Pixelworks (PXLW): The Short Continuum

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The Alternative Activist has shorted Pixelworks three times for big gains. Find out why PXLW is the gift that keeps on giving. 

The Alternative Activist first wrote about the Pixelworks short opportunity in March 2014 after the stock rose 90% in one day on Apple hype (see original article). The rise was fraught with retail investor over-exuberance. Longs ignored the limited relationship with Apple, core business declines, history of unprofitability and activist investor Becker Drapkin all teed up to dump its entire 10% stake in the Company. The stock dropped 23% the next trading session and went on to drop 33%+.

The Apple hype returned four months later in July 2014 and no amount of hate mail generated from the article could deter me. I shorted again on the same diligence and pocketed another 33% gain in two weeks.

2014 Annotated Stock Chart

PXLW went on to drop further still and toiled in obscurity until June 2015, when it was time to short yet again. The Pixelworks short continuum is the gift that keeps on giving. This time it was more hype around the Taiwanese-based ASUS announcing a design win for Pixelworks’ IRIS mobile display processor chip. This was the first customer to publicly acknowledge IRIS, which will be incorporated into ASUS tablets. ASUS is the #4 worldwide tablet player, but is only estimated to have ~4% of the worldwide tablet market share due to Apple dominance and a plethora of competitive offerings (Source: IDC). PXLW rose 43% in one week, closing at $7.12 on June 5, 2015.

Before we pick apart the latest hype cycle, to fully appreciate Pixelworks’ struggles, look no further than the unfortunate decade of revenue declines and abysmal return on invested capital in the chart below:

Picture1

After record revenue in 2004, Pixelworks borrowed $150M to ramp its business even further, but instead watched its revenue decline at a CAGR of 10% since. 2004 also marked the last time PXLW turned a real profit. As such, the Company has continued to tap shareholders for small, dilutive follow-on offerings to bridge losses. Its troubling that those overseeing this crumbling business have not been held accountable–half the current board has been around since 2005, including CEO Bruce Walicek, who officially came down from the board to take the CEO reins in 2008. No wonder Pixelworks caught the attention of activist investor Becker Drapkin. However, as I accurately predicted, Becker Drapkin dumped all its shares in March 2014 and is no longer represented on the Board. Albeit there is some new blood on the board, shareholders are still stuck with the same underperforming CEO and board members that quickly capitulated to activist demands as they knew a proxy battle would be a DeAndre Jordan-sized dunk.

Here is a current financial breakdown: PXLW Snapshot

What is IRIS?

Pixelworks’ core business is video display processing chips for large screens (projectors, TVs) and IRIS is the Company’s extension of its technology to mobile devices. Like any newly announced semiconductor chip, it reduces power consumption and enhances quality/performance. Pixelworks has been hyping the new product for over a year and is currently touting design wins, with mass production expected for 2H 2015 (PXLW originally exclaimed mass production in 2H 2014 when the product was announced in June 2014, but I digress).

No one disputes the market opportunity, which is the proliferation of mobile video and consumer demand of faster processing speeds and higher quality displays anywhere, anytime. But let’s be clear, Pixelworks is not the only semiconductor company chasing this opportunity. Notable competitors such as MediaTek, Qualcomm, NXP and Imagination Technology are all in the game. MediaTek is pushing what it calls Clear Motion technology by running video display processing in its octa-cores pipeline. Similarly, Qualcomm is promoting a video processing engine called Hollywood Quality Video for a broad range of devices, including smartphones, tablets, set-tops and TVs. NXP has been pitching the idea of bringing the living room HDTV experience to mobile by running its video sharpening software algorithms on mobile platforms. Imagination believes display processing and video post-processing in mobile devices is best handled in the graphics pipeline.

Semi’s is a tough industry. Any major market trend will certainly have competition, and in PXLW’s case, those competitors have many more resources, capabilities and better operating models. MediaTek, Qualcomm and NXP all have market caps greater than $20 billion and are profitable with EBITDA margins greater than 20% (while Pixelworks is unprofitable and has a LTM EBITDA margin of -12%). Of the companies that Pixelworks identifies as competitors in its 10K, almost every single one has significantly more scale and better operating margins (PXLW Comps).

Semi customers are a fickle bunch as well. It rarely matters if you have the best product on the market, what truly matters is how low you are willing to sell a product that is good enough to fit the spec. Any new innovation is typically a race to the pricing bottom–a race that always favors the good operators with scale.

Although history is no predictor of the future, why should we believe IRIS is the home run product for Pixelworks?

  1. Can Pixelworks produce it profitably? Pixelworks core business is digital projection, which accounts for ~90% of revenue and is running at ~$50M/year. Management believes it has 50% market share. If leadership is based on technology, a prudent investor should expect the market share leader to leverage its tech advantage and customer relationships into pricing power, thereby charging more for its products. However, Pixelworks hasn’t churned a true profit since 2004. Perhaps the reason PXLW is the market share leader is that competitors don’t see the value in pursuing a low TAM opportunity that loses money. If market leadership doesn’t = profits, the outlook for IRIS amongst competitive giants appears unlikely.
  2. The growth potential of digital projection appears to have been largely exploited. As with any industry that undergoes rapid change, Pixelworks management has the tough job of continuing to innovate and develop new products that will further increase total sales potential. Since the CEO took over in March 2008, Pixelworks has spent more than $200M in R&D and capex (while their market cap sits at ~$135M), so you can’t blame them for not trying. IRIS wouldn’t be the first time management got excited about an adjacent market opportunity. As an example, long-time Pixelworks investors are still waiting for the promising markets of smart TVs, 3D technology and 4K resolution TVs to bear fruit…
    • 04/20/2011 Earnings Call: “The trend towards smart connected TVs…the market for advanced video processors in 2012 is projected to be a $500 million market and represents a large growth opportunity for Pixelworks.”
    • 10/20/2011 Earnings Call: “Regarding what we are seeing in the advanced TV market…more high performance video processing such as 4K by 2K resolutions, glasses free 3D and fastest 3D panel technology are becoming mandatory for next-gen systems. These trends are continuing to drive the need for separate video processors and creating opportunity for Pixelworks.” 
    • When pushed by an analyst on TV market developments, this didn’t sound too promising…10/30/2014 Earnings Call: “One thing I will say about the [4K resolution TV] market and the way it’s developed, it has largely turned out to be a China market in terms of the bulk of the market; 60% — 60 maybe greater percent of 4K TVs are going into China. A lot of those tend to be very low price points and very sort of commoditized ones that don’t have a lot of video processing or high-quality video capability.”
      • So let’s get this straight…the big TV innovation is being adopted at a very low price point that doesn’t make sense to include Pixelworks high-end (read: costly) technology. Consumers are getting by with “good enough” solutions and the reprehensible commoditized word was used. Don’t worry, it still has a lot of promise for Pixelworks…
    • 02/05/2015 Earnings Call: “Another driving factor is the ongoing progress in new display technology, as the industry accelerates advancements with no end in sight. The entire video ecosystem will upgrade to 4K resolutions in the coming years, and we are just at the beginning of a multiyear transition to more capable displays across all screens.”
    • Pixelworks doesn’t mention smart or 3D TVs anymore. Despite the grandiose growth claims, the TV and panel revenue is running at less than $8M/year as of Q1’15.
  3. Despite the historical challenges, does management talk just as freely to investors about its affairs when things are going well vs. when trouble and disappointments occur? After reading the transcripts since 2011, management is quick to credit blame to bad luck, frequently bemoaning the difficulties of its environment:
    • When the word “below” or “difficult” was used in the context of quarterly results below expectations, the following reasons were used: slow environment, customer inventory corrections, lower visibility, customers working through inventory overhang, floods, earthquakes, Japanese FYE
    • The word “disappointing” has been used just once, for a quarter where year-over-year revenue dropped 40%+: worse-than-normal seasonality, difficult demand environment, severe inventory correction, timing issues
    • The word “execution” or “execute” was used 28 times, but never in a context for a lack of execution.
    • Shareholders deserve more than being placated with generic explanations for a decade of revenue declines and unprofitable operations, increasingly negative returns on capital, dilutive share offerings and big spend on R&D for unfulfilled potential and over-hyped market opportunities. Since Bruce Walicek was named CEO on 03/31/08, over $200M spent has been spent on R&D and capex, and the reward has been revenue dropping from $85M to $60M (-5% CAGR). To be fair, the market cap has increased $105M, but the reason for writing this article is measuring how much of that gain is illusory. I know that R&D and capex are investments to be realized in the future, but based on everything that has been laid out above, I will be there to short if shareholders decide to get overly excited about the future again.

Of course the risk to this short thesis is that the IRIS solution is finally what drags Pixelworks out of the doldrums of small cap purgatory. There is also the risk PXLW gets acquired. YTD semi’s M&A activity has been out of control and bigger semi’s companies take out smaller, unprofitable competitors all the time, should those targets have promising technology. For me, it’s the same old story. Retail investors are all over this stock and jack it up on any “promising” news. It has come back down from the $7.00/share range, but put this stock on your watch list and join the short continuum. You never know when the next headline will undeservedly shoot the stock up again, again, again…and again.

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