Why the Market Is 100% Wrong About Silicom

When a company beats earnings estimates by about 8%, on revenue that was up 26% (year over year), you don't expect the stock to drop 20%. But on April 24, that's what happened to Silicom . Let's take a look at why this was a really good quarter and why it was misunderstood by the market. 

The reasons for the market beatdown were two-fold. Generally, Silicom only experiences a 10% drop in sales between its first and fourth quarter. But because of lumpiness -- by way of an outstanding fourth quarter -- its first quarter revenue was down 25% sequentially. 

Second, its tax rate increased to 14.1% from 9.3% due to a change in Israeli tax law. So the $0.57 it earned per share would have ticked up to around $0.61 if its taxes did not more than double. It's hard to fathom why these two events would cause the stock to lose about $100 million of market cap, but sometimes the market is a voting machine. Fortunately, over time, the market is a weighing machine.

Source: silicom-usa.com. An intelligent bypass switch.  

The real story
Already the stock is up about 8.5% from its low on earnings day. Perhaps the market is realizing that Silicom's operating expenses grew a measly 16%, well behind its 26% sales increase. Maybe it sees that Silicom expanded its gross margin by 50 basis points to 40.8% year over year. Perhaps it's just starting to sink in that its operating income was up 37% year over year. This was a good quarter.

There's plenty of positive developments going on with its business, too. It just launched a virtualization offloading product, called the SmartSilc VHIO. Once you sort through the noise of the solution, it basically frees up a CPU to do other things. From CEO Shaike Orbach during the conference call:

It is based on a completely new concept that addresses the offloading challenge in a unique way, offloading some of the CPU consuming tasks which are directly associated with virtualization. It is the first of a family of unique cloud solutions which are geared for resolving the specific load caused by virtualization part of the cloud solution. The product operates under OpenStack umbrella, an emerging cloud management standard which is gaining significant industry traction. SmartSilc VHIO offloads all network and storage input/output tasks from the Hypervisor significantly reducing CPU utilization and consequently improving the performance of any compute node in which it is installed.

For OEMs like Cisco , this is critical. When it comes to the cloud and virtualization, getting more bang for your buck from a CPU is increasingly important. If Cisco can offload encryption and compression tasks to a Silicom hardware accelerator, it will save on cost, space, and be able to better manage power.

This allows Cisco to focus the attention of a CPU on other tasks thereby improving the performance of the system. Multiply this exponentially and we're talking about a serious cost savings and performance improvement for Cisco. It also opens the door for more mutually beneficial partnerships for Silicom and Cisco down the road. 

Orbach goes on to say that he believes the SmartSilc VHIO should become a meaningful revenue stream and will be another important growth driver for the company. This is yet more evidence that management has an uncanny ability to spot trends. Specifically, it's compression offering is focusing on the Hadoop market.

If you're not familiar with the term Hadoop you're missing out. It's used in big-data analysis and it's a processing technology. Right now, it's a $2 billion market. By 2020, it's projected to be a $50 billion market, that's almost a 60% growth rate per year. And Silicom will be there, offering solutions to capitalize on the boom.

Source: Allied Market Research.

A word about valuation
So you should expect to pay an arm and a leg for a business and management team of this quality. According to Yahoo! Finance, you can get Silicom for 21 times earnings and 15 times forward earnings. That's cheap for a $350 million company growing its profits an average of 38% over the last five years, but there's more to consider.

One of the hardest things to project is the growth rate of a business. It helps to focus on Michael Mouboussins' price-implied expectations, which determine what growth rate is needed for today's price to be fair. For Silicom, we can use a conservative $17 million in structural free cash flow, with a 10% discount rate, and a 3% terminal rate. Silicom only needs to grow 6% for the next 10 years, before settling in on that 3% terminal rate to be worth its current $49 price tag. Needless to say, Silicom's track record of outstanding performance makes it very likely it will clear this hurdle. Assigning more realistic growth rates would value this business around $100 per share.

Foolish final thoughts
When it comes to Silicom, the market has it wrong. This business is too good and the management team is too focused for this business to stay this cheap for long. The market's reaction to earnings has presented us with a nice buying opportunity. Spend some time learning about this company and perhaps you'll buy some shares for yourself.

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The article Why the Market Is 100% Wrong About Silicom originally appeared on Fool.com.

Wade Michels owns shares of Silicom Ltd. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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