Buy side interview

Are they planning on reading this in the room or are you sending it to them before the interview?

Rule of thumb for a broad pitch (to me anyway) has always been to keep it like a woman's skirt: just long enough to cover the topic but short enough to keep things interesting. I'd suggest going with 1 page per idea.

Agree on 1 pagers and make them all text.

You can have all your charts, graphs, tables with you if they want to see how you got to your valuation, EPS estimates, etc., but don't waste room talking about how the math works.

Start with the conclusion - "BUY XZY on succinct reason with xx% upside". (Note - if you can't sum up the reason for your recommendation, you either have a weak thesis or you aren't conveying it well).

They are reading from the room

What kind of valuations should I include? I'm doing long short equity trades

Thanks again guys!

This one is a little lengthy, but it should give you an idea of where to start. This write up covers Tessera Technologies (TSRA) and was the top idea for the week of November 12th on SumZero.

Thesis

Please refer to the attached PDF for additional exhibits. Feel free to contact me at [email protected] with any inquiries, either about Tessera or other names that I cover.

EXECUTIVE SUMMARY: I recommend a LONG position in Tessera Technologies (TSRA), with a 12-18 month price target of $22.50/share (+60% expected return). BACKGROUND & CONSENSUS VIEW: Founded in 1990 and headquartered in San Jose, Tessera is a holding company with operating subsidiaries in two segments. The IP segment (80% of 2012E revenues) holds 2,000+ patents for semiconductor packaging, most of which have been internally developed. Tessera licenses these patents to over 70 companies in DRAM and related industries, and obtains 99% gross margin on its royalties. The DigitalOptics segment (20% of 2012E revenues) develops and aims to commercialize MEMS (micro-electromechanical system) cameras for smartphones. MEMS is expected to be the basis for next-generation smartphone camera modules, which management believes could become a $9 billion market someday. Tessera shares are down 30% from their 52-week high of $20.34, which was achieved in February. In my view, there are two main reasons for the decline in share price. First, although DigitalOptics is on track to ship its first MEMS camera modules in early 2013, its efforts to vertically integrate have continued to necessitate significant capital expenditures and R&D investment. Consensus has grown concerned about the resulting negative divisional operating margins to date, as well as Tessera’s ability to execute on a product-driven strategy. Secondly, the IP segment had lost two key licensees in Powertech and Micron in 2Q12, and consensus has developed undue skepticism about Tessera’s ability to litigate despite its strong historical track record. Tessera is only covered by one sell-side analyst (Merrill Lynch), who has issued Underperform rating and $13.50 price target. INVESTMENT OPPORTUNITY: I believe Tessera shares are significantly undervalued. My investment thesis has been informed not only through my assessment of Tessera’s SEC filings and publicly available licensing agreements, but also through several proprietary diligence conversations with senior industry professionals and patent attorneys. A fundamental mispricing exists for several reasons: (1) Tessera holds ~$9/share in cash and equivalents with zero debt. If Tessera were to earn an ICC arbitration settlement award from Amkor of at least $125 million (which is expected in the coming months, as the ICC issued an interim ruling in July that Amkor owes Tessera royalties on three key patents due to breach of license), this would contribute an additional $2.41/share, bringing total cash and equivalents to over $11/share (~80% of current share price). I believe this sub-optimal capital allocation exists because an excessive amount of cash is being held by management as a “litigation war chest” against potential IP infringers. Much of this cash is being encumbered by the DigitalOptics business given its substantial vertical integration costs to date. DigitalOptics has also been a distraction for both the company and shareholder base given its strategic and financial differences with the IP segment. However, DigitalOptics could also be spun off within the 12-18 months, which could significant value for shareholders. This significant cash base also provides margin of safety and an asymmetric risk profile, which I will expand upon in points #2 and #3. (2) Consensus has overreacted to the recent termination of Powertech and Micron licenses (who accounted for 25% and 19% of company revenues in 2011, respectively) and the slowdown in the DRAM market. While Powertech is unlikely to renew with Tessera, I believe Micron will renew in 2013 after it completes its acquisition of the now-bankrupt Elpida, and could potentially be in negotiations with Tessera already. Normally, one would have expected Tessera to file for patent infringement immediately after the expiration of the previous licensing agreement on May 23. However, the fact that Tessera has not sued suggests that a new agreement is being negotiated in my view. Moreover, the two leading DRAM manufacturers, Samsung (43% market share) and Hynix (24% market share), have already signed licenses through 2017. Therefore, Micron cannot afford to avoid license renewal without risking the threat of litigation. With regard to the current DRAM over-supply, consensus currently expects DRAM industry capex to decline 10-15% through 2013. However, I believe this forecast may be too pessimistic. Samsung, Hynix, and Taiwanese DRAM companies have been moving quickly to eliminate excess capacity. Micron’s takeover of Elpida should drive further industry rationalization, especially since Micron plans to convert a meaningful portion of Elpida’s production to non-commodity DRAM. Notably, Micron’s takeout of Elpida (expected to close 1H13) would give it 24% of the worldwide DRAM market, putting it in-line with Hynix and trailing only Samsung. Although it may take longer for DRAM prices to recover versus volumes, this is less of a concern to Tessera since it earns $0.01-0.02 for every chip-scale package its customers ship, irrespective of the price that its licensees charge for the DRAM unit itself. In the medium to long term, Tessera’s patent portfolio also has additional legs of growth in the form of xFD and 3-D packaging, which could be used in emerging memory applications and provide additional royalties that are not currently captured in consensus estimates. The emergence of a DRAM oligopoly, where three firms control over 90% share of the DRAM space, gives me even more confidence that consensus is too pessimistic about their DRAM market outlook, especially since DRAM prices have begun to stabilize. Furthermore, with the shift in industry mix away from commodity DRAM towards mobile and value-added memory solutions (e.g. SSD and embedded memory), competition in the commodity segment – where most of Tessera’s current IP royalty streams are derived – should further abate in the coming quarters and lead to improved market dynamics. Under very conservative assumptions that 1 the current DRAM oversupply and pricing pressures do not abate until late 2013, 2 a 1H13 renewal of Micron at half of its previous royalty rates, 3 no further revenues from Powertech, 4 zero favorable outcomes of pending IP litigation (wherein Tessera is predominantly the plaintiff and has a strong track record of litigious success), and 5 a terminal growth rate of negative 5% from 2018+ to reflect the aging of the current patent portfolio with slight offsets from potential monetization of xFD and 3-D packaging technologies, I estimate the present value of the IP segment to be $6/share. Moreover, at current valuation, investors get a call option on any upside in the IP business as well as the DigitalOptics segment for free. (3) Management’s decision to transform DigitalOptics from a licensor of legacy voice-coil IP to a fully-integrated product manufacturer of MEMS smartphone cameras over the last year has created a significant rift among its shareholder constituents. While the IP segment (Tessera’s legacy business) carries 99% gross margins and a strong set of royalty streams from most major DRAM manufacturers, the DigitalOptics segment comes with some execution risk. First, although MEMS is widely believed to be a disruptive, value-added technology for smartphone cameras given its superior mechanical and imaging capability versus legacy voice-coil technologies, the timing of a full-scale product launch remains uncertain. Secondly, Tessera’s efforts to vertically integrate in DigitalOptics has created a major drag on the bottom line: compared to the IP segment which carries operating margins of nearly 50%, the DigitalOptics segment has required over $100 million in annual capital expenditures and R&D expenses since 2009, leading to massive divisional operating losses and EPS dilution. Lastly, I estimate that MEMS camera modules will carry gross margins of 25-30% based on conversations with industry contacts that are knowledgeable about smartphone camera technologies. These three factors have led to disagreement among Tessera’s investors, and have been a driving force for the company to explore a spin-off of DigitalOptics. DigitalOptics may not be the best fit for Tessera, but could someday have substantial value as a standalone company or even to a strategic acquirer. Possible acquirers could include a leading buyer of consumer and mobile MEMS devices (e.g. Samsung, LG, Apple), or a camera component manufacturer or integrator that wants to obtain an emerging technology (e.g. Omnivision, Aptina, Sony, Largan). The camera module integrator market represents a $9 billion market opportunity that is highly fragmented, and there is presently no dominant player or vertically integrated manufacturer across lens, actuators, camera design, and image enhancement technologies. Tessera is furthest along in its efforts to vertically integrate as a MEMS smartphone camera maker, and is on track to ship its first product to a Tier 1 OEM customer by the end of 2012. Based on the value of its fixed assets, IP portfolio and employees as well as discounted cash flow calculations, I conservatively estimate the present value of the DigitalOptics segment to be at least $5/share. A successful sale or spin-off of the DigitalOptics business would unlock significant value for shareholders and enable Tessera to pay a one-time dividend via its cash, the majority of which is domiciled in the United States (hence there would be negligible repatriation taxes). It would also liberate Tessera from further cash burn and allow the company focus on its legacy chip-scale packaging IP business. There is reason to believe that the likelihood for a spin-off is more probable now than ever, since 1 Tessera’s board of directors voted to restructure CEO incentive compensation to explore a spin-off of DigitalOptics, and 2 management has reiterated that it is on track to ship MEMS camera modules starting in early 2013. VALUATION: Based on a sum-of-the-parts analysis provided on the last page of this report, I estimate the fair intrinsic value of Tessera to be ~$22.50/share ($6 for IP segment, $5 for DigitalOptics segment, and $11.50 in cash and equivalents). POSITIVE CATALYSTS & EVENT PATH: Numerous catalysts could drive upside in Tessera’s current stock price: (1) Spin-off or sale of DigitalOptics in 2013-2014 (in October, the board of directors restructured the CEO’s compensation such that the equity portion would be contingent on a successful spin-off) (2) Micron IP license renewal (expected 1H13) (3) DRAM market recovery (expected by 2H13) (4) Favorable outcomes for ongoing IP litigation, where Tessera is asserting breach of contract or patent infringement against a number of DRAM manufacturers or subcontractors; my model assumes zero revenues or settlement payments going forward, so any incremental positive outcome would provide upside to my estimates (5) Disbursement of excess cash to shareholders via one-time special dividend (6) Share buybacks (Tessera has only used 10% of its $100 million allocation under its 2007 share repurchase plan) (7) Shareholder activism – Tessera’s corporate governance is ripe for activist improvement, as management and insiders only own 1.7% of the company, the board is single-class with annual elections, seven of eight directors are over 60 years old, and several of them have already retired professionally. Given the governance situation and past activist activity, future activism could serve as a key agent of change, especially with respect to a DigitalOptics spin-off. DOWNSIDE RISKS & MITIGATING FACTORS: (1) Tessera could lose another key customer --> My view: I believe this risk is mitigated by the fact that Samsung and Hynix, the two largest DRAM manufacturers, have already signed licensing agreements through 2017, albeit at about half of the royalty rate under their previous agreements. I also expect Micron (19% of Tessera’s 2011 revenues) to sign a new licensing agreement around the time that they complete their acquisition of Elpida in 1H13. I believe Powertech (25% of Tessera’s 2011 revenues) will most likely refuse to sign a new licensing agreement, but this is already factored into expectations as consensus expects zero future revenues from Powertech. Importantly, any judgment favoring Tessera in its ongoing dispute with Powertech regarding breach of contract (discovery date in January 2013; prospective trial date in April 2014) could yield significant upside for Tessera in the form of legal settlement payments. (2) Litigation risk exists if federal courts rule in favor of Tessera’s customers or competitors, specifically saying they did not infringe on Tessera’s patents or breach Tessera’s contract. --> My view: Unfavorable legal outcomes are a standard risk that Tessera or any IP-based company faces. Litigation is inherently uncertain, but prior rulings by federal courts or international arbitration panels regarding key patents have generally been favorable to Tessera. In many cases, Tessera has also settled with its defendants before an actual trial. (3) Tessera continues to hoard cash instead of reinvesting it for higher-ROI projects or distributing it to shareholders --> My view: Tessera announced in October 2012 that its board of directors and compensation committee modified the CEO’s incentive plan to motivate him to explore a spin-off of DigitalOptics. Management could also sell DigitalOptics to a strategic acquirer, wherein the range of possible acquirers is highly underappreciated by consensus. In my view, potential acquirers could include leading buyers of consumer and mobile MEMS devices that have historically considered vertical integration (such as Samsung or LG), a major supplier of CCD/CMOS such as Omnivision and Aptina that may aspire to enter the MEMS business but presently do not have in-house capabilities, or a camera module integrator such as Largan Precision that wishes to become an end-to-end provider of next-generation mobile camera units. Furthermore, although management has historically defended its decision to hoard cash as a “litigation war chest,” I believe that recent earnings calls reveal that Tessera is considering how to better deploy its cash. (4) DigitalOptics’ MEMS technology takes longer than expected --> My view: This is why DigitalOptics is considered a high-risk, high-reward business. After all, Tessera has historically been a licensing company and frankly has a mixed track record in product execution despite promising technology (e.g. silent air cooling). However, I believe there are two key factors that mitigate DigitalOptics execution risk. First, management noted on its 3Q12 call that will have its first Tier 1 OEM customer signed up by the end of 2012, and that it remains on track to ship its MEMS camera modules starting early 2013. Secondly, the CEO has been now incentivized to spin-off this segment, which would eliminate the risk posed to investors that want to own only the legacy IP business.

Should I include news that involve the company, expansion, merger plans, etc

For example: They have a lucrative deal coming up and they expect EPS to rise, something like that

Since I am doing long short pair trades, I guess P/E is one of the key things to include to determine, what other things might I include?

Sorry for all the questions; first time doing a report like this

@captainkoolaid

Thank you very much, that's very useful for getting a sense of the format; albeit a bit long lol

Are they making you do this before they have even met you? As in, is this your first round?

@ixjunitxi, it's 2nd round

Already went through 1st, I already had stock pitches ready just in case but I wasn't sure how it was done in report format

Wondering what are some of the important metrics/valuations that I should include for this report?

I mainly talk about P/E and EPS should I include anything else?

Metrics - why does one trade at premium P/E versus the other? earnings growth, rev growth, margin expansion, etc. So touch on whichever metrics are key to your thesis on why they are mispriced.

I assume since you say P/E that these stocks don't trade on EV/Rev or EV/EBITDA.

No need for deal comps and probably not trading comps since this is a pair trade.

Do I include holding period as well?

Thanks for all the advice guys, really helpful