REPRINTED AS BELOW -
ISSI/INITIATING COVERAGE WITH A STRONG BUY RATING
SG COWEN
Billy/Romaine
3 October, 2000
Integrated Silicon Solutions (ISSI $14 1/4)
Strong Buy (1)
Initiating Coverage With A Strong Buy Rating
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Quarterly EPS
FY Sep Old EPS New P/E Q1 Q2 Q3 Q4
EPS
1999A ($0.52) ($0.23) ($0.20) ($0.06) ($0.03)
2000E $0.86 16.6 $0.02 $0.14 $0.32A $0.39
2001E $2.00 7.1 $0.42 $0.48 $0.54 $0.57
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Key Points:
1. ISSI should continue growing significantly faster the overall SRAM
market
2. Its growth is tied to the communications infrastructure equipment
market
3. Plenty of operating leverage still exists
4. Exceptional visibility extends through, at least, the end of C2000
5. The shares are extremely cheap-our target is $30-40
Summary: We are initiating coverage of Integrated Silicon Solutions (ISSI)
with a Strong Buy rating. We believe that near-term visibility for both
ISSI and the high performance SRAM market are excellent. ISSI will likely
grow at 4x the rate of the SRAM market in C2000 (100%+ vs 24%). As one
would expect with a standard products company, ISSI is enjoying a high
degree of operating leverage. Gross margin will go from 21% at the
beginning of C1999 to an estimated 36% by the end of C2000. We expect this
momentum to persist in 2001. We are projecting 70%+ revenue growth (vs 20%
for the worldwide SRAM market), with further gross margin expansion (to
approximately 40%). The progress of operating profit margins is expected
to be much more dramatic, rising from 8.8% last Q, to an estimated 12.5% in
the quarter ended last week, to 20% by mid-C2001. Longer-term we expect
ISSI to continue to gain share of the SRAM market, due to its positioning
in the high growth communications markets, and grow 1®-to-2 times the 15%
rate expected of the SRAM market. The shares are very cheap by historical
standards. The stock market is valuing stocks like ISSI as if a severe
cyclical downturn were imminent. It is our belief that the semiconductor
"cycle" has, at least, another 15-18 months of expansion ahead of it. If
so then the correction that many of the semiconductor stocks have
experienced in the last two quarters is the classic "mid-cycle correction,"
not discounting of the next recession. For semiconductor stocks to have
begun discounting the next recession almost two years before its onset
would be unprecedented. It is our view that ISSI is undervalued, even if
one does not appreciate the company's superior positioning within its
market. We recommend purchase of the shares and believe a reasonable price
target is in the 30-40 range.
SIA SRAM Market Forecast (Y/Y % Growth in US$)
1999A 2000E 2001E 2002E 2003E
19.7% 24.3% 19.7% 11.2% 9.6%
Source: SIA
Background--ISSI is a fabless semiconductor company that designs, develops
and markets memory chips. Approximately _ of revenue is derived from SRAM
with most of the remainder from a line of low-to-mid density, specialty
DRAM. ISSI's DRAM is sold to its existing high performance SRAM customers
and levers those relationships. While a very small player in the overall
SRAM market (<3% share worldwide) the company's primary focus is on high
performance SRAM for communications infrastructure applications. The focus
of its SRAM business is similar to the SRAM businesses of Integrated Device
Technology (IDTI:$90, Strong Buy) and Micron (MU:$46, Buy), who along with
Cypress Semiconductor (CY:$42, Strong Buy) are its primary competitors.
About _ of all ISSI revenue is derived from communications customers.
Cisco is the largest customer at about 13% of revenue. This is a
significant, and perhaps under-appreciated, change from the PC cache memory
focus of the company (and the rest of the SRAM industry) as recently as the
mid-1990s. The communications market is growing much faster than the PC
market. The infrastructure (as opposed to handset) portion of the
communications market shows signs of being a significantly higher profit
margin opportunity for SRAM companies like ISSI, IDTI and Cypress.
Products sold into the cellular telephone handset market account for less
than 10% of revenue. ISSI has some other product lines (including EPROM
and EEPROM) which, collectively, account for less than 10% of revenue and
equity ownership in companies, most notably ISSI-Taiwan, which further its
product and geographic scope. ISSI-Taiwan sells commodity SRAM primarily
to the PC motherboard market in Asia. It is roughly the same size as ISSI.
Contrary to investor sentiment, SRAM market continues to be capacity
constrained-It is our sense-from IDTI and Cypress, as well as ISSI-that the
high performance SRAM market is essentially "sold out" through the end of
C2000 at stable, or rising, Average Selling Prices (ASP). This strength is
a function of both the customer base-companies like Cisco, Lucent, Nortel,
Motorola etc.-and the very modest additions to capacity in the SRAM market.
On balance, the communications infrastructure market is growing much faster
than the semiconductor market, overall. Most major semiconductor memory
manufacturers in the US, Europe and Asia have focused on increasing Flash
memory capacity first and DRAM capacity second. Very few consider SRAM a
strategically important commodity. Our sources indicate that the high
performance SRAM market is currently capacity constrained. Certainly that
is the case for ISSI. TSMC supplies about 60%, Chartered 20-30% and UMC
>20% of ISSI's wafer needs and collectively they have not been able to come
close to supplying wafers equivalent to the potential demand that could be
placed on ISSI. Capacity constraints are management's primary concern in
its 2001 planning process.
Operating leverage will continue to contribute mightily to EPS-While
investor seem it be looking under every rock for signs of the end of this
"semiconductor cycle," ISSI is in the relatively early stages of benefiting
from classical operating leverage. SRAM ASPs have been rising 5-10%/Q in
2000. So far this cycle, rising wafer costs from ISSI's foundries has
offset much of that increase. While it is likely that SRAM ASP will rise
through the end of C2000, at least, we believe that ISSI will be able to
improve its gross margin in 2001 without ASP increases. Prospectively unit
costs should decline for ISSI as a result of accelerated improvements in
process technology. Its wafers from TSMC will shift from 95% 0.25 micron
today to 80% 0.15 micron one year from now. Chartered is producing 0.30-
0.35 micron wafers for ISSI now. Chartered is qualifying 0.18 micron
wafers now and 0.15 micron wafers are expected by year-end. UMC, which has
made only DRAM for ISSI, has committed to build some 0.18 micron SRAM
wafers for ISSI in F2001. Given the large percentage increase in number of
die/wafer generated by these shrinks, it is inconceivable to us that its
foundry partners could increase wafer prices by anywhere near as large a
percentage over the same period of time. Our model calls for relatively
stable SRAM prices in Q1 2000 and a return to "learning curve pricing"
thereafter. Revenue volume alone should lower operating expenses from
23.3% in the most recent quarter, to about 19% by the beginning of C2001.
We expect pretax profit margins to rise from 8.8% in June Q to 12.5% in the
September quarter and reach a peak of 20-21% by mid-C2001. In F2001 this
margin improvement will be offset by a significant increase in its tax
rate-from 10% to 27.5%-- and a reduction in its equity income line. Equity
income will decline as the company reduces its ownership in ISSI-Taiwan
from 40% last quarter to 27% by year-end. The company should generate a
significant amount of cash-perhaps $30-40MM--from this sale of stock.
Valuation is compelling-Given the very cyclical nature of ISSI (and other
semiconductor memory companies') EPS historically, it is hard to compare
its current valuation to any sort of historical average. However, it is
clear from any review of historical PE that the current PE is relatively
low. Based on SG Cowen estimates, the shares are trading at 31% of the S&P
500 multiple of C2001 earnings! This is the lowest relative PE in our
records and compares to an average of 94% (according to StockVal) since
1995. The range of PE on forward EPS since 1995 is 5.5-to-infinity, with
21.7 being the average. The shares have spent most of the time that ISSI
has had earnings in the 20-30 PE range. The shares are valued similar to a
group of related companies in the SG Cowen semiconductor universe that we
also rate as Buys and well below Cypress Semiconductor, its nearest comp.
Our price target of 30-40, implies a PE ratio of 15-20.
SGC 10/2 C2000E C2001E PE C01E
Rating Price
Cypress CY Strong 39 $2.20 $2.72 14.3
Buy
ISSI ISSI Strong 14 $1.26 $2.06 6.8
Buy
Micron Tech MU Buy 42 $2.94 $6.03 7.0
Vishay VSH Strong 30 $3.45 $4.05 7.4
Buy |
