March 7, 2014
- Apple customer relationship is really just a one-time, non-exclusive licensing contract signed with Pixelworks, of which ~80% of its value has already been recognized as revenue in 2013.
- Activist shareholder Becker Drapkin (PXLW’s largest shareholder) has systemically lowered its position and has contracted Tourmaline Partners to begin selling its 10% ownership stake starting…well today, March 7th.
- Excluding the Apple revenue, Pixelworks’ core business from 2012 to 2013 saw its revenue drop 33% from $59.7M to $40.0M and net income drop 200% further into the negative.
Pixelworks (PXLW) shot up ~90% yesterday on the heels of disclosing Apple as a significant customer in its most recent 10K, filed after market close on Wednesday 3/5. While there had been speculation that Apple and Pixelworks were already working together, it was not confirmed until now, as Apple had accounted for more than 10% of Pixelworks total revenue for 2013 and the SEC requires companies to disclose any customer that crosses the 10% threshold. As PXLW shareholders celebrated, I dug into the filings, and as laid out in the summary above, uncovered a major short sale opportunity.
Reading Between the ‘Apple now a Significant Customer’ Headlines
Combing over Pixelworks 10K, you can fairly easily ascertain Apple made up 17% of Pixelworks revenue in 2013.
At 17% of 2013 revenue, that comes out to ~$8.1M in Apple-related revenue. As an aside, for a company that did ~$174 billion in 2013 revenue, clearly Pixelworks is in no way a major partner, but back to the 10K. In the MD&A section you find the following “During the third quarter of 2013, we entered into an agreement with a third-party to provide a non-exclusive license for a package of our technologies and to provide certain services, under which we expect to receive a total of approximately $10.3 million. The license revenue recorded during 2013 was primarily due to achieving milestones under this agreement. We expect to record an additional $2.2 million in licensing revenue related to this agreement upon the achievement of additional milestones, most of which are expected to be achieved in the first half of 2014.” What is $10.3 less $2.2 remaining on the contract? $8.1M! So we can assume Apple is the referenced third-party and 100% of the Apple-related revenue can be attributed to the license agreement. A few key takeaways are that the contract is not recurring, i.e., one time, and ~80% of the contract has already been recognized as revenue in 2013, with only $2.2M left to be recognized in 2014. Also, the contract is non-exclusive, meaning Apple is free to use competing technologies, which could reduce or replace Pixelworks technology in Apple products (not to suggest its technology is even in Apple products). Given how Apple has treated past partners such as Peregrine, Cirrus Logic, and Audience, to name a few, I’d be wary of expecting much from Apple in terms of loyalty to one technology vendor. So those investors expecting a huge ramp in Apple-related revenue, Apple is not buying Pixelworks products, it merely licensed some IP that only costs it $8M to do so. There is no recurring relationship mentioned. If Pixelworks was expecting a major ramp in Apple revenue, you would rightfully expect a subsequent increase in guidance, however, revenue guidance for Q1 of 2014 is only $12M to $14M (a drop from the $15.0M just reported in Q4 of 2013) and includes at least a portion (if not all) of the remaining $2.2M in Apple licensing revenue. Further, Pixelworks is also guiding to a non-GAAP net loss of $0.02 to $0.09 per share, which is a significant reduction from the non-GAAP net income of $1.3M or $0.05 per share reported in Q4 of 2013. Reading between the headlines paints a meaningfully different picture.
Becker Drapkin and the Contracted Sale of its Shares
Becker Drapkin is an activist fund I admire and follow closely. They first filed a 13D to report an ownership stake of almost 14% of PXLW shares in December 2011 and subsequently launched a campaign in early 2012, which ultimately earned them two seats on the board. Becker Drapkin has since maintained a significant position in PXLW, with its ownership percentage ranging from ~13.0% to 15.5%, right up until late 2013, when it starting dumping shares. Since late November 2013, Becker Drapkin has sold over 20% of its shares, or 575K shares worth $2.7M. Given its lower cost basis in the stock, I don’t blame them for taking a little off the table for a 100%+ gain. However, in its most recent amended 13D filed on 2/13, two things caught my attention.
The fund sold exactly the number of shares it needed to get to 9.99% ownership in PXLW. Why is that significant? At 10% or greater ownership, you are considered an “insider” of the company and your purchases and sales of the stock are reported immediately to the SEC and available for people like me to interpret and act accordingly. At less than 10% ownership, you are only required to file an amended 13D ten days after a material change in ownership has occurred. Therefore, if you don’t want to tip any shareholders off that a significant shareholder is dumping the stock, better to give yourself a longer leash and duck below the 10% requirement.
The second item, which is even more telling of what is to come for Pixelworks, is the contracted agreement between Becker Drapkin and Tourmaline Partners. Who is Tourmaline Partners? They provide trading and execution services to asset managers. This is from their website on services offered to mature managers like Becker Drapkin “Well-established managers typically have a different set of needs. With a fully-staffed internal trading desk in place, they usually turn to Tourmaline when the complexities of anonymity and liquidity become their overriding concern. In these cases, we serve as an extension of internal capabilities on a targeted basis, offering: complete anonymity, single point of access to multiple, deep pools of street liquidity.” So why did Becker Drapkin contract Tourmaline Partners? Well, the contract is for Tourmaline to sell shares of Pixelworks on behalf of Becker Drapkin starting…that’s right, today 3/7! Peculiar timing. See for yourself, the exhibit of the 13D Amendment and the 13D Filing. Pixelworks files its annual report revealing Apple as a major customer after market close on Wednesday, stock pops through the roof on Thursday, let the fire sale begin Friday. Sounds like the perfect plan.
Further, on 2/28, PXLW amended its stock trading plan and insider trading policy to persons who are not in possession of material, non-public information at the time the stock trading plan is adopted to establish prearranged written plans to buy or sell securities under specified conditions. Again, peculiar timing.
Keep in mind, Becker Drapkin still owns 2.2 million shares, and aside from yesterday’s trading session, Pixelworks has an average 3 month trading volume of ~500K shares per day, and it would take a week for PXLW to digest that trading volume. And I’m not suggesting Becker Drapkin did anything wrong here, as they did not buy any shares of Pixelworks in anticipation of the Apple announcement. I just find their recent activity and arrangements very interesting. The contracted sale of shares starting today, coupled with the desired anonymity behind trading through Tourmaline Partners and slipping just beneath the 10% ownership requirement, offers up a ripe situation for quick sell-off without tipping off other shareholders that the Company’s largest shareholder is exiting the stock.
A Quick Look at the Rest of the Business and Valuation
Even with the Apple as a customer in 2013, Pixelworks total revenue dropped 20% from $59.7M in 2012 to $48.1M in 2013, accelerating a declining revenue trend seen since 2010. The Company’s operating margin of (16.9%) is its worst since 2007. Ditto for its net income margin of (18.4%). Pay close attention to what happens when you remove the Apple-related revenue of $8.1M from the rest of the business. I assumed since the Apple revenue is a license of IP, the gross margin is 100%, so no reduction in cost of revenue. Also, the R&D behind the licensable IP is likely incurred as an expense prior to 2013, so no reduction in R&D either. What you’re left with a core business whose revenue dropped 33% from $59.7M in 2012 to $40.0M in 2013 and an even uglier loss position as its margins regress, with net income dropping further into the negative from ($5.7M) to ($17.0M) or 200%.
Let’s take a quick look at the competition Pixelworks identifies in its 10K for a comparable companies analysis. Note we can’t do a P/E or EBITDA multiple valuation given Pixelworks loss position.
Clearly Pixelworks is now trading at the top end of the group. On a business model and market cap basis, it may make the most sense to compare PXLW to players such as Silicon Image and Sigma Designs, of which both have better operating profiles and revenue growth than Pixelworks, but are trading at a significantly discounted value. PXLW current EV / LTM revenue multiple of 3.8x is its highest multiple valuation the Company has seen since 2004! If you use a normalized EV / LTM revenue multiple of 2.1x, which is the average of the comparables, see the table below for what happens to the diluted price per share. Clearly a significant discount from the $9.00 per share PLXW closed at yesterday.
You take away the “Apple effect,” which is a very likely scenario as described above and you’re left with a rapidly declining business generating a substantial loss as a percentage of revenue. You now understand that Becker Drapkin, Pixelworks largest shareholder, has methodically armed itself with the ability to start selling off shares in droves as of today. Pixelworks’ current valuation is its highest seen in a decade. All signs point to a significant short opportunity. As always, do your own research and you will be amazed at the depth of information available in publicly filed documents.
2014 Annotated Performance (share price and volume)