Stock Analysis of EMCORE Corp. (EMKR): A Seemingly Asymmetric Risk-Reward Situation

A wise man once told me: “Never recommend a stock to anyone. You’re bound to loose. If it rises, they’re brilliant. If it tumbles, you’re an idiot.” In length, I emphasize that the following write-up is not a recommendation. It’s merely a collection of reflections that document my reasoning behind my investment decisions, hence allowing me to go back and learn from my mistakes and successes.

Following my disappointing quest to uncover if a bargain was hiding among the “expensive defensives”, I needed to find a new hunting ground. I found three seemingly interesting picks in the most unlikely universe: the notoriously ‘expensive’ universe of technology stocks. The first investment thesis I would like to present concerns EMCORE Corp. (EMKR).

The Business
This B2B $138.7 million market cap company that designs and manufactures components and systems for 1) broadband devices such as cable TV, 2) chips for telecommunications, 3) and navigation systems to the defense industry. EMCORE’s customers include networking and telecommunications hardware manufacturers such as Cisco Systems Inc. and ARRIS International. An in-depth walk-through of EMCORE’s products, markets and customers can be found on p. 2-6 of the 2017 annual report.

The business has a rocky past marked by unstable revenues and years of negative income. Since Jeffrey Rittichier took over the CEO position in late 2014, EMCORE has grown its revenues at 30% annually over the past three years while going from a negative EBITDA of $11 million to a positive $11 million according to afore report. The company has – in Jeffrey’s own words – been “rebuilt”.

The Stock
The stock’s price nearly tripled thanks to the impressive performance led by Jeffrey & Co., cf. below chart.

Though the stock rallied from $4 to $12, it snapped in Q3 2017. It’s now trading at $5.10, 56% below its $11.70 high. If one dives into the latest 10Q and accompanying earnings call, you’ll learn why. Revenues decreased on a quarter-to-quarter basis from $30.2 million in December 2016 to $24 million in December 2017 as a result of management’s decision to discontinue a product line within its broadband business due to poor margins. Though the revenue hit seems impactful, a new product line with better economics is in the offing. As a result of the revenue hit from this decision, management has made some cautious guidance estimates for 2018. Based on their preliminary results for the quarter ended on March 31, they didn’t meet these cautious estimates causing yet another stock price slump from $5.60 to $5.10.

Yet, on the longer term (3-5 years) management remains very optimistic – perhaps too optimistic, but let’s assess that in due time. I found EMCORE compelling since the downside seems somewhat protected so even if management’s expectations are too ambitious, I shouldn’t get hurt too badly; but if they do materialize, there’s quite a substantial upside.

Assessing the Downside
Let’s go through the protected downside argument first. At face value, EMCORE doesn’t exactly scream bargain with a P/E multiple of 25. However, the balance sheet is booming with cash! This $138.7 million market cap business is practically debt-free with just $1.7 million in total long-term liabilities and $16.6 million in current liabilities. It sits on $119.2 million in current assets of which $64.2 million and $23.1 million is cash and accounts receivable, respectively.

When you buy a stock, you have a proportional claim on the assets on the balance sheet. One may thus consider the net cash per share “free” (in lack of a better word), since you could withdraw the net cash as so forth you bought the entire enterprise. If EMCORE paid all liabilities there would still be $45.9 million in “free cash”, or $1.69 on a per-share basis. A more accurate purchase price of EMCORE is thus $3.41 ($5.10 – $1.69 = $3.41).

Given the liquidity of the balance sheet, one could go even further in terms of assessing the true ‘price of the business’. Namely, I’ve tried to subtract the net current asset value (NCAV) from the market cap of EMCORE – though it might be quite an unorthodox way to approach a stock valuation. Though Benjamin Graham used the NCAV figure to spot businesses that were worth more “dead than alive”, I think subtracting it from the market cap is a suitable measure to determine the price investors pay for the actual operations and earnings power of a business – especially companies with such liquid balance sheets as EMCORE. If one subtracts all $18.3 million worth of liabilities from the current assets of $119.2 million, we’re left with a net current asset value of $100.9, or $3.71 in per-share terms. That’s the amount an acquirer could theoretically ‘cash in’ as so forth he or she bought the entire enterprise; one could withdraw the cash, claim the receivables and sell-off the inventory (though such would not bring in the face-value as stated on the balance sheet). If one subtracts that $100.9 million from the market cap of $138.7 million you’re in effect ‘only’ paying $37.8 million for the ~$20 million of properties, plants and equipments as well as the business’ earnings power. In other words, one is paying $1.39 in per-share terms for the operational assets and the future prospects of EMCORE ($37.8 million / 27.2 million shares outstanding = $1.39). That translates into a current P/E of 6 given the TTM EPS of $0.23; I find that ratio compelling for a business that has demonstrated remarkable progress the last 3-4 years.

In my view, $3.71 per share thus seems to be the downside strongpoint ($5.10 – $1.39 = $3.71). Though a ~27% downside is a painful potential pullback, let’s discuss those future prospects and whether an asymmetric risk-reward situation exists.

Assessing the Upside: Taking a Stab at EMCORE’s Intrinsic Value
During the latest year-end earnings call, management outlines how and by how much EMCORE expects to grow. I’ll let you listen-in on the how pitch for yourself, but I would like to give voice to my reasoning behind the how much part. The valuation method I employ is quite unorthodox in comparison to i.e. a DCF-analysis, which is my usual valuation weapon of choice. However, given the unstable past free cash flows, the ‘reset’ brought along by Jeffrey, one-time gains in 2015, and limited coverage of this small-cap stock, I found it to be the way I could assess it with the most substantiated arguments in hand.

Management’s goal is to grow the chips and navigation systems product lines’ revenues to the same level as the broadband business’ 2017 number, namely ~$98.4 million (of $123 million in total revenues). Let’s assume that happens and the broadband business’ revenues stay flat. In this speculative scenario, EMCORE’s revenues would be made-up of three equally large chunks of $98.4 million, bringing the company’s total revenues to $295.2 million. I wasn’t able to find a break-down of each product line’s margins, so I took the easy route and assumed EMCORE is able to maintain the last few years’ average net margin of 7.45% across the board. That translates into a net income figure of $22 million ($295 million * 0.0745 = $22 million). Divide that by the 27.2 million shares outstanding and you get an EPS figure of $0.80. If one assumes that the stock is trading around a P/E ratio of 15 in 2022, you arrive at a stock price of $12 ($0.80 x 15 = $12). If we discount that back at a generic rate of 10% over four years, the calculator says the present value is $7.87. We can then add the $1.69 of cash or the net current assets of $3.71 depending on your level of conservatism. These assumptions produce an intrinsic value estimate of $9.56-$11.58, which translates into an upside potential of 87-127%.

Yes, these ambitions are quite optimistic. The latest fiscal year revenues figure of $123 million should compound at 24.5% over the next four years to reach $295 million, and the net income figure at 29% to go from $8 million to $22 million (and even higher if one takes a point of departure in the TTM numbers given the current challenges)! Despite the fact that EMCORE has +$400 million in net operating losses, which means it won’t have to pay taxes for the foreseeable future, these numbers seem outlandish. Yet, EMCORE has grown its revenues and net income at 30% and 20%, respectively, since 2014. Furthermore, management says the heavy R&D expenses during Q3 and Q4 were made to accelerate the growth of the chips and navigation system product lines: “The company is now at an inflection point that it has been preparing to take advantage of for nearly three years. EMCORE is finally poised to become much more than a cable TV business. The operational and technical foundations we’ve built in chips and navigation markets is ready to support rapid growth.” Obviously, one needs to consider management’s own optimistic statements with a grain of salt. However, now that EMCORE has cut its workforce by 34% and the fact that R&D expenses are expected to stay flat due to the recent heavy investments, one might speculate that the average net margin of 7.45% could go north. If EMCORE is able to achieve a net margin of, say, 10%, it would ‘only’ need to reach $222 million in revenues to make that $22 million net income fantasy come true – it’s still an ambitious revenue growth rate of 16%, but surely more reasonable than 29%.

Another catalyst could be rooted in a share buyback program. Say EMCORE buys back 7.2 million shares to make the number of outstanding shares an even 20 million. That $22 million in projected net income would then translate into an EPS of $1.1 rather than $0.80 ($22 million / $20 million = $1.1). Multiplying that by afore P/E of 15 spits out a stock price of $16.5. Discounted at 10% over four years produce a present value of $10.83. In this hypothetical scenario, EMCORE spent $36.2 million on buying back the shares at $5.10, so we add the remaining $28 million of cash ($64.2 million – $36.2 million = $28 million), or $1.4 on a per-share basis ($28 million / 20 million shares outstanding = $1.4) to arrive at an intrinsic value estimate of $12.23. We could also add the NCAV of $3.24 (above-mentioned 100.9 million in NCAV – the $36.2 million allocated to share buybacks = $64.7 million / 20 million shares outstanding = $3.24) in order to produce an estimate of $14.07.

I guess I went on a rant here, apologies. Nevertheless, the above guesses are just that, guesses. From management’s 2022 dreams to the margin estimates, from the employed P/E ratios and discount rates to speculations of stock buybacks – it’s all guesses. However, in my view it looks like there’s value in EMCORE even if management’s ambitions aren’t met; how – and if – the value gets materialized is a pure guessing game.

A Quick Glance at EMCORE’s Qualitative Aspects
Again, I went a bit crazy length-wise on the above section, so in order to not bore you silly I need to summarize the more qualitative aspect of this stock analysis:

Management: How can one not be impressed with Jeffrey and his management team’s performance the past 3-4 years? Based on his background it seems he’s moulded in the industry and has a proven track-record. Furthermore, he has proved to be a shareholder friendly capital allocator by returning +$80 million in excess cash to shareholders in 2015-2016. In length, I don’t find it unlikely that EMCORE might initiate a share buyback program.

Risks: EMCORE presents an array of potential risks on p. 12-33 of the 2017 annual report. The four main concerns from my point of view are: 1) EMCORE is still highly dependent on the broadband business, specifically their cable television product line – which is currently experiencing headwinds. Management’s “top objective” the next few years is “revenue diversification”, meaning Jeffrey is aware of this dependency. However, until it’s more equally diversified, EMCORE could be endangered – especially if the last quarters’ struggles in said segment continues. 2) EMCORE’s three biggest clients are accountable for 10% of the business’ revenues, each – loosing any one of these can have quite an adverse impact. 3) The recent trade-war initiated by Trump is bad news for companies who are dependent on China – as is EMCORE, the company has manufacturing facilities there. This risk is explained in-depth on p. 14-15. 4) An inherent risk in most technology stocks is the fear of being outdated and replaced by newer, better or even cheaper technologies. I have zero insights in this field, so I hope my downside protection argument above proves true in case EMCORE should become ‘obsolete’.

Moat(?): In length of my ignorance in this field, I can’t properly assess what the business’ moat is – as so forth it even possess one. All I can hope for is that EMCORE’s 60 US patents, 30 foreign patents plus 10 pending patents protect the business’ product lines into the future thus ensuring that the company enjoys a moat rooted in intangible assets.

Conclusion
In short, EMCORE is a business within an industry I know very little about. It seems, however, that there is a favorable risk-reward asymmetri, which tempted me to go outside of my circle of competence and strike at EMCORE at $5.10 despite some – I admit – quite concerning risks. I’m aware that an intrinsic value span of $9.56-$14.07 is optimistic, and it is indeed based on some very ambitious statements from management as well as a fair amount of speculative inputs. Yet, even if the company doesn’t meet these revenues and earnings objectives, the margin of safety seems sufficiently large for your’s truly to place a bet.