Steve,
This is the reason that Cube increased 10% in stock price today.
I agree with the analysis that SVCD (Chao Ji VCD) will increase in Q4, 1998 and Q1, 1999.
I am not so sure same thing goes with DVD.
This news ought to help ESS stock value as well since ESS is doing well in SVCD in China....
T.J.
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Copyright 1998 CREDIT SUISSE FIRST BOSTOM CORPORATION
Equity Research-Americas Semiconductors
Charlie Glavin,
Regina Crilly
BUY
C-Cube Microsystems (CUBE)
Summary
We are initiating coverage of C-Cube Microsystems (CUBE) with a BUY rating and a $33 price target.
C-Cube's DiviCom subsidiary (roughly half of total revenue) continues to enjoy success and is a strategic
key for the company. DiviCom produces complex systems that enable digital video networking and has
attracted a quality list of top broadcasting customers (such as EchoStar and DirecTV).
We believe that the company's semiconductor business, with 40% of the MPEG market, has stabilized and
can leverage its hardware expertise to further support DiviCom.
We believe the company will grow, at a minimum, in sync with the digital video market over the next three years (roughly 20% CAGR). Further, depending on how quickly C-Cube penetrates the DVD and DBS market (for HDTV), we believe the stock can trade beyond our multiple target of 25x, providing additional upside opportunity for the stock.
Price Target Mkt.Value 52 Week
11/23/981 (12 MthS) Div. Yield (MM) PriceRange
$23.25 $33 NA None $923.0 $25.13-13.25
Annual Prev. Abe. Rel. EBITDA/EPS EPS P/E P/E Share
12/99E $1.30 NA 17.9X 72% $1.69
12/98E $1.12 NA 20.8 80% $1.40
12/97A $1.15 NA 20.2 76% $1.65
March June Sept. Dec. FY End
1999E $0.34 $0.29 $0.32 $0.35 Dec
1998E $0.27 $0.25 $0.28A $0.31E
1997A $0.40 $0.21 $0.25 $0.30
ROIC (9/98) NA
Total Debt (9/98) $26.2
Book Value/Share (9/98) $5.48
WACC (9/98) NA
Debt/Total Capital (9/98) 12%
Common Shares 39.7
EP Trend2 NA
Est. 5-Yr. SPS Growth 25%
Est. 5-Yr. Div. Growth NA
1 On 11/23/98 DJIA closed at 9174.3 and S&P 500 at 1188.21.
2 Economic profit trend.
C-Cube is a leading provider of highly integrated digital video compression / decompression (codec)
solutions, including a >40% market share for MPEG decoders / encoders. Balancing its component and
system level expertise (through its DiviCom subsidiary), CUBE products are used extensively in the fast
growing VCD, DVD, and digital set-top box end-markets.
C-Cube is a market leader of ICs required for the rapidly growing market for next-generation digital
consumer products. C-Cube is a leading provider of highly integrated digital video
compression/decompression (codec) solutions, including mixed-signal integrated circuits used for the
encoding and decoding of high quality video and audio. C-Cube solutions are critical enablers for the rapidlygrowing next-generation of consumer electronics, including video CDs, DVD, and set-top boxes. According to Dataquest, CUBE had 41% of the estimated $461 million market for MBSG and AC-3 decompression IC8 worldwide, a market that is expected to grow 30% a year through 2002.
DiviCom subsidiary enables digital video networking and is a strategic key for future Success. Acquired in
August 1996, C- Cube's DiviCom subsidiary produces complex systems that allow the manipulation of video and data for bead-end broadcasts (uplinks) over satellite, fiber, wired, and wireless mediums. Through its encoders, decoders, controllers, and multiplexers, DiviCom enables "digital video networking" through signal processing, control management, and conditional access (i.e. used in interfacing with billing services). DiviCom has already been successful selling its solutions to Telcos and direct home satellite providers, and is currently targeting its next generation of products For cable and HDTV (high definition TV) applications. DiviCom has grown to &4% of the company's 9Q98 revenue, and should become the largest revenue contributor beginning in 1999 as DiviCom growth outpaces both the market and the rest Of C-Cube.
The emergence of DiviCom has also mitigated C-Cube's exposure to the more commoditized nature of its
semiconductor business especially in MPEG-1 decoders and VCD chipsets.
CUBE business mainly driven by growing digital video end- markets and a growing, quality customer base.The market for digital video is one of the faster growing markets for consumer and communications
products. Aside from DiviCom, C- Cube products are mainly focused on 3 markets:
Video CD Players - We estimate C-Cube has a 66% market share of a $240 million market for VCD
decompression chips. This is down from a 85% market share of a $270 million in 1996 due to ESS
Technology engaging in a fierce price war to gain market share (ESS went from roughly 6% to 32% market share during that same period). The VCD market (for China alone) is only expected to grow 6-8% per year through 2001 as that market eventually transitions over to DVD.
Digital Broadcast Satellite Set Top Boxes - C-Cube has emerged as the second largest provider of ICs for
the backend (compression functions) of set-top boxes with $20 million Of a $190 million market in 1997
(estimated CAGR of 22% through 2001), or a 13% market share. There is another set Of IC designers that
supply component for the front-end (interface functions) which C-Cube does not compete.
DVD Players - C-Cube is the fourth largest provider Of DVD (digital videodisk) chips in 1997, with 11% of an estimated $93 million market (CAGE of 70% through 2001). However, DVD was only introduced to the market in 1996 and for its first two years, captive (in-house) providers such as Matsushita, STM, and
Toshiba initially dominated this market. We believe that dedicated merchant providers such as CUBE (and
others such as LSi or VLSI) should continue to gain significant market share in 1998 and beyond as the
market grows in size - -providing lower cost, dedicated solutions than those captive OEMs.
We believe C-Cube has an advantage over it's vertically integrated competitors who usually compete against their own potential customers.. Consequently, C-Cube's customer base also includes some of the
leading OEMS within each of these end-markets, including:
Consumer Samsung, SAST, Idall, Malata, ChanHong. and Xiamin Solid.
Communications: General Instruments, Scientific Atlanta, NDS, Comsat, NEC, and ABL.
Computer: Dell, Toshiba, Gateway, Diamond, Kasan, NEC, and Quadrant.
DiviCom: EchoStar, DirecTV, Bell South, GTS, US West, NTL, British Digital Broadcast, and various TV
affiliates.
The integration of complex solutions favors CUBE'S experience and technology. Semiconductor technology will be a critical enabler for market acceptance of STBS, VCD, etc. Integrating encoder and compression capabilities also significantly increases the complexity of the semiconductor designs needed to facilitate advanced digital video futures for next- generation consumer electronics and PCs. This should reward those IC companies who have both technology advantages and solid systems level expertise.
As one of the the original creators of MPEG (Motion Pictures Expert Group) video
compression/decompression standards and the integration Of DiviCom, we believe C-Cube has a distinct
advantage over its competitors. In this market, merely being a good IC designer is not enough to succeed; a
company also needs to integrate systems level experience in order to differentiate developing digital
solutions for professional applications into consumer devices, too.
Digital television also favors DiviCom's technology and professional expertise. The introduction of digital
television (via the required FCC mandates) could also provide significant upside to C-Cube prospects.
DiviCom's professional products are expected to facilitate the proliferation of digital broadcasting
capabilities. DiviCom is already servicing a Seattle ABC affiliate to handle 4:2:2 (a high-level compression algorithm ratio) encoding of standard definition transmission and is targeting U.S., television affiliates for High Definition TV (HDTV) encoding. These affiliates are attracted to HDTV because Of the additional bandwidth it provides, allowing TV stations to run standard definition broadcasts when they are not running the government mandated High Definition broadcasting. Over half of the 40 government-mandated stations should be tested by November 1 with mandatory conversion occurring May 1, 1999. Consequently, we expect large HD-encoder product announcements in 1H99, although our current model does not incorporate the full potential impact. We anticipate that this market may be relatively small in unit sales, but should be very large in revenue.
Complexity of implementation helps differentiate C-Cube's encoders and extend life of decoders, While
research groups such as Dataquest track MPEG market share as an aggregate, it is important to break the
market down between encoders and decoders. Decoders enable playback of video or audio, but are far less
complex than encoders. MPEG decoding can even be performed in embedded software using the host
processor to execute the instructions, such as in PCs. However, such "soft- MPEG" implementations
usually require most of the available processor headroom in order to playback video (for a Pentium- II
266Mhz system, roughly 90% of CPU is used during MPEG-2 complexity of implementation takes even a
higher percentage of the host CPU's available time. We believe the only direct competition in the encoder
market currently comes from IBM, but given C-Cube's dedicated market focus, we believe that C-Cube
should continue to differentiate itself in the market. C-Cube currently has roughly 80% of the total
Consumer and communications encoder market, and IBM (with the remaining 20%) has Given no
indication of entering the consumer market with its encoders.
CREDIT SUISE FIRST BOSTON CORPORATION CREDIT SUISSB FIRST BOSTON
CORPORATION Analyst: Glavin, C Telephone: (415) 836-7715 charlie.glavinc?fb.com CREDIT
SUISSE FIRST BOSTON CORPORATION CREDIT SUISSB FIRST BOSTON CORPORATION This
memorandum is for informative purposes only. Under no circumstances is it to be used or considered as an
offer to sell, or a solicitation o? any offer to buy, any security. While the information contained herein has
been obtained from sources believed to be reliable, we do not represent that it is accurate or complete and
it should not be relied upon as such. We may from time to time have long or short positions in any buy and
sell securities reffering to herein. This firm may from time to time perform investment banking or other
services for, or solicit investment banking or other business from, any company mentioned in this report.
Copyright 1998, CREDIT SUISSE FIRST BOSTON CORPORATION
= = C-Cube Microsystems == CUBE:Buy
CUBE should benefit from a more stable semiconductor business and leverage strength for DiviCom
business. We believe there are three fundamental reasons why investors should buy C-Cube.
Semiconductor business appears to have stabilized.
Divicom less well known, but growing portion of business.
Leverage between the two groups.
Over the past two years, C-Cube's market was hit by severe price erosion, in large part due to market
delays in new products (VCD, DVD, and HDTV).
With these markets now ramping, we believe product life cycles will shrink, Placing more emphasis on
product development than on price in order to gain market share. We believe that this favors C-Cube,
especially with the addition of Umesh Padval, former head of VLSI'S set-top box group to oversee
C-Cube's efforts. We believe C-Cube can leverage the silicon innovation of the traditional C-Cube business
with the extensive systems level experience of DiviCom to produce a preferential solution to
communications and consumer applications.
The table below shows that C-Cube is in the process of relying more on systems level business than on
semiconductors, per se.
Revenue breakdown by end markets (as % of total revenue) Asia is one of several geographic markets that
CUBE has targeted for future strength.
C-Cube has leveraged its market leadership in VCD to help leverage large growth Opportunities in
emerging geographic regions. In Asia, the predominant in China, for video CDs such as karaoke machines.
As mentioned, DiviCom was picked by DirecTV in Japan to supply encoders and multiplexers- The
Company also expects to leverage design wins within Europe for both broadcast STB and cable STB.
4Q98 represents the first full season of DVD sales. AS mentioned previously, C-Cube has steadily
increased market share in the DVD market since it was first introduced in 2H96. 4Q98 marks the first
Christmas season with bona fide DVD players sold as Stand-alone machines and as standard
configurations on mainstream PCs. Consequently, we believe C- Cube could be a large beneficiary of the
expected strength in the PC market this 4Q.
Systems expertise and product roadmap should enable C-Cube to overcome competitive challenges.
C-Cube's business faces several challenges that could severely limit its growth potential, but we believe that CUBE can overcome these potential obstacles.
Slow growth in China. After much debate and speculation, the Chinese government has now endorsed a
next-generation standard for video CD players, called Chao Ji VCD. While C-Cube had been pushing for
its own CVD version (Chinese videodisk), the difference for OEMS should be minor as all
CVD titles should be able to be played on Chao Ji VCD players, and vice versa. Furthermore, C-Cube has
already begun taking steps to diversify its geographic concentration.
Rapid migration to software solutions. As microprocessors become more robust, there is a natural migration for more functions to be executed in software using the host processor. By having fewer chips in a system, an OEM benefits from lower costs and more headroom (to add other features)†However, as mentioned earlier, this is only provided such that the software Solution does not take up too much of a CPU's available capabilities.
However, we believe that this rate needs to fall below the 25% level before software truly displaces
hardware solutions and therefore, we believe this risk is not an immediate threat to C-Cube.
Competitive pricing pressures. we believe this is probably the most significant risk to C-Cube, but one that
the company can withstand given its more diversified product line and the benefit of experience. For
example, in 1996, C-Cube was the clear leader in MPEG-1 technology, but saw earnings contract as ESS
Technology over-compensated for its trailing technology solutions, we believe, by cutting prices sharply.
Normally, we would expect prices for high volume Its to decline about 30% per year, but in 1996-97 the
MPEG-1 market ASPs declined nearly 57%. Yet, while the MPEG-1 market declined nearly 24% in 1997 due to rapid ASP declines from an oversupply in the DBS market, C-Cube's MPEG-2 business grew 12% (increasing its market share to 14% of that $197 million market, second only to STMicroelectronics's declining 40% share).
Introducing new EPS estimates of $1.12 for 1998 and $1.30 for 1999. Due to continued pricing pressure on
semiconductor sales, earnings growth for CUBE is not expected to keep pace with our 20% revenue
growth assumption for 1999. However, we do expect slightly better earnings for the company during 4Q98
than consensus (our EPS estimate is $0.31 versus Street estimate of $0.30) due to Strong DVD and VCD
sales out of Asia. We believe that at our 16% growth estimate for 1999, C-Cube should outpace the
semiconductor market's growth rate (estimated to be 9-10% in 1999). In addition, we believe C-Cube's
earnings growth will accelerate as the company exits 1999, increasing approximately 20-25% in 2000. The
speed in which the DVD market takes off and how well DiviCom products penetrate the HDTV broadcast
market should determine the degree of upside potential to our estimates.
Balance sheet is solid with room for improvement during strong 4Q98. Now that C-Cube's business has
stabilized, the balance sheet has shown renewed strength. Inventory levels stand at 39 days (partly due to
seasonal impacts) but down from 67 days one year ago and 50 in 2Q98. Receivables continue its steady
improvement with DSO at 35 days, down from 38 days in 2Q98 and 50 days Last year. Since 2Q98,
C-Cube has repurchased $63 million ($43 million in 3Q98 alone) of an original $86 MM face value in
long-term convertible debt, thereby reducing the company's Debt-to-Equity ratio to 12%, down from 50% at the end of 1997. We expect further balance sheet improvements as the company experiences seasonal
strong sales in 4Q98 and into 1Q99 (due to VCD sales around Chinese New Year). Finally, with $179 in
total cashs, net cash has nearly tripled since 3Q97 to $3.85 per share, providing the company with an
adequate war chest to fund new developments in a competitive market.
We are initiating coverage of C-Cube with a BUY rating and a 12-month price System solutions Supplying
the fast growing digital video market. With its DiviCom business and a stabilized semiconductor business,
we believe the company has the balance necessary to exploit several fast growing markets in DVD, VCD,
digital STB, and HDTV. CUBE should encounter some strong competition from other hardware providers
and software alternatives. However, the company has shown that is it more than a one-hit wonder and
continues to not only attract new talent, but introduce innovative products that customers want. Currently
the stock is trading at 16x our FY99 EPS estimate of $1.30, but should be able to trade back up to a 25x
multiple, depending on future DiviCom design wins. At a 25x multiple, the stock should trade in line with
S&P relative earnings and is currently trading at a 78% relative multiple, versus its 103% average (last
reached 10/97).
Therefore, we are initiating coverage of CUBE with a BUY rating and a 12-month price target of $33.
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