Has This Apple Inc Supplier Just Shot Itself in the Foot?

Overpaying for a company with declining revenue isn't a good idea, especially when your own business is on the decline.

May 19, 2014 at 11:15AM

At first sight, Cirrus Logic (NASDAQ:CRUS) looks like a can't miss investment. It trades at just 13.6 times last year's earnings, and derives around 80%-90% of its revenue from Apple (NASDAQ:AAPL). In addition, the company impressed the Street with its fourth-quarter results last month, trumping the analyst estimates by $0.09 per share. Also, Cirrus' outlook was strong. 

Recent news focuses on Cirrus acquiring U.K.-based microchip maker Wolfson Microelectronics for a sizable $489 million to bolster its audio division. This decision must have gone down well with investors as Cirrus was being blamed for being too reliant on Apple and this acquisition would probably help it add Samsung to its client list. In fact, Cirrus was so eager (think desperate) to diversify its revenue base that it's paying a premium of 75% for Wolfson.

A very risky bet
Now, Cirrus will need to borrow money to close the deal since it has just under $300 million in cash. The news is that Cirrus will borrow $225 million, and then use its cash to fund this new purchase. The downside is it will muddy up its balance sheet. Till now, Cirrus has been a debt-free and cash-rich company, but this days are over.

Moreover, there's no guarantee that the Wolfson purchase would bring much to Cirrus in the long run. Of course, the acquisition will be accretive to earnings immediately after the deal closes, and Cirrus will finally have access to Samsung. However, it looks like Cirrus paid too much for a company that is in the decline.

According to the Financial Times, Wolfson had a market capitalization of 630 million British Pounds back in 2006 when it used to supply audio components for Apple's iPod. Before the acquisition was announced, Wolfson's market cap was just 160 million British Pounds. Further, Wolfson's revenue in its last-reported quarter, that ended on March 30, was $29 million, a sharp decline from the $48 million in revenue that it reported last year. 

Of course, Wolfson is a supplier to Samsung and its chips are present in the Galaxy S5, but why would revenue fall year over year? Well, Wolfson management cites the "faster-than-anticipated transition from 3G to 4G (LTE) smartphones" as the reason behind its downfall, and expects its relationship with vendors in China to lead to improvements in the future. So, effectively, it seems that the relationship with Samsung didn't work for Wolfson in the previous quarter.

There might be some respite as Wolfson gains traction in the Chinese market, but Cirrus paid way too much for a company that just saw a big drop in revenue, is trying to make a comeback, and appears to be past its prime.

Even Cirrus is past its prime
While the estimate-beating results and strong outlook look good, digging deeper into the company's financials will reveal some concerns. Its revenue was down almost 28% year over year, while earnings were halved from $26.4 million to $12.6 million. 

Fool contributor Adam Levy says that Cirrus improved its margins 8.6 percentage points from the year-ago period, probably driven by an improvement in Apple's product mix. Apple's iPhone sales were better than expected last quarter, while lower than expected iPad sales didn't affect Cirrus since it had lost an amplifier spot in the tablet to Maxim Integrated Products.

However, it should be noted that Apple's revenue in the last quarter was up year over year, while Cirrus' crashed comprehensively. Also, Apple's iPhone sales came in at 43.7 million units in the second quarter, up from 37.4 million last year. Thus, it doesn't make much sense to compare the financial performance of the two companies. Apple might be paying less to Cirrus for its solutions than it has in the past, and an increase in iPhone shipments won't necessarily mean an increase in revenue for Cirrus.

Apple's product refresh, which might include bigger iPhones, could provide some relief for Cirrus. However, an increase in iPhone sales wasn't enough to boost Cirrus' financial performance last time: So why should it be counted on this time?

Stay away
Ultimately, the Wolfson acquisition might not bring much to Cirrus Logic. According to Fool analyst Evan Niu, Apple's contribution to Cirrus' top line will still be a huge 70% after the acquisition. Further, Cirrus isn't making any progress in its operation. Its revenue and earnings are taking a solid beating, despite an increase in iPhone sales. As such, it would be wise to stay away from this stock until it shows the ability to grow its core business.

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Harsh Chauhan has no position in any stocks mentioned. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple and Cirrus Logic. 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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