19%	20%	22%
non-GAAP EBITDA	$13.5	$16.1	$22.4

Taking into consideration management's visibility and superb guidance for this segment, we assume CY14 Solar PV revenues benefit from recent contract wins and a slight solar panel penetration by growing 13%. Our FY15 estimate includes the $15 million from the lower-end of solar panel expectations, with an improving non-GAAP EBITDA margin to 22%

EMCORE currently holds a first-to-market advantage with micro-ITLAs, a fiber optic component designed into 100Gb/s telecom transmission products. The industry tailwinds for 100G products are incredibly strong, as Infonetics expects a 77.8% CAGR through 2017; however, competition is fierce and requires significant R&D to keep pace. Management is launching the micro-ITLAs into volume production over the next two quarters and expects a steep trajectory through the back half of the year and beyond. The start-up costs and initial cannibalization of old ITLAs should depress margins for CY14, but we expect FY15 to experience revenue growth near 30%, gross margins in the mid-30s, and non-GAAP EBITDA margins of ~20%. From company-provided information, our best estimates are below:

(millions)	2013	2014E	2015E
ITLA/micro-ITLA revenue	~$35.6	$44.7	$57.8
non-GAAP EBITDA %	Minimal	minimal	~20%
non-GAAP EBITDA	Minimal	minimal	$11.6

Broadband segment to achieve slight growth; new product kickers await. EMCORE's broadband segment (mostly cable TV products) slowed in 2013, as Time Warner and Comcast's capex allocations for scalable infrastructure never materialized. The expectation for 2014 is slight top-line growth centered on a resumption of U.S. cable providers' capex and China's network converting to a DOCSIS platform, allowing cable operators to offer the triple-play package. We assume quarterly revenue hovers in the mid-teens for CY14; and project growth of ~10% for FY15 revenues, with gross margin in the high teens and non-GAAP EBITDA at ~8%:

(millions)	2013	2014E	2015E
Broadband revenue	57.3	61	68
non-GAAP EBITDA %	N/A	7.5%	8%
non-GAAP EBITDA	N/A	$4.6	$5.4

Within our estimates, we did not include the following new product developments currently in sample/start-up mode: fiber optic gyroscopes that management expects to ramp in three quarters; a disruptive linear RF semiconductor laser in sample mode; and components for distributed antenna systems in start-up mode (Wi-Fi in stadiums). Any of these could offer upside to FY15 estimates.

Loss carryforwards are enormous. Although, we do not expect a full realization, as most of these will expire; but we also do not expect EMCORE to have a major tax expense anytime soon. We choose to display the loss carryforwards due to the potential value from a turn to profitability, at which time this topic should be revisited. Per the 2013 10-K:

As of September 30, 2013, we had net operating loss carryforwards for U.S. federal income tax purposes of approximately $490.7 million which begin to expire in 2021. As of September 30, 2013, we had foreign net operating loss carryforwards of $18.5 million which began to expire in 2013, as well as, state net operating loss carryforwards of approximately $364.5 million which began to expire in2013

VALUATION

Our valuation consists of a sum-of-the-parts analysis for FY15 (ending 9/30/15). We believe with Becker Drapkin's Board involvement that CY14 is most likely a year of transition due to possible restructuring of operations, cost-cutting, and asset divestiture (potentially the Broadband cable TV segment). The table below is our FY15 EBITDA estimates and assumed EV multiples for each segment:

(millions)	EBITDA	EV multiple	FY15 EV
Solar PV	$22.4	10x	$224
Micro-ITLA	$11.6	8x	$92.8
Broadband	$5.4	6x	$32.4
Total EV			$349
Cash-debt			0
Mkt. Cap			$349
Diluted shares			32
Share price			$10.90

Based on our SOTP analysis, we arrive at a FY15 fair value estimate of $10.90, representing potential upside of ~120% over the next 18 months.

RISKS

Progress derived from Becker Drapkin's involvement may not materialize as expected, or may require more time than expected. Management may continue to destroy shareholder value by sticking with the tunable XFP business line. The micro-ITLA business line may not ramp to expectations due to possible production issues or heightened competition. Though EMCORE has experienced zero in orbit satellite failures, Solar PV operations would be severely hampered in the event of a failure caused by an EMCORE product. The long-term commitments in the Solar PV space may not materialize. Another natural disaster in Thailand could negatively impact the Fiber Optics operations. Cable TV providers' capex may continue to slow. Industry consolidation within the cable TV space may redirect capex spending in favor of EMCORE's competitors. Customer concentration risk is evident as the top five accounted 34% of revenue, and losing a top customer would negatively impact operations. In October, Nichia Corporation alleged a patent infringement by one of EMCORE Broadband products, no details have been announced.

Source: Emcore: Activism, Sum-Of-Parts Analysis Suggest Significant Upside

Disclosure: I am long EMKR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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