Summary and Investment Conclusion
After the market closed on January 11, Rambus reported fiscal first quarter (December) earnings of $0.12. The earnings were $0.01 below our estimate and the consensus estimate of $0.13 per share due to a higher tax rate (40% versus 35% previous guidance). Overall, we found the results were generally in-line with our estimates.
Reflecting weaker DRAM pricing toward the end of calendar third quarter 2000, royalties of $26.8 million were $1.2 million lower than our estimate of $28.0 million. Royalty revenue increased 35% sequentially due primarily to the increased payments on non-Rambus compatible ICs. Rambus recognized income from Samsung and Mitsubishi for the first time in the fiscal first quarter. Royalties accounted for 77% of total revenues versus 22% in the year-ago quarter.
The increased revenues and strong leverage from Rambus intellectual property business model drove an increase in operating margins to 57.3%, an increase of 350 basis points sequentially. Engineering expenses (cost of contract revenues plus R&D expenses) were $1.5 million below our estimate while higher than expected legal expenses ($4 million versus $3 million expected) drove SG&A higher and offset some of the efficiency gains. We expect the legal outlays to rise in the next several quarters due to increased legal and administrative expenses, yet the expenses should taper off as legal issues are resolved and cases go to trial.
Due to weaker DRAM pricing and the higher expected tax rate, we have reduced our revenue and earnings forecasts for fiscal 2001. Rambus recognizes royalty one quarter in arrears. We believe weak DRAM pricing in the December quarter will result in lower royalty income in the March quarter. In addition, the higher tax rate of 40% should result in a $0.01 reduction in earnings per quarter in fiscal 2001. Consequently, we have lowered our fiscal 2001 EPS estimate to $0.45 from $0.55. Based on revenues expected from existing licensees only, we are also introducing a fiscal 2002 EPS of $0.65, with the potential for higher revenue growth as the company adds new licensees. We believe the long-term earnings power of $3-5 per share in the 2003 timeframe for company remains intact. Consequently, we maintain our Strong Buy rating and $200 price target.
Demonstrated strength of IP business model
With higher royalty income and escalating operating margins, Rambus clearly demonstrated the strength of its intellectual property business model. For the December quarter, we believe approximately one quarter of the royalty income was derived from logic ICs used in the video game market with the remainder from memory. In addition, we believe RDRAM contributed about 33% and SDRAM about 67% of the royalty income from memory in the quarter. Driven by higher shipments of RDRAM and DDR SDRAM, we expect a richer product mix for Rambus' licensees in 2002, resulting in higher royalty rates and income. In the long term, we believe Rambus' IP-based model can support an operating margin greater than 80%.
First trial scheduled to start in February
Rambus has lawsuits pending with Infineon, Micron, and Hyundai in Europe and the US. The lawsuit against Infineon was originally scheduled to go to court in Germany in late December but was rescheduled to May 2001 due to the promotion of the judge previously assigned to the case. Management still expects the lawsuit against Micron and Hyundai in German courts to begin on February 16, 2001. Rambus expects the decision from the first trial in Germany to be rendered approximately three-to-four weeks after the hearing.
In the US courts, the Infineon jury trial is currently scheduled to begin on March 13, 2001. The Micron trial is scheduled to start in the Delaware court in October 2001. Rambus is seeking to consolidate its lawsuits against Infineon and Hyundai in the US courts. The Hyundai lawsuit is currently scheduled to go to trial in 2002.
We believe the issues raised by Infineon and Micron focus on JEDEC (Joint Electronic Device Engineering Council) procedures rather than on invalidating Rambus's patents by demonstrating prior art or obviousness. We believe there is risk inherent to any legal proceedings, yet management believes it has sufficient legal resources to successfully defend its IP and strongly believes the company will prevail in the courts.
Last quarter, Rambus signed three DRAM license agreements--next battlefront is logic
Last quarter, Samsung, Elpida, and Mitsubishi signed license agreements with Rambus covering SDRAM, DDR SDRAM, and the associated logic controllers. Outside of Infineon, Micron, and Hyundai, we believe Rambus has signed agreements with the remainder of the world's top-tier DRAM manufacturers covering slightly higher than 40% of the global DRAM market.
With the recent successful completion of several licensing agreements, we believe that Rambus will begin to devote more resources to increase licensing efforts at targeted logic companies. Based on the scope of its patents, we believe that every DRAM supplier and the concomitant logic interface suppliers will need to license Rambus' patents, including Acer Laboratories, ATI Technologies, Fujitsu, IBM, Intel, LSI Logic, Motorola, National Semiconductor, NVIDIA, Silicon Integrated Systems, Transmeta, Via Technologies, and many others. Similar to the DRAM negotiations, we expect that some companies will settle to obtain favorable royalty rates, and other companies will choose to litigate and run the risk of higher royalty rates or potentially losing and not being licensed.
Next generation technology should provide future revenue streams
Over the next several years, Rambus will license its 1,066-MHz RDRAM, QRSL (Quad Rambus Signaling Level) RDRAM and SerDes (serializer/deserializer) cell technologies to generate future income. Management believes that the first SerDes license will be signed in the current quarter. The 1,066-MHz RDRAM increases memory bandwidth to 2.1 gigabytes per second compared to 1.6 gigabytes per second for the current 800 MHz RDRAM, and QRSL technology will provide 3.2 gigabytes per second for short channel applications (1-4 devices versus 32 devices for long channel applications). The Rambus roadmap also extends to 1,200-MHz short channel devices for 2002.
Investment thesis unchanged, reiterate Strong Buy
Our investment thesis on RMBS remains unchanged, as we believe the key issues surround the company's intellectual property. While we were able to accurately forecast the license agreements that were struck with NEC and Samsung in the second half of 2000, it now appears that Hyundai and Infineon will not settle before their trials begin. As a result, investors should be aware that the potential for an adverse decision in the various legal venues being pursued by Rambus is possible, and a defeat could potentially negate our investment thesis.
Based on our analysis of the company's patents, combined with the settlements by Hitachi, Mitsubishi, NEC, Oki, Samsung, and Toshiba, our rating on the stock implicitly assumes that Rambus will prevail in the upcoming trials. Provided this assumption proves to be correct, we still believe that Rambus is capable of enjoying $3-$5 per share of earnings power in the 2003 time frame. Consequently, we maintain our 12-18 month stock-price target of $200, which derives fair value from a 10-year discounted cash flow model.
While we maintain our Strong Buy rating on RMBS to reflect the upside potential from successfully defending the company's patent portfolio, we believe that the stock will likely be stuck in a trading range environment until a decision from one of the upcoming court cases is rendered. Risk averse investors may want to hedge their position in the stock once the trials commence.
Rambus Earnings Model
E = Morgan Stanley Dean Witter Research Estimates
Source: Company data, Morgan Stanley Dean Witter Research
FY Ending Aug 31: 2000A 2001E 2002E 2003E
EPS ($) 0.20 0.45 0.65 -
Prior EPS Ests. ($) - 0.55 - -
P/E 244.5 108.7 75.2 -
Price/Book 33.0 23.9 18.2 -
Market Cap ($ m) 5,311
L-T EPS Grth ('01 - '04E) (%) 130.0
P/E to Growth 0.58
Shares Outstanding (m) 108.6
Q'trly 2000 2001E 2002E
EPS actual curr prior curr prior
Q1 0.02 0.12A - 0.14 -
Q2 0.04 0.10E 0.13E 0.18 -
Q3 0.04 0.11E 0.14E 0.16 -
Q4 0.09 0.12E 0.15E 0.17 -
E = Morgan Stanley Dean Witter Research Estimate
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