SMART Global Holdings (SGH) has enjoyed a huge boom in its share price as of recent. In the time frame of just three weeks, shares have risen 50% following sound quarterly results, followed by what appear to be two savvy deals. Enough news and moves to update on the former bullish thesis.
In January of this year, I wondered if SMART was a smart investment at the time with shares of players in the wider semi sector down quite a bit. Shares of SMART Global fell to $24 at the time as I was buying the dip and, in fact, averaged down to $22, although a fall further to a low of $16 was pretty scary, I must admit.
A Quick Glance
SMART Global buys flash product and memory modules from names like Micron Technology (MU) and Intel (INTC) after which it customises these for huge clients like HP (HPQ), Cisco Systems (CSCO), and Dell (DELL), among others. In essence, these are lower value-added tasks in a competitive and very cyclical industry.
The company has a broken book year, which ends in August. For the year ending in August of 2018, the company generated $1.3 billion in sales, of which nearly $800 million from Brazil (mobile memory and DRAM). Remainder of sales mostly come from a specialty memory unit generating $438 million in sales, and Penguin, a specialty compute and storage company with $52 million in sales last year. Note that the Penguin acquisition was only announced in 2018 and contributed merely a quarter to revenues.
With earnings power trending at over $5 per share per annum for 2018 and adjusted earnings even coming in a dollar higher, earnings multiples were not very high with share trading at $35 by the autumn of 2018 (even as they fell already from a high of $50 in spring of 2018). That being said, this remains a cyclical industry as has become apparent.
2019 – Softness Followed By Relative Strength
While I was pleasantly surprised by the strength of the first quarter results for the fiscal year of 2019, with revenues hitting $394 million, and adjusted earnings coming in at $1.75 per share, the outlook for Q2 was soft. Sales were only seen at $310-325 million, while adjusted earnings were seen at just $0.75 per share. While the company managed to reported earnings of $0.77 per share for that second quarter, sales fell back to just $304 million.
Worrying is that the company guided for third quarter sales to fall further to $260-270 million, with adjusted earnings seen at $0.34-0.38 per share. As it turned out, in late, June sales collapsed further to $236 million, yet it is comforting to see a flexible costs structure limiting the fall in adjusted earnings to $0.34 per share. Despite the hard operating conditions, the company has delivered on sound cash flow generation, with net debt down to $81 million. This means that, even if EBITDA is down nearly two thirds on the year, annualised EBITDA still comes in at around the net debt load, for leverage ratios around 1 times.
Comforting is that the company sees fourth quarter sales at $270-280 million, the first sequential hike in quite a while now. Adjusted earnings are seen at $0.55-0.65 per share, with earnings improving, thanks to continued cost cutting efforts.
Getting Confident Again
With the company guiding for sequential increase in sales again, SMART is getting more confident about the future and is announcing another acquisition; in fact, two acquisitions. SMART acquired Artesyn Embedded Computing in an $80 million cash deal with milestone payments having the potential to up the deal tag to $90 million. The company furthermore acquired Inforce Computing in a $12 million deal, for a combined $92-102 million deal tag for both firms. With these deals, the company is reducing the reliance on Brazil, which arguably has created headwinds in obtaining a high valuation.
Not much has been said about the revenue contribution, or in fact anything at all, in either the press release or deal presentation, other than that deals will be accretive to earnings per share, while that accretion was not quantified.
With net debt doubling to roughly $180 million, leverage ratios come in at around 1.5-2 times, yet with growth having returned, deleveraging capacity is rapidly becoming quite impressive, and relative leverage ratios could and should come down quickly again.
In January, I noted that declines reported at the time were more than just a dip, as 50% reliance on Brazil was quite a concern as well. I furthermore concluded that the 12-13% operating margins were not sustainable based on historical performance and the low value-added nature of the activities.
My base case in January called for $1.2 billion in annualised sales with just 5% operating margins, for operating profits of $60 million, at least that was my best guess for average sales and revenues across the business cycle.
Assuming $10 million in interest expenses and a 10% tax rate, I am still working with earnings power of $2 per share, as current earnings power (albeit adjusted) is still trending at $2.50 per share. This means that a $30 current valuation remains non-demanding at 12 times earnings with operational momentum returning in the business, as cost control is quite impressive, I must say.
Having averaged at $22, I am very much aware that a 50% move in a time frame of just a few weeks a huge move, and thus, I have cut half of my position. At the same time, I look forward to continuing to cover this great volatile trading stock with above-average interest.
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Disclosure: I am/we are long SGH. 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.