IDTI: New Products, Cost Cutting, and Limited Downside Risk: Upgrading to BUY

Upgrading on Growth Potential: We see further upside to IDTI’s performance, following discussions on enterprise flash and wireless charging with industry contacts. We are raising our rating to BUY and setting a $10 12-month target price (19x FY14 EPS) as new products are positioned to drive growth in 2H and consensus estimates appear too conservative given our checks.

• Our discussions with industry contacts suggest that enterprise flash is building momentum and point to IDTI’s advantages from its PCIe expertise  and while we see a slow roll out of wireless charging solutions, we see IDTI well positioned regardless of the identity of the winner in the standards battle.
• We have completed a product-oriented breakdown of revenue drivers for IDTI to assess its potential for growth over the next two years and have found room for the company to outperform current market expectations.
• Besides recovery in Communications and some growth from SRIO, we see the major drivers in Computing and Consumer (early wireless charging revenue here).  We see Computing revenues of $158M and $172M in FY14 and FY15, respectively, driven by our assessment of the Enterprise flash products; we see Consumer growing from $67M in FY13 to $76M in FY13 and $88M in FY14. But our research also suggests upside from these sources of ~$30-40M in FY15.

Key Growth Drivers: We focus here on the new product drivers for growth for IDTI, but fully expect continuing, though gradual, economic recovery to help its core businesses to move up from recent lows.

Consumer: IDTI appears well-positioned to benefit from the deployment of wireless charging technology for smartphones and tablets with its broadly applicable transmit and receive solutions. The ongoing standards battle being waged over alternative approaches (magnetic resonance, magnetic induction) and four different implementations implies a slow growth trajectory for this new business, but IDTI has developed single-chip integrated components which support all four variations. Moreover, IDTI offers products for after-market solutions to enable wireless charging – and these can reach the market before smartphone makers settle on one standard. Revenues for IDTI from this source remain below $1M/Y, but we expect to see meaningful revenues by the December quarter and to see that segment reach mid-single digit millions by the middle of 2014. A small step, but one which we expect to verify IDTI’s future place in what we expect to be a billion dollar market in the next few years. Combine a dollar or two in content and over 600M smartphones sold in a single year with the transmit technology finding its way into PCs, tablets, stand-alone pads, and even furniture, we see the $1B-TAM estimate as an early target for this opportunity.

Cautionary Note:  Standards battles are notoriously slow to resolve and this one includes powerful players on different sides of the technologies – including Intel, Qualcomm, Samsung, and AT&T. For now, IDTI appears to have a unique advantage: its line of products supports all the four competing standards and it now is the only provider of a dual-band receiver which works with both induction and resonance approaches.

News:  We are beginning to see some unification of standards with yesterday’s news that Powermat (behind the PMA standard) is merging with PowerKiss (European deployment using PMA) and this will ultimately allow a common technology to be used in thousands of public stations at public locations, such as airports, Starbucks and McDonalds, currently using these two companies’ technologies.  PowerKiss had embraced elements of the PMA standard, but had diverged in critical aspects which made the charging technology incompatible in the U.S. and Europe. PMA is based on magnetic induction technology. Magnetic resonance approaches, supported by QCOM, INTC and others may ultimately dominate based on its greater flexibility of use; it is still in development but is expected to reach the market in 2H13.

PS4: The company sees advance orders for its PS4 components driving 15% Q/Q growth in the Consumer segment this quarter and the timing of Sony’s ramp and our checks in Asia suggest to us that IDTI sill see even stronger sequential growth from this driver in the September quarter. Other sources of consumer (primarily timing products) are likely to be muted this quarter, but we expect some seasonal pick up in September.

Cautionary Note: the new Xbox One is likely to give Sony more competition if it reaches the market with good volume  in time for the holidays (growing less likely). We think Sony’s own 16M unit target for 2013 will be difficult to reach given the slow start to builds and we are modeling just under 10M shipments for 2013.

Cloud Computing/Big Data: Flash memory for enterprise applications offers superior performance and reliability compared to HDDs, and these and other features suggest that the market for components to support enterprise flash will continue to see strong growth. Some industry estimates indicate that the market for enterprise flash will nearly triple from $2.8B in 2012 to $7.4B  by 2016. Fusion-io has seen early success with a proprietary technology for flash memory implementation, but an open standard for the flash interface is just now reaching readiness and may prove more appealing to users who wish control over software and other operational attributes. IDTI’s controllers adhere to this emerging standard and the company states that is has design wins with 8 leading customers—from makers of flash to drive providers to the largest data center operators. This standard, NVMe, or non-volatile memory express, uses PCIe technology—and IDTI’s depth of expertise and product success with PCIe gives it an advantage, in our view, over others trying to design controllers for this new market. Its first major customer—that large Cloud/data center operator—is reportedly set to take delivery in the December quarter with others to come on board in March and through 2014. We expect $3M in December revenues with a step-up to $5M in March. Look for this business to be lumpy, and so we see revenues averaging $3-5M/Q for the first full year for an annual sales level of ~$15-$16M.

Cautionary Note:  Our discussions indicate that building flash drives requires careful collaboration between those building NAND and those designing the interfaces. IDTI’s collaboration with Micron early in this process may very well have given it a leg up the learning curve, but NAND characteristics vary from one semiconductor firm to the next. We expect that IDTI’s next memory customer will be Samsung—which would be very good news—but one concern is that the controller technology could eventually be brought in-house both by Micron and by Samsung. We think it likely that IDTI’s patent portfolio in PCIe and now NVMe would be afforded significant protection, but we will be watching to see whether in-house integration becomes a threat some years down the line.

Comm Infrastructure: IDTI’s Serial Rapid I/O (SRIO) interface and related analog components for wireless base stations brings between $25 and $50 of dollar content for every new installed base station that supports 4G/LTE. This product delivered revenue at a $40M/Y run rate exiting 2012 and we expect that to climb to $65M over the next three years. Timing devices for wireline and wireless equipment adds to IDTI’s exposure to the gradual growth in telecommunication infrastructure spending around the globe.

Cautionary Note: service providers have been slow to spend on new equipment in the face of lingering economic weakness. This has pushed Europe well-below expectations and even has China apparently pushing spending into 2H13. Further macro weakness could delay adoption of 4G/LTE networks and reduce IDTI’s growth from this source.

New Estimates:

Look for operating expenses to fall in absolute dollars once we reach the September quarter. We expect this to combine with a growing mix of new products (21% of total last Q, 6% growth), and the higher gross margins they bring, to move operating margin toward the company’s 20% goal (non-GAAP) by March 2014. Given the uncertainty in economic recovery and in adoption rates for both wireless charging and NVMe-based enterprise flash, we are taking a cautious stance on revenue growth and gross margin and see operating margin reaching 16% by F4Q14; more positive scenarios we consider, however, see stronger revenue and mix and that pushes operating margin to 19%.

Modest recovery in core product lines combines with new product introductions to lead us to our forecast of $504.8M in FY14 sales and non-GAAP earnings of $0.36 per share (vs. consensus of $494.8M and $0.30); for FY15 we expect $541.3M and $0.53 (vs. consensus of $536.0M and $0.46).

IDTI is trading at 27.5x 2013 consensus estimates, 18.0x 2014E consensus estimates, and at an EV/Sales of 1.7 for 2013, and at 1.6 for 2014E. Our 12-month price target of $10 implies a 2014E P/E of 19.1x and an EV/Sales of 2.2. We expect valuation to rise as estimates move higher and on slight expansion of multiples as the risk inherent in this turnaround story declines further.

Potential risks to our investment thesis, rating and estimates include, but are not limited to, changing global economic conditions, failure of the company to maintain our assumed pace of innovation, an unexpected degree of price competition from other companies, customer decisions to switch to other suppliers, and IDT and the semiconductor and electronics supply chain’s disruptions from global physical, political, and economic shocks (earthquakes, hurricanes, floods, revolutions, etc.).