Note: This report has substantially new material. Subsequent reports will have changes highlighted.
Overview
Pennsylvania-based Agere Systems Inc. (AGR-A) designs, develops, manufactures and sells integrated circuit solutions for applications such as high-density storage, mobile wireless communications and enterprise and telecommunications networks. These solutions form the building blocks for a broad range of computing and communications applications. Some of the company's solutions include related software and reference designs. Its customers include manufacturers of hard disk drives, mobile phones, high-speed communications systems and personal computers (PCs). The company has realigned its business into operating segments that focus on four target markets: Storage, Mobility, Enterprise and Networking, and Telecommunications. The company has two reportable segments: Consumer Enterprise and Telecommunications. Important customers of Agere include Apple, Cisco, HP, Lucent, Maxtor, NEC, Nokia, Samsung, Seagate, and Western Digital.
For more information about the Company, please visit its website: www.agere.com
The analysts have identified the following factors for evaluating investment merits of AGR.A:
Key Positive Arguments / Key Negative Arguments· Once the semiconductor arm of Bell Labs, Agere is one of the leaders in the desktop HDD and wireline network IC segments. / · Agere has several notable products, but the company lacks execution and focus. Hence it is finding it difficult to maintain its market share.
· The company reorganized its business into four segments. It also took steps to lower headcount and cease operations at its Orlando fab facility. Margins are expected to improve in the long run. / · Visibility is limited due to heavy reliance on a few customers, primarily within HDD and wireless segments. Several of AGR.A’s large customers are experiencing unusual pricing pressure and high levels of channel inventory.
· Proposed reclassification of shares and reverse stock split are expected to reduce common stock-related expenses, thereby improving EPS. / · Operating expenses may increase due to recent acquisitions. Difficulties in integrating these acquisitions may adversely affect forecasts.
· The company’s cash flow has been positive for the past few quarters, and it is expected it will not have to secure additional sources of funding at this point of time. / · Sales may be stalled due to high levels of inventory especially at OEM customers and at distribution partners.
Among the 8 analysts covering AGR.A, 1 has given a positive rating, while the remaining 7 have given a neutral rating.
NOTE: The company’s fiscal year ends in September and all the quarterly and annual references are to be construed accordingly.
Sales
Sales for 2Q05 were $417.0 M, down 9.7% YoY, but up 1.7% sequentially. Performance for the quarter was in line with company’s guidance in January.
From an end market perspective, Mobility, Storage, Enterprise & Networking, and Telecom accounted for 21.0%, 36.0%, 27.0% and 16.0% of revenues respectively, compared to 20.0%, 41.0%, 25.0%, and 14.0% in the prior quarter. The Storage segment was down 10.0% sequentially and was the only business segment that declined on a sequential basis. An aggressive pricing environment and product mix were cited as the primary factors driving the sequential decline. Despite this decline, Agere’s Storage business continues to be ranked with tier-I customers such as Maxtor and Seagate, both of which were greater than 10.0% customers during March quarter. The Mobility segment was driven by increased shipments of 2.5G standard product shipments to Samsung. Growth in Enterprise and Networking segment was primarily due to increased shipments of digital satellite radio chips for Sirius and computer-oriented custom products.
The company expects 3Q05 revenues to be in the range of $415-$435 M. Storage revenue is expected to be flat but Mobility, Telecom and Enterprise and Networking revenues are all expected to see single digit sequential revenue growth in Q3. Additionally, the management announced a broadening of AGR.A’s existing relationship with Western Digital, beyond preamplifiers, to include storage SoCs for future drive designs. Revenues are expected to see an upside, based on this program win.
Provided below is a summary of total revenues:
2Q04A / FY04A / 1Q05A / 2Q05A / 3Q05E / 4Q05E / FY05E / FY06EDigest High / $462.0 / $1,912.0 / $410.0 / $417.0 / $431.9 / $455.0 / $1,712.0 / $1,905.0
Digest Low / $462.0 / $1,912.0 / $410.0 / $417.0 / $425.0 / $446.0 / $1,697.0 / $1,792.0
Digest Average / $462.0 / $1,912.0 / $410.0 / $417.0 / $428.0 / $450.4 / $1,703.8 / $1,854.8
Zacks Consensus / $428.0 / $452.0 / $1,703.0 / $1,879.0
For more color on Sales by individual analysts, refer to the ‘Consensus’ tab of the AGR.A spreadsheet.
Margin
Gross margin for 2Q05 was 43.9%, down 12.5% YoY, but up by 0.5% sequentially. This was in part due to decline in storage revenue. Operating margin improved slightly to 2.4%, maintained at same levels YoY, and up 25.0% sequentially. Operating margin gained as opex improved slightly, benefiting from lower design expenses. Gross margin is expected to be nearly 45.0% in the coming quarter.
Plans to close the company’s Orlando facility remain on track and the closure is expected to take place in 1Q06. Due to the fab closure, the management expects the Orlando facility to be underutilized during the last quarter of operation. Consequently, gross margins are expected to be negatively impacted during 1Q06. However, in the quarter following the closure, one analyst expects (MorganStanley) gross margin to recover and gain additional cost efficiencies from the closure.
Provided below is a summary of expected maximum and minimum margins:
2005E / Gross / Operating / Pre-Tax / NetDigest High / 45.0% / 4.1% / 2.7% / 1.3%
Digest Low / 44.5% / 3.6% / 2.1% / 0.8%
2005E / Gross / Operating / Pre-Tax / Net
Digest High / 47.0% / 9.2% / 8.1% / 6.8%
Digest Low / 45.3% / 6.5% / 5.6% / 4.3%
Provided below is a summary of margins:
2Q04A / FY04A / 1Q05A / 2Q05A / 3Q05E / 4Q05E / FY05E / FY06EGross / 45.0% / 45.3% / 44.4% / 43.9% / 45.2% / 45.6% / 44.7% / 45.8%
Operating / 2.2% / 5.1% / 2.0% / 2.4% / 4.1% / 6.6% / 3.8% / 7.8%
Pre-Tax / 0.9% / 3.3% / -0.5% / 1.2% / 3.1% / 5.6% / 2.4% / 6.8%
Net / 18.0% / 6.4% / -2.0% / -0.2% / 1.9% / 4.4% / 1.1% / 5.6%
For more color on Margins by individual analysts, refer to the ‘Consensus’ tab of the AGR.A spreadsheet.
Earnings Per Share
Agere recorded a net loss of $1.0 M in 2Q05, up 101.2% YoY, but down 87.5% sequentially. That gave an EPS of $0.00, which remained flat both sequentially as well as YoY. GAAP EPS for the quarter was ($0.04), down 200.0% YoY, but remaining flat sequentially. The Proforma EPS came in above most of the analysts’ forecasts as also above the Street estimate of ($0.01). Higher revenues in most segments and improved opex boosted EPS.
The majority of the analysts have guided up their respective EPS estimates for the third quarter based on better than expected 2Q05 results, improved management guidance ($0.00-$0.02) and expected cost efficiencies related to fab closure.
With shareholders’ approval to reclassify two classes of stock into a new, single class of common stock, and a reverse stock split, EPS should go further up due to savings in certain common stock-related expenses. EPS is expected to breakeven or be above that level in the coming quarter.
Provided below is a summary of EPS as given by Zacks Digest:
2Q04A / FY04A / 1Q05A / 2Q05A / 3Q05E / 4Q05E / FY05E / FY06EDigest High / $0.00 / $0.02 / $0.00 / $0.00 / $0.01 / $0.01 / $0.02 / $0.08
Digest Low / $0.00 / $0.02 / $0.00 / $0.00 / $0.00 / $0.01 / $0.00 / $0.02
Digest Average / $0.00 / $0.02 / $0.00 / $0.00 / $0.00 / $0.01 / $0.01 / $0.06
Zacks Consensus / $0.01 / $0.06 / $0.01 / $0.06
For more color on Earning per Share by individual analysts, refer to the ‘EPS’ tab of the AGR.A spreadsheet.
Target Price/Valuation
The average Zacks Digest target price is $1.67. Prices range from $1.50 (D.A. Davidson, Deutsche Bank) to $2.00 (Lehman). Most analysts have used an EV/Sales multiple except one (D.A Davidson) who used the P/E multiple.
The highest target price of $2.00 (Lehman) is based on an EV/Sales multiple of 1.9x CY05 sales. He feels the stock has minimal risk at current price levels.
The lowest target price of $1.50 (D.A. Davidson) is based on a P/E multiple of 25x FY06 EPS estimate. Although AGR.A trades at 1.4x his FY05 revenue estimate, he believes upside is limited until Agere outlines a long-term strategy and executes for several consecutive quarters.
One analyst (Thomas Weisel) holds the opinion that Agere already trades at a discount to its peer group. He believes that the shares are relatively attractive and that further restructuring should build potential upside to them.
For more color on valuation and target price by individual analysts, refer to the Valuation Tab of the AGR.A spreadsheet.
Long-Term Growth
The long-term growth ranges from 10.0% (D.A. Davidson) to 20.0% (Thomas Weisel), giving an average of 14.6%.
Despite a diverse set of products, Agere’s visibility remains limited due to its heavy reliance on a few customers, primarily within the HDD and wireless handset sectors. Despite strong unit growth within the HDD industry, Agere does not appear to capture the same level of momentum. The company has failed to maintain market share, and has lost its technical advantage to companies such as Marvell, Philips and Broadcom.
Agere faces an uphill battle as it tries to find and successfully hold a leadership position within a specific segment. Competition comes from two major areas. The first group consists of companies that have developed strong market positions and technological advantages in specific areas where Agere competes. The second group consists of low-cost overseas vendors. While one analyst (D.A. Davidson) believes Agere has strong intellectual property that it can leverage into new markets, such as consumer electronics, the company must use its current round of restructuring to refocus on high-growth markets.
The company announced last month that it has an SoC design with Western digital for a future drive platform. Although it did not give additional details on that, one analyst (Thomas Weisel) believes this should provide AGR.A with growth opportunities. Agere is also expected to grow on Toshiba drives across multiple platforms and is currently ramping its preamplifier and read channels on Samsung desktop drives.
Other
· Agere announced that its board of directors has approved plans to consolidate its Class A and B common shares into a single class of common stock, which will trade under the ticker “AGR”. This action should become effective on May 27, with first day of trading on May 31. The resulting capital structure will be 181 M common shares with expected savings of approximately $2.0 M per year. This should also eliminate potential confusion over the two classes of shares.
· The company also announced that the board approved for a 1-for-10 reverse split. One analyst (Merrill) expects it to be effective on May 27th. This should reduce the company’s long-term common stock administration-based costs, and allow incremental revenues to have a more meaningful impact on EPS results.
· Although cash and cash equivalents decreased sequentially by around $11.0 M., one analyst (D.A. Davidson) believes that Agere has been cash flow positive for the past six quarters, and feels that the company will not have to secure additional sources of funding at this point of time. The decline in cash during the March quarter was primarily due to Agere’s acquisition of Modem Art, according to another analyst (Morgan Stanley).
· Other liabilities of AGR.A include the company’s pension benefits to its U.S employees. It contributed $40.0 M to the pension plans in the March quarter and anticipates adding a further $35.0 M to the plan in FY05. The company believes the plan is fully funded and does not anticipate any required pension contributions for FY06 or FY07.
Recent Events
Date / Event / CommentsMay 27, 2005 / Consolidation of two classes of shares into one common stock; 1:10 reverse stock split / Earnings should increase with savings in common stock-related administration costs.
May 2, 2005 / Agere Systems Announces world's first integrated offering to enable convergence of current, future wireless network deployments / Global savings potential of new Agere Solutions to service providers estimated at $300 Million
May 3,2005 / Agere Systems announces gigabit ethernet solution for businesses / 10 Times faster performance at a fraction of the cost
Individual Analyst Opinions
POSITIVE RATINGS
Thomas Weisel – Report Date: May 10, 2005 – The stock is rated Outperform with no target price.
Agere continues to trade at a discount to its peer group (1.1xTEV/CY06 sales versus 4.0x). The analyst believes that the shares are relatively attractive and that further restructuring and potential upside from the company’s infrastructure business could drive leverage in the P&L model in CY06.
NEUTRAL RATINGS
C.E.Unterberg – Report Date: April 27, 2005 – The stock is rated Market Perform with no price target.
While Agere is heading in the right direction with fab restructuring and stable revenue base, the investors will prefer to “wait and see” with weakness in the HDD business. The analyst expects meaningful HDD growth beginning Sep’05 qtr from micro drives solutions.
D.A. Davidson – Report Date: April 26, 2005 – The stock is rated Neutral with a price target of $1.50.