International Rectifier

International Rectifier Master File – November 2010

International Rectifier Pre-determined Game Plan – October 29, 2010

** Thesis: International Rectifier (IR), a semiconductor company that focuses primarily on power savings, will benefit from a turnaround driven by a new management team whose new manufacturing strategy should lead to higher EBIT margins. To be clear, we see IR as a unique turnaround opportunity as opposed to a secular investment in “power management”. We expect the “power saving” value proposition to generate a top line backdrop that is interesting but not “monumental” in and of itself. However, the margin expansion that can be achieved through fab closures, outsourced manufacturing and the consolidation of assembly and test partners is more compelling to us, and we see IR making its way toward its goal of high teens EBIT margins over the next couple years from 2010’s 2% and 2011E’s 11%.

** Burning Questions (November 2010)

#1) Why will a new product ramp affect mix and margins “now” given the fact that International Rectifier has thousands of products?

#2) Can Oleg Khaykin be a legitimate change agent at IR or are the remnants from the last management team and the accounting scandal too large to clean up?

#3) Beyond the things that are in IR’s control (eg, outsourcing, consolidation of fabs, new product ramp), what other forces have to come into alignment in order for IR’s gross margin target to be realized? What other factors might be holding IR’s margins back? Competitor pricing, perhaps?

#4) Why wouldn’t IR shift more than 30% of its manufacturing to outside foundries over time?

#5) Has anything changed materially on the competitive front in the last five years?

#6) Just how much can IR get SG&A down by implementing a new ERP system? How can we grow conviction *today* that the 15% SG&A goal is achievable (2010’s SG&A is 19%).

#7) Why would the secular “power saving” theme turn into a powerful top line force *today* when it hasn’t done so for the past five years? Related: What specifically has changed at the government / regulatory level with regard to variable speed motor drives? Are governments demanding that *they* are to be used? Or are governments only mandating that appliances hit certain power efficiency milestones?

** Where Our Thesis Can Be Wrong (November 2010)

#1) The semi cycle may dominate IR’s fundamentals moreso than the positive changes we’ve identified.

#2) If there has been a negative change in the industry structure that has led to a permanently lower EBIT margin level (eg, permanent pressure on the prices of power mgmt chips), it may be more difficult for management to get margins to their desired targets by the methods they are attempting (mix and scale). In other words, perhaps management’s progress gets “priced away”.

#3) The emerging market opportunity that IR speaks of as a top line driver may moreso represent a spin of the “wheel of desperation” than a reality.

NODE #1 CONSIDERATIONS

Positive but the potency and how these changes translate to growth in NODE #4 is questionable.

** Digital Demographic Revolution: As “the revolution” progresses, electronic content is increasing in end user devices and appliances, leaving the semiconductor industry with better than average growth prospects.

** Human Population Change: This is the NODE #1 that is driving the change around clean tech and energy efficiency solutions which IR’s power management chips address.

NODE #2 CONSIDERATIONS

Mixed but more positive than negative.

The end markets that IR sells into are relatively mature and not exciting in and of themselves. We’re talking about selling power management chips into devices and appliances ranging from servers to automobiles to washer / dryers and air conditioners. The interesting element for IR is that such devices increasingly have a ‘power saving’ crisis about them such that there will be more power management content per device five years from now than there is today.

We have more about the company’s end markets and penetration rates in the master file that is attached.

A lingering question: what’s different today? IR has been telling the “power saving” and “more electronic content per automobile” story for years. Why is today any different?

Their answer:

1) Burgeoning middle class in emerging markets will drive growth for appliances like washer / dryers.
2) The variable speed motor drive – which is responsible for much of the power savings in home and industrial appliances – wasn’t invented until 2003 and still has very low penetration. As government mandates around energy usage get more stringent, penetration will increase.
3) In automobiles, the heavy electronic usage that was once exclusive to high end autos is moving into the mainstream. “Next year’s Ford Taurus will feel like a BMW of old, electronic content-wise”.

Our take? All things considered, we find IR’s NODE #2 attractive but not enough to make this compelling for monumental change investors like us. That is, the company has been selling the same promise for a decade, and while we think the “energy efficiency” promise is real, our conviction that … say … washer dryers in China and the new electronic content in a Ford Taurus is any more exciting here in the 2010 – 2012 timeframe than it was in 2006-2008 is relatively low. And, if IR didn’t experience rapid top line growth *then*, our conviction that they’ll experience it in 2010-2012 is also relatively low.

Another way to frame this: in our Decision Engine’s DCF, we use “just” 7% for IR’s mid-term growth as opposed to the 13% or 16% we might use for a company whose top line growth story we had high conviction in.

NODE #3 CONSIDERATIONS

Mixed.

To be clear, IR’s competitive landscape is highly fragmented. Our thought is that the strength of IR’s NODE #3 advantage depends on which segment of their mix we are assessing.

Its strongest position appears to be in the Enterprise Power and High Reliability segments. In the Enterprise segment (12% of revs), IR has an approximately 40% share in the Intel server voltage regulator market, due to their chips improving server performance and reducing energy consumption.

In the High Reliability segment (17% of revs), where there are high structural barriers to entry due to the requirements in commercial aviation, military, and space industries, IR has a strong brand and a 30+ year track record with the major aerospace producers.

In each of these segments, pricing and – consequently – margins have held up reasonably well … likely a testament to the company’s advantage.

In their core power management devices (important at 40% of revenues), it is unclear if IR’s current chips are significantly better than their competitors. And, the company faces an abundance of competition and as would be expected…pricing pressure.

All things considered, there are more questions to answer and more conviction to build in NODE #3. Our thought is that – no – there isn’t anything “special” about IR on the competitive front. We don’t expect top line growth through massive share gains, for instance. What we’re more interested in is the industry structure itself. We know it’s crowded. But will the many participants compete in a rational fashion such that the pricing environment will be relatively benign? Or will competition be so intense enough that any EBIT margin that is gained through the new management’s changes and “right-sizing” of manufacturing will be stolen away by price pressure?

More to learn …

Separately …. more central to our thesis – and also relevant to NODE #3 – is the prospect for a turnaround at IR. The new management team comes highly regarded from Amkor and has already made some very real changes to the company’s manufacturing strategy.

- Internal fabs: Internat’l Rectifier aims to cut this from 4 to 2 and take the % of revenues generated by internal fabs from 98% to <70%.

- Bringing up new foundry partners: As of 2008, they had 1. Their goal in the future: to have 2 or more with them growing from 2% of revenues to 30%+.

- Consolidating and upgrading backend OSAT (assembly & test). In 2008, they had 17 partners. Presently, they have 11. And in the future, they aim to get to 5-7.

We see such change as evidence that the new management team is serious about turning this company around.

NODE #4 CONSIDERATIONS

Positive but with questions.

IR’s NODE #4 can be characterized by a top line that is highly susceptible to the swings of the semiconductor cycle and an EBIT line that is improving more dramatically.

The big question: are the changes that management is making enough to grow EBIT margins even further?

** Here are headline estimates for fiscal year 2008 through 2013. (Fiscal year = June)

- Revenue growth: (18%), (25%), 21%, 23%, 8% 8%
- EBIT margin: (11%), (17%), 2%, 11%, 12%, 13%
- EPS: ($0.80), ($3.42), $1.13, $1.40, $1.58, $1.88

** Some context: Management’s long-term target operating model:

- Annual Revenues: $1.25bn target vs. about $1.1bn in FY 2011E.
- Operating Margins: high teens vs. 11% in FY 2011E.
- Gross Margins: low 40% range vs. 38% in FY 2011E.
- R&D as a % of revenue: 10-11% vs. 11%
- SG&A as a % of revenue: 15% vs. 18%
- Capex as a % of sales: 10-12% vs. 8%

** Segment mix, and margin profile:

Here are gross margins from 2007 through 2010 by segment. The point: the bulk of the margin expansion is expected to come from the power management segment.

- Power mgmt.: (39% of revs) 35% … 22% … 11% … 17% … Target = 25-35%
- Energy saving: (21% of revs) 47% … 35% … 37% … 40% … Target = 45-50%
- Auto: (8% of revs) NA … 32% … 22% … 24% … Target = 30-40%
- Enterprise power: (15% of revs) 52% … 36% … 37% … 42% … Target = 40-50%
- HiRel: (17% of revs) 51% … 50% … 52% … 52% … Target = 50%+

** DCF: Decision Engine

Using the following assumptions, we get “upside” of 110%, which would put IR in the least expensive quintile. Again, the key line item is margin: Mid-term revenue growth: 7%. Mid-term EBIT: 17%.

A separate perspective: assumptions needed to make 50% in 18mo’s:

- Top line growth: (FY11 to FY13): 23%, 8%, 8%. In line w/current Street est’s.
- EBIT margin (FY11 to FY13): 12%, 14%, 17%. Assuming mgmt makes more progress toward its “high teens” target than the Street gives them credit for.
- Forward PE: 16x – even with today’s PE.

** CONCLUSION

Let’s take a small position and follow up on some of the burning questions as we go.

What makes me positive on IR is that management has taken *real* action to get margins higher. They seem serious about the changes. Additionally, I think the NODE #2 tailwinds are decent enough to allow IR to reach its $1.25bn to line goal in the not-so-distant future. According to *them*, the growth will create scale and improve utilization such that margins will go higher.

Makes sense.

But one ‘where we can be wrong’ consideration that springs to the top of my mind is this: much of the change to the manufacturing process has been implemented already. Last qtr, 77% of IR’s chips were manufactured internally as opposed to the 98% from a few years ago (and the target of 70% in the next few years). So … some of this change has already been implemented. And, one can argue that the next 600-800bps of margin expansion is expected to come moreso from new products – with higher prices and higher margins – than from consolidation and the things that management can control.

The big question: will the pricing environment in power mgmt allow for this? Has pricing gotten worse over the years? Will pressure *there* steal from any margin that management can gain from the changes they are making to the manufacturing process?

So … more to dig into, but we are taking a position. The company has a decent (not great) secular tailwind around power management …. And a management team that has already demonstrated a willingness to make serious changes …

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QUICK LOOK: International Rectifier (Ticker: IRF); $ 1.4 Bn Market Cap; Semiconductors

***What is the PROMISE:
By incorporating its technology, International Rectifier promises customers improved performance and lower energy consumption from their products and systems.

***** Description:
International Rectifier Corporation designs, manufactures, and markets power semiconductors, including a metal oxide semiconductor field effect transistor called a MOSFET. The Company’s products include power integrated circuits and advanced circuit devices, power systems, and power components. International Rectifier’s products are sold worldwide.

Source: Bloomberg

***** Rev Split – what they do:
The company reorganized into 5 reporting segments last year, and they also generate revenue from patents.

Power Management Devices – 40% – power supply, notebooks, and commercial/industrial batteries Energy Saving Products – 22% – used in appliances, pumps and compressors, and specialty lighting (LCD TVs) High Reliability – 17% – satellites, aviation, military, medical devices Automotive Related – 8% Enterprise Power – 12% – servers, storage, routers, and switches

Intellectual Property – 1% – patent portfolio

****What is the Change?

2 changes at work here:
1. New management team was brought in at the end of 2008 to turn the company around after a 3 year period of accounting irregularities.
2. Increased emphasis on energy efficiency by electronic products of all stripes.

*****Operating Model
Revenue growth: 2005-2012E:
11%, 0%, 3%, -18%, -25%, 20%, 21%, 12%
EBIT margin: 2005-2012E
19%, 14%, 10%, -8%, -19%, 3%, 9%, 12%

***** 4 Steps:

** Node 1: What is the cultural change?

*Do More with Less
*Digital Demographic Revolution
*Addicted to Video/Communication
*The Meaning of Life is to be Entertained

** Node 2: Is there a monstrous & growing market?
From a broad macro viewpoint, the demand for power management semiconductors is tied to the secular shift towards more energy efficiency seen across products in every sector of the global economy. According to the Energy Information Administration (EIA), the rate of growth for electricity demanded globally has slowed to around 1% annually in the last decade from 2.5% in the 1990s. They expect this level to remain constant through 2030. The EIA sees overall electricity demand doubling from 2005 to 2030 to a level of nearly 32 trillion kilowatt hours.

So what?

It is the growth in the absolute level of electricity demand that puts a strain on electrical utilities globally, and THIS is the impetus for the need for power management semiconductors.

While it’s always hard to accurately peg the exact dollar amount of a market opportunity, we can get a ballpark estimate from different industry research firms. One of these, iSuppli, pegged the overall market for power management semiconductors at $18.7bn in 2009.

International Rectifier operates in 5 different market segments, and offers a very large portfolio of products, so let’s try to get a handle on each market opportunity, using figures from IR’s management as a general guide:

IR Management pegs their Power Management Devices market opportunity at $3.1 bn and their Energy Saving segment as an anticipated $2.2 bn sized market. Both of these markets are helped by a trend towards variable speed motors in household appliances – this is what is talked about when we hear about energy saving appliances – appliances with power managed motors use 33% less electricity then conventional models. In 2009, IMS Research estimated that the demand for these motors would grow at a 16% CAGR from 2009-2013.

The High Reliability segment that provides chips for satellites, medical devices, and military applications is measured at a roughly $750m market, driven in part by an energy efficiency mandate by the US military, who is seeking to reduce energy costs by $1.6bn a year .

The company defines their Automotive market opportunity at $2.8bn, as they sell chips used in a wide range of auto systems such as steering, pumps, plugs, and lighting. The shift towards hybrid and electric cars is the growth driver in this market. iSuppli forecasted the demand for low voltage MOSFETs used in vehicle electrification to grow at a projected 18% CAGR from 2009 through 2013.
Finally, IR’s management estimates their Enterprise Power market opportunity at $1.4bn, highlighted by a large and growing server and datacenter market that is placing greater emphasis on power efficiency.

**Node 3: Is there a sustainable competitive advantage?

The company likes to present themselves as a leader in green technology, but it is unclear if this is International Rectifier’s actual strategy, or if its products are merely now being used in appliances and products that like to tout energy efficiency. While this may be more a philosophical question, it does seem that the company’s so called clean technology advantage is more by happenstance then design. Whatever the reason, they ARE leveraged to a trend towards energy efficiency in electronics products.

Founded in 1947, International Rectifier was one of the original giants in the semiconductor industry. In the 1970s, they were the developers of the original power metal oxide semiconductor field effect transistors (MOSFET). These Power semiconductors are what translate raw electricity from an outlet into refined electricity for electronic products.

Today, with MOSFET technology reaching their technical limitations, IR is among the industry leaders in the development of Gallium Nitride based power semis. The company laid out a roadmap this year showing how their GaN products will greatly improve the performance of their core MOSFET devices – when compared with traditional silicon based, GaN based semis significantly increase performance, decrease energy consumption, reduce size of the devices, and will be less expensive to produce.
These next generation chips won’t be widely produced by IR until 2011.

Focusing on their NODE 3 competitive advantages today, their strongest positions are in the Enterprise Power and High Reliability segments. In the Enterprise segment, IR has an approximately 1/3rd share in the Intel server voltage regulator market, due to their chips improving server performance and reducing energy consumption. In the High Reliability segment, where there are high structural barriers to entry due to the requirements in commercial aviation, military, and space industries, IR has a strong brand and a 30+ year track record with the major aerospace producers.

In their core power management devices, it is unclear if their current chipsets are significantly better than their competitors, and the company faces an abundance of competition and as would be expected…pricing pressure.

Power Management Devices: Intersil, Linear Technology, Maxim, Semtech and TI

Power Components: Fairchild, Infineon, ON Semiconductor, Philips, STMicro

** Node 4: Is there leverage in the model (operating/multiple)?

Operating leverage?:
Revenue growth: 2005-2012E:
11%, 0%, 3%, -18%, -25%, 20%, 21%, 12%
EBIT margin: 2005-2012E
19%, 14%, 10%, -8%, -19%, 3%, 9%, 12%

The company went through a real downturn from 2005-2009, with a series of accounting irregularities related to revenue recognition problems, compounded by the economic downturn, and management turnover.
Their model is showing some signs of turning around. At their analyst day in June, IR’s management tweaked their long term operating model target that they laid out when they took over the company in 2008. Their targets and where they are at currently (as of the most recent March quarter):

Annual Revenues: $1.25 B Target vs. $791m Current
Gross Margins: low 40% range vs. 36%
R&D as a % of revenue: 10-11% vs. 11%
SG&A as a % of revenue: 15% vs. 18%
Operating Margins: high teens vs. 7%
Capex as a % of sales: 10-12% vs. 8%

This model includes slightly lower gross and operating margins (200-300bp) from when management first took over. Their explanation was that newer chips have taken longer to ramp due a slowdown in design activity during the economic downturn. As a result, their product mix shift will take longer to move away from their lower margin discrete products. The increase in capex as a % of sales is due in part to IR introducing an Oracle ERP system across the firm over the next two years. This 10-12% level is well below the previous regime’s 16-18% rates. The company has looked to shutter manufacturing operations over the past two years in an effort to reduce operating costs, closing 2 of their 4 large wafer fabrication facilities, which they estimate will generate annual savings of $12.7m beginning in CY2011.
Along with bringing capital expenditures under control, the new management team has made strides in turning their operating model around from 2008. At the time the new team took over, their model looked like this:

Annual Revenues: $784
Gross Margins: 20%
R&D as a % of revenue: 13%
SG&A as a % of revenue: 35%
Operating Margins: -46%
Capex as a % of sales: 16-18%

Digging a bit deeper into their segments, we can see where the operational improvement will have to come from to generate leverage. Here are the current segment gross margins along with management’s targets:

Power Management Devices – 40% of sales – current GM is 21%, management is targeting 25-35%

Energy Saving Products – 22% of sales – current GM is 45%, management is targeting 45-50%

High Reliability – 17% of sales – current GM is 56%, management is targeting 50%+

Automotive Related – 8% of sales – current GM is 27%, management is targeting 30-40%

Enterprise Power – 12% of sales – current GM is 42%, management is targeting 40-50%

Intellectual Property – 1% of sales, 100% GM

Looking at these figures, and the room for improvement between current levels and management targets, we can infer that Power Management Devices is where International Rectifier will derive operating leverage from going forward IF they can execute.

Valuation leverage?
International Rectifier trades at 16x forward earnings vs. a 5 year historical average of 39x forward earnings. It trades roughly in line with its historical averages on a P/S (~2x)and P/B (~1x) basis. The stock is up 17% over the past 52 weeks, and down 12% YTD. 6 months ago, there were large upwards earnings estimate revisions for 2010 and 2011, and since then there has been little change.

***** HQ: El Segundo, California
***** Management:
Oleg Khaykin, CEO -Oleg Khaykin joined International Rectifier in March 2008 as President and CEO. Khaykin came to IR from his position as COO of Amkor Technology, a semiconductor assembly and test services company. He was at Amkor from 2003-2008. Previously, Mr. Khakin was the VP of Strategy and Business Development at Conexant Systems and its spin-off Mindspeed Technologies from 1999 to 2003. Prior to Conexant, he was with The Boston Consulting Group. Mr. Khaykin holds a BSEE with University Honors from Carnegie-Mellon University and MBA from the J.L. Kellogg Graduate School of Management.

Ilan Daskal, CFO – joined International Rectifier in October 2008 as CFO. Prior to joining IR, Mr. Daskal most recently served as VP Finance for Infineon Technologies. Prior to joining Infineon in 2001, Mr. Daskal held senior financial management and strategy positions at several Israeli technology companies, including Savan Communication, a firm that was acquired by Infineon under Mr. Daskal’s strategic direction as CFO. Mr. Daskal holds a BA in Accounting from the Tel-Aviv College of Business and an MS in Finance from the City University of New York.
Michael Barrow, COO – joined International Rectifier in April 2008 as COO. He has 30 years of computing, semiconductor and operational leadership experience to IR, having served with, Amkor Technology, Intel and Unisys. In his previous position at Amkor, Barrow was SVP of the Flip Chip and Wafer Level Business Unit. Prior to Amkor, Mr. Barrow spent 12 years at Intel, as Technology General Manager of Intel’s Communications Group and Technology Manager of Intel’s Chip Set Group. Before joining Intel, Mr. Barrow held positions at Unisys in increasing levels of responsibility having begun his career as a power design engineer at Electro Pacific Inc. Mr. Barrow holds a BSEE/BSME degree from Natal Technikon (Institute of Technology), Durban, South Africa and holds 22 United States Patents and Invention Awards.

Source for bios: Company website.

***** Price performance, Valuation, Growth expectations:
Stock International Rectifier Corp
Mkt Cap ($US) $1,393
Price US$ $19.71
1wk % -1
1mo % 0
3mo % -7
12mo % 17
vs 50day 0.99
vs 200day 0.95
Rev Grw FY’10 20%
Rev Grw FY’11 21%
EBIT % ’10e 3%
EBIT % ’11e 9%
P/E FY ’10 20
P/E FY’11 16

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International Rectifier Extended Look 8/20/2010

I think CRITICAL to dig into the mgmt and their addiction and skill in making money

– why did they get the job – prior track record?
– public statements of commitment/will
– plan to specifically get power mgmt GMs up?? W o high share? Or do they have high share ? share n each segment

Question – How did the new management team come in? why were they chosen?

Turns out International Rectifier has a fairly interesting corporate history. It was a family run business since the 1940s. It was founded by Leon Lidow in 1940 during the aerospace boom in Los Angeles during WWII. Leon’s son Eric took over the company, expanded overseas and took it public in 1958. The company then passed to Eric’s engineer sons Derek and Alexander, who developed the original MOSFET chips in the early 1970s…these two sons ended up feuding constantly, were made CO-CEOs, and eventually Alexander became CEO in 1999. From 1999 to 2004, Alexander doubled revenue from $500m to $1B and made 8 acquisitions for over $300m in total. Over that period, Alexander changed the focus of the company from producing low margin (20% GM) components to higher margin (65% GM) circuits. In 1999, advanced circuits accounted for 20 percent of IR’s revenue. By 2004, they represented 67 percent of the company’s revenue volume.

In April 2007, the company announced their internal audit committee would be reviewing premature revenue recognition at a foreign subsidiary going back to the September 2005 quarter. In October 2007, Alex Lidow resigned as CEO. The company’s chief counsel, Donald Dancer, served as interim CEO until March 2008 when the current CEO Oleg Khaykin was brought in from Amkor Technology. The board had hired a search firm to look across a bunch of different semiconductor companies for a new CEO. They brought in a new COO in April, Michael Barrow, who was also from Amkor.

In September 2008, once the company had restated their revenues, Vishay Semiconductor made an unsolicited bid to acquire the company. At the time, IR was trading around $20/share and Vishay bid $23. They eventually got into a proxy fight for the company, which ended in mid October 2008 when Vishay couldn’t provide a letter of credit to show the financing for their offer…so the credit crisis essentially saved IR from being acquired.

Shortly thereafter, IR added their current CFO, Ilan Daskal from Infineon. Finally, in January 2009, IR sued their former CEO Alex Lidow for stealing intellectual property related to gallium nitride power devices. This case is ongoing.

Question. What was the track record of Khaykin/Barrow at Amkor Technology?

Khaykin was with Amkor from 2003-2008. Because of the time period – coming out of a recession to the top of a boom…his results are going to look good either way, so keeping that in mind, lets look at revenue growth, gross margin, and EBIT margin for Amkor from 2000-2009. 2007 was the last year Khaykin was with Amkor for a full year.
[brackets imply khaykin’s time as COO]

Revenue Growth 2000-2009:
25%, -36%, 8%, [-2%, 19%, 10%, 30%, 0%], -3%, -18%

Gross Margin 2000-2009:
23%, -1%, 7%, [20%, 19%, 17%, 25%, 25%], 21%, 22%

EBIT Margin 2001-2009:
14%, -17%, -7%, [8%, 6%, 4%, 14%, 14%], 10%, 11%

Obviously, this record shows sustained improvement and a company that didn’t fall apart right after he left, even in the downturn, so he appears to have a good operational track record. Of course, its hard to determine how much of this is due to operational excellence or just good timing.

Question – Any public statements of commitment from the new management team?

Found an interview with Khaykin he gave right after joining IR. Have to say, it was somewhat cliché-d and by the book….Some highlights:

++ Khaykin’s background was on the test/manufacturing/operational side at Amkor.
++ Decided to sell off some older technology to Vishay (this was before the proxy fight), thought IR had become somewhat defocused, and they needed to concentrate on sectors where it could differentiate itself from the competition.
++IR will work very closely with Intel and AMD on their server product roadmaps re: energy efficiency and thermal management aspects of their chips – - – this ended up being true, as they have a 1/3rd market share in the Intel server voltage regulator market.

++The Clean Tech Angle:

Q. Although the firm has a long history of utilising the environment as a major driver for the sale of its products, and this is increasingly becoming a factor in electronics system design here in the West, is this going to be the same in developing countries?
A. In India, the Tata $1,000 car is clearly going to be more attractive than hybrid alternatives, and in China the majority of the populace will look for the cheapest appliances and consumer goods, not the most energy efficient. Doesn’t that make whatever happens over here almost irrelevant? (true, but yikes!)

With energy costs rising exponentially worldwide, energy efficiency is now becoming an important consideration for consumers when they buy electronics goods. They no longer look at the acquisition cost alone, they have to think about the operating costs that will be accrued over its lifetime too. This will be true of people living in developing countries just as much as in the West. It will affect everybody globally.

Question – Is there a plan to specifically get power management GMs up? With or without high share? Do they have high market share?

From what I could glean from International Rectifier’s IR presentation and their call transcripts, the plan to get the GM up for power management was twofold: (1) refocus on selling the discrete ICs rather than components and (2) fab consolidation / capacity utilization increases. For the last 2 quarters the sales of the components have been very strong due to a tight supply market, so they’ve been selling more of those then they would want to (mixshift wise).

But the real answer is they think they will get power management GMs up through scale from increased sales. From last quarter’s call…

“So I think and in that answer to your question, as our revenue continues to grow, will our margin continue to expand? The answer is yes. But given I guess current mix of discreet devices versus the rest of the business, will it hit 40 percent at $250 million revenue level? It’s kind of hard to tell until we see a couple of quarters of stability and able to squeeze out the operational efficiency.”

Their management claimed they’ve been taking share, but this is really hard to tell. The best data I could find on the market shares related to the power management device was a 2008 Gartner study on discrete components (diodes and transistors)…This showed IR with a 4% market share, the 10th largest company in the space…but none of the top 10 had even 10% share….very fragmented market, as would be expected for a commodity-ish product. The leaders were Toshiba with 9% and Infineon with 8%.

Question from (client) – How leveraged is IR to energy efficiency and the electrification of the automobile? Are they similar to Polypore in that they have a strong exposure to battery trends without us having to determine the battery “winner” as it was selling “bullets” to all the contenders in all the categories. To what extent is IRF is an arms dealer in categories where energy efficiency is an increasingly important part of the competition?

I would say the comparison to Polypore is not a precise one…there are many more providers of power management semiconductors than battery makers. A lot of the same discrete components sold in the power management devices segment are what goes into automobiles; as such, they compete against the same big names: Vishay, Fairchild, STMicro, Infineon, NXP, and ON Semi…and likely have a similar market share as we mentioned above.

Building on that, I’m not sure IR’s research on the next generation GaN platform is translated into the technology used in the automotive segment…my instinct is not – I think this is more used in servers and PCs and the like.

In terms of comparing them to an arms dealer to all sides? That is somewhat true…they sell to many different OEMs that sell autoparts – Delphi, Nagares, Continental Auto, Bosch, TRW, Honda, and Alcoa.

A little Q&A on this topic from the last conference call:

Q. In regards to the automotive side, what is your view from IR’s business perspective as hybrid vehicles and plug in hybrids eventually take off and you know when do you start seeing benefits from that?

Oleg Khaykin: Well, I think the – on the automotive, today if you look at hybrids as predominantly a relatively few models. As a broader range of cars adopt hybrids or micro hybrids, we have designs in – with multiple component manufacturers that will go into these products. So I think clearly we expect to see stronger than the industry growth for our automotive business unit. Now in terms of the when it’s going to happen, typically you know you get a design win today, it may take you two to three years until it goes into production and we now have several designs that are approaching the revenue ramp and what we are seeing is some increase in our growth from new products.

But are the overall business prospects for International Rectifier REAAALLY leveraged to auto electrification? I think the answer is no…the auto sector only represents ~7% of their sales, and this is not the swing segment in their operating model. So while they may sell to the auto sector, I don’t think IR is the best way to “play” this trend.

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International Rectifier Extended Look 2 – September 16, 2010

** Conclusion & Context: I think Internat’l Rectifier merits more work. My bias is to leave it in “Extended Look” and do even more work on the competitive landscape, management’s pedigree, AND the new products.

This is my first look at Internat’l Rectifier after Aaron’s previous two rounds of work. Our key questions leading into this round:

1. Dig even deeper in the plan/likelihood of gross margin expansion in the power mgmt division. It’s about 40% of revs and THE key to ebit margin expansion. Update: more to learn, but just about every comment the company makes about margin has to do with (a) mix, (b) utilization & fab consolidation, and (c) new higher margin products ramping. It’s all sensible … but my one consideration is that Internat’l Rectifier has told similar stories in the past. What’s different today?

2. Why is THIS mgmt team specifically qualified for the task… ? We don’t DOUBT it but we want to be inspired… The pedigree from Amkor is generally a pretty good one. Update: I’ve asked Carl Johnson if he knows of these guys (he said he doesn’t but he knows people at Amkor and will check). I also wanted to chat with the company to hear what they have to say – but they haven’t responded to my calls. So – what I’ve done is simply pour over many transcripts going back to 2008. My sense? I like the steps the company is taking, though none seem to be outside the ‘norm’ when it comes to running a semi company. Cost cuts, fab consolidation, focus on new products, etc. All good stuff …but i have more to learn about whether these guys are special.

3. Internat’l Rectifier’s overall market is quite fragmented. How do they know they are really stealing share and if they are, why are they and do they have a target?? Update: without talking w/company, I haven’t made much progress on this one.

I read some old notes I had about Internat’l Rectifier and also poured over every transcript I could find from 2008 to the present to get a better understanding of margin expansion and such. Here’s what I picked up:

#1: Internat’l Rectifier’s roots.

I found some old notes from 2005 when we were watching this one fairly closely. The promise at the time was ALL about margin expansion that would occur as mix shifted from commodity products to more proprietary, higher-margin, power and motor control offerings. Remember when they broke out both a “non-aligned product” segment AND a commodity segment? Ugh. In 2005 the non-aligned products were about 10% of sales, and part of the promise was that they’d divest that. At any rate, at the time, gross margins were 43-44% and they were targeting 50%. Today, their target is less.

So what? Yes, this is a “new” Internat’l Rectifier with a new management team and even new segment categorization. But, the promise for bottom line growth seems largely the same.

#2: Regarding margins.

Every mention I see about margin expansion in the transcripts I’ve read (from 2008 to the present) lists the following as margin drivers:

- Mix. Mix. Mix. … which is a function of end market, the proprietary nature of the chip (or lack thereof), and whether it’s a new product or not.
- Utilization rate improvement through fab consolidation.
- And headcount reductions, which frankly seem to be more the result of the semi downturn than anything.

… more on all this in a sec, but the point is that mix toward higher margin products is still the key promise.

#3: Mix considerations – Line loading & shift toward newer products

From a conference call in late 2008, this sheds a light on some of the levers management will push and pull to keep margins from imploding. They said that in their discreet business, they are doing some line loading, which is the practice of reloading older products that were once discontinued. Mgmt said there were a number of older products that Internat’l Rectifier used to sell into the market that they’ve gotten out of because of the lower margin profile. However, they say there is still significant demand and much of this product are high volume runners and “all we have to do in that case is reengage with the customers and they were very eager to place the orders with Internat’l Rectifier product.”

So … in late 2008, this hurt margins a bit in the power segment b/c it involved lower margin products while filling some capacity which helped lower the cost from the rest of Internat’l Rectifier’s business.
So what? This seems like a sensible thing to do when utilization gets low. And, at the time, management said this was only a short term fix. What they’ll do in the medium term is develop new product based on new process technologies that have significantly lower cost and higher margin and replace the commodity business with this new product.
The point is – again – that the margin expansion is expected to come in part from improved utilization and – moreso – from a mix shift toward new products which will be both higher margin AND give Internat’l Rectifier the ability to increase their content in various products.
#4: More on the new products …

Just some color on the new products and timeframe of launch. From August 2009: the new products are Gallium Nitride products and their first revenue contribution is expected in mid-2010.

… more about the Gallium Nitride products:

- Internat’l Rectifier claims that they enable higher levels of integration for dense and efficient power conversion.
- This reduces the size of PCBs in computers ….
- … and also shrinks motor drives which help with cooling.

Burning question: when Internat’l Rectifier talks about the new, higher margin products, are they talking *only* about the Gallium Nitride products? Or are their others we should be aware of?

Another burning question: New, higher margin products always seem to be a part of the Internat’l Rectifier story. So, is there a way to measure what the promise of *today’s* “new products” are from a NODE #4 perspective relative to what that same promise would have been … say … five years ago?

At any rate, there’s still more to learn here, but I do think it’s a key part of the Internat’l Rectifier story we’ll want to get up to speed on.

#5: Margin expansion through plain old cost cutting….

In February 2009, Internat’l Rectifier announced that it’d reduce its workforce by about 850, or approximately 18%. The move was expected to save $33mn starting in FY2010. (Note: If you think it should save more than this, the company noted that a large amount of this workforce is in Mexico – lower cost.) These savings will be in mfg and SG&A.

Also, they announced that they’d consolidating their Newport fab at the end of CY 09 which would save approximately $8mn. (COGS)

Finally, they said they planned to close their El Segundo fab and consolidate its production capacity to our Temecula fab by the end of CY 2010 – saving $12.7mn per year. (COGS) Note: they pushed this back when demand improved, and their current plan is to close it mid 2011.

At any rate, all told, this removes about $50mn or so from their cost base. For context, the company’s COGS is expected to be ~ $530mn in 2010 (excl depreciation) and its opex is closer to $270mn. Against these types of numbers, an incremental $50mn in savings might not seem like much. However, when you consider that FY09 (june) EBIT was minus $68mn and FY10 came it at about $16mn, the $50mn carries more weight.

Anything to take away from this regarding Internat’l Rectifier management? Nah. Seems like normal fare for running a semiconductor company.

#6: Details on operational improvements.

- Internal fabs: Internat’l Rectifier aims to cut this from 4 to 2 and take the % of revenues generated by internal fabs from 98% to <70%.

- Bringing up new foundry partners: As of 2008, they had 1. Their goal in the future: to have 2 or more with them growing from 2% of revenues to 30%+.

- Consolidating and upgrading backend OSAT (assembly & test). In 2008, they had 17 partners. Presently, they have 11. And in the future, they aim to get to 5-7.

So what? Again, there isn’t anything outside the normal fare of running a semi company, but I like the specificity that Internat’l Rectifier outlines here.

#7: Two more considerations about mix & margins.

Just pounding home the same point about mix & margins….

a) Comment from CEO in Feb 2009 when asked once the facilities are closed, what is the amount of revenue capability out of their existing fab infrastructure: “haven’t done the math yet” … but the intention is to that mix will be the top consideration b/c there’s a big spread between different types of products regarding the revenue per wafer that Internat’l Rectifier gets. They’d load the highest margin, most proprietary processes in house first and outsource the older, lower revenue per wafer processes to sub contractors.

b) From August 2009: What’s behind the expected improvement in margins into the mid-20%s for the coming quarters? #1) Utilization. #2) Mix. Internat’l Rectifier will start seeing some of the higher margin products in the industrial automotive space starting to come back that will improve the margin mix. The CEO pointed out that last quarter, there was more strength in Taiwan and China that was overwhelmingly focused on the consumer and computing segments which have fairly aggressive pricing and not very rich margins.

So what? Another burning question: what exactly is involved in shifting capacity back and forth? How easy is it? It seems as though the company’s margin prospects depend greatly on it!

#8: Utilization rates.

Just for background, rates were pacing at about 60% in June 2009 and were 90%+ in the June 2010 quarter – a function of industry demand picking up and the removal of some of the capacity mentioned in #2 above.

#9: Key question: Can secular trends reeeeeeaally result in NODE #4 improvement?

This is an open question but one worth considering. This is from a run of the mill upgrade note from way back in in August 2005: “For the last fiscal year in the automotive segment, Internat’l Rectifier has won new customers including Honda, Bosch and Continental Temic for advanced technology programs such as integrated starter alternators for hybrid vehicles, electric power steering, and diesel direct injection. The company had about 200 design wins over the last year into various automotive applications.”

The point: before getting involved in Internat’l Rectifier, we ought to answer the question whether anything has *really* changed since 2005. Perhaps it’s that the crisis for power efficiency has grown significantly in cars … or perhaps it’s that the new Gallium Nitride chips are a real game changer. But it’s an important consideration, because the “power mgmt in autos” story is NOT new.

- My lingering question: can Internat’l Rectifier turn this into a nice, simple business case like … say … ARM has with smart-phones? As in, “our share of the auto market is growing from X to X+ … and our content per car has grown from Y to Y+?” While the long-term future for power efficient cars is relatively positive, the auto market as a whole isn’t a fast grower … so Internat’l Rectifier will depend on either higher ASPs … share gains … or more content in order to grow, no?

** CONCLUSION

There’s a lot going on here and there’s more to learn about all. A potential turnaround … a promise of new products … and a secular tailwind toward power management that, frankly, isn’t all that new. I think INTERNAT’L RECTIFIER merits more work, but I can’t say I’m ready to move to the model stage just yet.

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International Rectifier Extended Look 3 – September 23, 2010

** Conclusion: I’m modestly biased to taking this to model, long. Frankly, I haven’t moved the ball forward as much as I would have hoped w/regard to our key questions about things like culture and specifics about fab consolidation plans, but I learned a bit and I’m a tad more positive after this round.

I think meeting / talking to the company would help a good bit, but they haven’t returned my call or three emails.

So, here is where I am: I think the secular change around “power efficiency” gives IR a slightly better than average NODE #2 to sell into, but my conviction that this change is enough to single-handedly & meaningfully alter the “money out” in IR’s model is low.

With that said, I also find IR potentially interesting as a turnaround (as opposed to a secular grower). On *this* front, after this round of work, my conviction that there has been some real change internally at IR is higher, but it’s unclear to me how much leverage it might generate in NODE #4.

So … for now, I think we should pursue IR as a possible turnaround and look at a model to see if there is EBIT margin leverage to be had. In the background, we can do more thinking about whether there is *any* growth angle that we can gain conviction in.

** Context: Here are the thoughts after my last round: “I think aiming to see if the culture has really changed… The old mgmt was scummy. Did the board change out What catches my eye is that they will go from 98% of revs from own fabs to under 70%… THAT is a monumental change for THEM.. Sounds run of the mill but it is a big first step that suggests a lot has changed and that this may be a 6-7 yr turn as they then go from 70% to, who knows, zero over the next bunch of years”.

#1: THE BOARD

Yes, it has changed out. I’m not sure who was on it back in 2006….but … here’s a rundown of the current Board with a quick note of who the person is and when they joined. For context, the scandals were circa 2007. Oleg was brought in in early 2008.

• Robert Attiyeh – On board since 2003. A principal in the real estate investment firms of Beacon Hill Properties LLC and Yarlung LLC.

• Mary Cranston – On board since May 2008. A sr partner at a major law firm.

• Richard Dahl – Chairman. Joined in Feb 2008. So he’s new. He’s a director at IHOP. Yes, the IHOP. Prior to that, Dole Foods.

• Dr. Dwight Decker – Since Sept 2009. Previously CEO at Conexant.
• Oleg Khaykin – President and CEO.
• Thomas Lacey – On board since March 2008. Has a tech background. Phoenix Tech, Applied Materials, Flextronics.
• Dr. James D. Plummer – On board since 1994. Dean of School of Engineering and the John M. Fluke Professor of Electrical Engineering at Stanford University.

• Barbara L. Rambo – On board since Dec 2009. Runs private mgmt. consulting company.

• Dr. Jack O. Vance – On board since 1988, scientist at California IT School.

#2: THE MANAGEMENT

Tidbit from Carl Johnson. My take: just one data point, but it’s complimentary w/regard to the “new” CEO.

“This morning I talked with a friend who was employed at AMKR when Oleg and Michael were there. He said he really had a lot of respect for Oleg – going as far to label him as a very bright individual. Oleg was brought into be a President at AMKR but after a brief stint hit the glass ceiling (his control over sales and marketing was limited) and decided to leave. My friend gave him credit for pushing AMKR in to their debt reduction program. If you will recall, AMKR had over $2 billion in debt just a few short years back. Today they have around $700 million.

When Oleg left, Michael Barrow and 7 other AMKR people went with him. While Michael Barrow was a AMKR he ran the flip-chip organization.”

Related: regarding Michael Barrow (the COO): we knew he was from Amkor too, but I wasn’t aware that prior to that, he served 12 years at Intel, most recently Technology GM of their Communications Group. So what? Our thoughts on Intel are mixed, but relative to running a chip making process smoothly, it’s not a bad background to have.

#3: RESTRUCTURING

Quick one, and not a ton to extrapolate from it … but this data point is consistent with the idea that Oleg is being relatively aggressive with the changes he’s making at IR operationally. A year after he was hired, headcount at IR had fallen 22%. Granted, the industry was in the midst of a major downturn and the cuts were by no means limited to IR, but they were substantial relative to some other co’s.

By comparison, peers hadn’t cut that much: from 2007 thru the downturn, Fairchild cut headcount by 12%. STMicro cut by 2%. Infineon down 9%.

At any rate, I’m not suggesting a 22% reduction is necessarily a good thing – but it does signal that he is making some aggressive moves.

Related: the 22% reduction was from june 2008 to june 2009, but during the recovery over the past year, headcount at IR actually *rose* 15%! Seems odd. I’d like to know what’s behind such changes. I know the company announced the closures of those fabs and then said they were re-opening one, but surely that can’t account for such big swings, can it?

#4: CULTURE: INTERVIEW W/OLEG

I found an interview with Oleg at Electronic Product News from late 2008 that discusses his new role and the direction of IR.

My thoughts after reading the article? There isn’t much *new* to say. He came across well. Gave very sensible answers – though, nothing really stood out to me.

Some of the takeaways:

- What will he do to restore employee confidence in IR? Answer: He embarked on a world tour and aimed to meet every member of the engineering and customer facing teams. Got a good sense of what makes IR tick … and it boosted morale.

- What skills does he bring to the table? From his past roles, he brings a strong financial background, strategic development, and sense of market dynamics. Those were honed at Conexant and Boston Consulting. Then, at Amkor, he got operational and manufacturing expertise.

- He went on to talk about how a more holistic approach to semiconductor mfg and design has become more important over the years – integrating software, digital design, analog design, and packaging all together to create a product that is quick & easy for customers to implement. So what? Makes sense — though, is he implying that IR can do this better than anyone? Worth asking if/when we chat…

At any rate, the whole article is here …but there isn’t much in it that meaningfully alters my perception of Oleg or IR: http://www.epn-online.com/page/new59006/with-oleg-khaykin-ceo-international-rectifier.html

** CONCLUSION

The goal today was to assess whether there has been meaningful change *inside* IR and to learn a bit more about Oleg. On both measures – with the board changes and with Carl’s feedback – I’m more positive and think we should move IR ahead in the funnel.

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International Rectifier Model Oct 2010

** Conclusion: Have a model meeting and move to follow-up. My conviction hasn’t been altered much by this modeling exercise. I’m still interested, but no burning questions have been answered. What this exercise *did* do is increase my conviction that the previous burning questions we already had in mind are in fact the ones to drill into with I talk to the company this week which got at the question of EBIT margin expansion and how *specifically* they’ll get there (inclusive of new packaging partners, some use of foundries, etc).

At any rate, the top takeaways from the model:

• In a rather odd twist, unlike most other publicly traded companies I’ve seen, IR doesn’t report non-GAAP earning which, frankly, makes the model a bit of a mess. I’d like to learn why this is so (a by-product of the scandal from a few years ago?)

• There were large write-offs and one-time charges associated with restructurings in the past few years, which leaves me with – at least for the time being – low conviction about what the steady state operating model is. Important to drill into with the company.

• Management’s long-term operating margin target is the ‘high teens’ but the Street only has EBIT margins getting to 13% by 2013.

• Importantly, when I look at the segments in which the gross margin increases are supposed to expand, there *is* a precedent of the margins having achieved such levels before (2007). That is, power mgmt products had gross margins of 35% in 2007 as compared to 21% today and a target to get back to 25-35%. However, the 35% in 2007 was before all the restatements, so I’m not sure whether the comparisons will be apples-to-apples.

All things considered, I’m still interested in IR. I’m moreso interested in pursuing it as a turnaround (with new mgmt and the prospects for EBIT margin expansion) than in pursuing it as a secular grower. Quick scenario: if 2013 EBIT margins were … say … 18% (inside the target) as opposed to the 13% that the Street projects, EPS would be $2.47 as opposed to the current $1.88. It’s *this* prospect of margin expansion that I’ll want to dig into with the company when I chat this week. … more to come…

** Headline estimates (2008 – 2013, FY June)

As I say above, the numbers that IR reports are GAAP and GAAP only, which generates some pretty big swings because of the big restructurings.

- Revenue growth: (18%), (25%), 21%, 23%, 8% 8%
- EBIT margin: (11%), (17%), 2%, 11%, 12%, 13%
- EPS: ($0.80), ($3.42), $1.13, $1.40, $1.58, $1.88

Now … one broker I saw broke out all the one-timers and provide a non-GAAP model, and the EBIT line looked like this:

- EBIT margin: 1%, (9%), 2%, 11%, 12%, 13%
- EPS: $0.20, ($0.92), $0.30, $1.40, $1.58, $1.88

So what? So … 2008 and 2009 were a mess, but looking at 2010 thru 2013, there aren’t expected to be any big one-time charges, so it’s safe to say that the 12% and 13% figures accurately reflect the Street’s margin assumptions.

** Margin profile

- Gross margins have ranged from 38% to 41% over the past four years but are expected to grow to 45-46% in 2013.
- SG&A is far more dynamic – ranging between 26% (FY2009) and 19% (FY2010). The goal is to get this down to 15% over time.
- R&D margin: fairly steady in the 10-12% range.

So what? Looking ahead, the leverage expected to come mostly from gross margin, with another couple hundred bps coming from SG&A.

Importantly, when we look at the company’s gross margin target by product line, there is a precedent for the target range IR is trying to achieve. Here is gross margin by product line from 2007 thru 2010 … as well as the long-term target. (Notice the power mgmt. segment. THIS is a key cell that I’ll dig into with the company this week).

- Power mgmt.: (39% of revs) 35% … 22% … 11% … 17% … Target = 25-35%
- Energy saving: (21% of revs) 47% … 35% … 37% … 40% … Target = 45-50%
- Auto: (8% of revs) NA … 32% … 22% … 24% … Target = 30-40%
- Enterprise power: (15% of revs) 52% … 36% … 37% … 42% … Target = 40-50%
- HiRel: (17% of revs) 51% … 50% … 52% … 52% … Target = 50%+

At any rate, I’ll want to learn what happened to Power Mgmt between 2007 (35% gross margin) and 2010 and what *specifically* will be done to get them to 25-35%. What’s the decline been a function of?

** Balance sheet & Cash Flow

- Balance sheet is clean. No debt. $229mn in cash … ($586mn if you include short term investments and such). They paid down about $550-600mn in debt in 2007.

- Cash flow statement. On a FCF basis, IR lost money from 2007 thru 2010 but is expected to return to positive territory in the coming years. Again, however, the 2007 thru 2010 timeframe shouldn’t represent “the norm” for IR. There were big charges and tax adjustments that affected operating cash flow … and, on the flip side, Capex was well below normal in the “Investing Sources & Uses of Funds”. In 2009, IR spent just 3% of revenue on capex … and in 2010 it rose to 6%. The 2011 (and beyond) goal is 10-12% … so capex will likely be going higher.

** Taxes? I’ll need to learn what the long-term tax rate is for IR so I can input into our DCF analysis. It’s been all over the map.

** DCF

Not that it’s time to concern ourselves with security analysis, but running IR through our decision engine yields some pretty compelling results. Using the following assumptions, I get “upside” of 185%, which would put IR in the least expensive quintile. Again, the key line item is margin….

- Mid-term revenue growth: 7%
- Mid-term EBIT: 20%. Note, using 13% gets 85% upside.
- Tax rate: 35%. Again, I need to find out what is the appropriate one to use.

One thing to ask about here: capex vs depreciation. We typically expect these to cancel each other out over the long-term, and I see no reason why that shouldn’t be the case with IR. However, Depreciation is only running at about $70mn per year …but the company’s capex has been WELL above that in the past (on the order of $160mn or so). So – is it fair to assume that these will, as usual, cancel each other out? I assume so in my DCF…

** Conclusion: I’m still interested in IR and this model confirms my view that the *key* questions to really get at with the company include margins. The thesis that is shaping up is this: we have a mgmt team that seems to be making some real changes here … and they’ve set a long-term margin target that is well above what the Street models. That’s where I’m going to focus my energy. Specifically – power mgmt products. Why will those margins increase? What *exactly* has to happen to get them higher? Is it purely about scale and utilization? Will prices have to go up? To what extent will it be dependent on new products? Just how important are the new gallium products they talk about?

I also have some base questions that will help my overall understanding.
Are all these products manufactured in the same fabs?
How easy is it to shift production capacity from one product to another?

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International Rectifier Follow Up October 13, 2010
** Call with IR Chris Toth… 310.252.7731

** Conclusion: I had a call with IR’s investor relations, Chris Toth. I learned a lot, and I’m more positive. Let’s move IR to “pre-determined game plan” – Long. The key takeaways:

- The 30% / 70% outsource plan doesn’t appear to be “step 1” toward a goal of 100% / 0%. Still, it seems like a very sensible strategy brought forth by the new mgmt team.
- My sense is that this mgmt team is making some real changes that are consistent with a turnaround.
- I still don’t sense the secular growth drivers the company presents will generate rapid top line growth – but I do have the thought that they’re good enough to give management some room to grow margins.
- I have a better understanding of where the margin growth could come from: part scale, part mix of new products. There is no one key product to watch, however. Just an ongoing ramp of newer, higher priced ones.
- I found no good reason why Street EBIT margin est’s are only 13% for 2013 even though the long-term target is high teens. It’s odd.

****** MANAGEMENT / CULTURE…..

** What have been the biggest changes since Oleg came on board? (have any been cultural?)

Three things:

- #1: The company’s goal prior to Oleg was to get to 50% gross margin. Management was deeply dedicated to it – but by being so dedicated to it, they made some missteps. For one, they were walking away from tier 1 customers and going after tier 2 where they could get higher GMs. Today, the focus is on securing relationships with tier 1 customers – go after high volume opportunities even if it means giving up some margin. They’ll make up for it by building relationships with top customers. So – one change was to re-segment the channel partners and actually become *less* stringent about gross margins.

- #2: Prior mgmt sold off high voltage MOSFET business with a plan to unwind MOSFETs in their entirety. This is part of the power management segment and it’s a high volume, low ASP business. Relatively low margin. The new management recognized two things. 1) The company’s heritage was about MOSFETs. They *invented* the MOSFET 30 yrs ago. It’s part of what this company is. And so it’s worth keeping. 2) Power mgmt provides all the volume for IR and if you own your own facilities, you have to have volume to fill it! So …they kept it.

- #3: Shift whole manufacturing strategy toward 70/30. This provides a lot of flexibility – they had no flexibility in last downturn, so when utilization dropped significantly, margins get crushed. The 70/30 should help a good bit.

So what? There’s nothing in here that jumps off the page and suggests that Oleg is a Mark Hurd type character. However, as the conversation progressed, my conviction started to grow that he is a change agent and that he has the company moving in the right direction.

****** ON THE MARGIN EXPANSION GOAL & OUTSOURCING

** Question: Power management. Looking through filings, it looks like 2007 power mgmt. gross margins were 35% (21% today). A) Is that apples to apples? (b) What needs to happen to get them back there?

Answer: Apples to apples? No. In 2007, there was no PCS, high voltage MOSFETS. So, the power mgmt business back then was just larger and the scale helped margins. So … no, it’s not good to compare.

OK … so what needs to get power mgmt margins back to the 25-35% range?

Mostly mix, some scale.

Mix: The biggest element is the launching new products. New products will have higher gm’s. Each product will have lifespan of 6-8yrs. 45% margin at the front. Natural price decline each year. End at 20%.

Lingering question to follow-up on: what do the new products bring the customer? Why can’t they just stay with the old ones and keep benefiting from the shrinking prices??

** Question: Are there any products we should be particularly mindful of? Any that will move the needle?

A: Nope. This whole portfolio of power mgmt. has 1000s of products. So, there are lots of new ones.

** Question: Do they break out any metrics like “% of revenues from new products” or anything that can give us an idea of their progress?

Nope. If we’re looking for anything in this regard, look at where they are as far as outsourcing goes. The point: they’re outsourcing the older generation of products. A few years ago – 98% of products were internal. Last qtr – 77%/23%.

Importantly, what is being outsourced is primarily power mgmt – older platform – lower gross margin products. They’re being offloaded to foundries that are good at running high volume, low cost type products. This opens up space to run higher margin, new products internally at IR.

** Q: Is 70/30 a “step #1” that will eventually lead to 50/50 or even 100% outsourced?

No. It’s fair to say that 70/30 might one day go to 60/40 … but that’s going to be capped by:

(1) they’re only outsourcing older stuff … which, as long as there are new products ramping on an on-going basis, will prevent the ratio from going to 100%.
(2) they want to maintain some leverage w/foundries on pricing (“we’ll do this in-house if you try to price too aggressively”)
(3) also a bit worried about losing IP if everything was outsourced.

THAT SAID …. The company’s internal capacity can only support about $800mn in revenue. They are currently on a run rate of $1.1bn. So … if IR is one day moving towards $1.6bn, theoretically, the ratio could move toward 50/50. But – no – the goal is NOT to outsource everything.

** Q: IR has a target for high teens long-term EBIT margins …. but the Street is only at 13% for 2013. Is there a reason for that?

A: IR had no real good answer. My sense after talking to them is that the Street may be overly conservative. But my conviction is low. Perhaps the 13% is in part the result of a consensus view that the semi industry will be in a downcycle in 2012 or 2013? Or perhaps the Street just isn’t giving the company the benefit of the doubt? Dunno.

With that caveat aside, the 13% does seem conservative!

There are two sub-components of this target:

#1: It comes with a top line target of $1.25bn. This, says IR, should provide enough scale (assuming the product mix is right) to get to the low 40%s gross margin and the high teens EBIT. Interestingly, the Street does in fact model $1.25bn in FY 2013 …with an EBIT margin of 13%. Hmm.

#2: Part #2 of the vision is to lower SG&A through the implementation of a new ERP system. IR admitted the company has been run on spreadsheets more or less and that just by getting a new system in place ,there are opportunities to save in SG&A.

So what? So … if the $1.25bn in revenue AND the ERP opportunities coincide, then – sure – IR sees the possibility of getting to high teens margins by 2013.

Separate thought: it might make sense to drill into this “run on spreadsheets” comment. Was this just a really poorly run company for a couple decades? I’d like to learn more about what this ERP change is all about? How is it being implemented? Is the company culturally ready to move beyond ‘spreadsheets’? Sounds simple – but I think there may be a lot to learn here holographically.

Another thought: This sounds wayyyyyyyyyyyyyyyyyyyyy too much like our thesis about Fairchild did three years ago, no?

** Question: Back to the gross margin goal, is it *ALL* about the power management segment?

Answer: No. As I’ve just explained, some of it has to do with scale … which is of course generated through volume/revenue growth. So … to the extent that other segments can benefit on the top line from secular shifts around power / energy, it helps margins too.

IR walked through a couple such themes that could generate growth in more detail. To be clear, I haven’t done much work in these areas or the legitimacy of these claims since I’ve focused more of my work on the internal changes at IR. But here’s what the company’s stated growth opportunities are.

#1: Energy Saving Products (20% of revenues)

- This is all about penetration of variable speed motor drives into things like air conditioners, washer dryers, compressors on refrigerators. IR says there’s a shift taking place from a manual brush motor to a fully electronic variable speed motor drive.
- The energy efficiency – 30-40% savings.
- The penetration rate of variable speed motor driver is very low – low teens. But … rates are growing rapidly inside of what is ultimately pretty slow growing markets. Compressors in fridges: 6-7% penetration. Washing machines 15% penetration. A/C = 25% penetration.

Q: So why now? Why is now the time for variable speed motor drives? Hasn’t “energy savings” been part of the story around such appliances for years and years? Why such low penetration?

A: There’s more action internationally. More governments mandating things like variable speed motor drives. And more folks with disposable income in … say … China who are buying such things.

Also, it was always cheaper to use older ones. Variable speed motor drives didn’t come out til 2003. Without any push toward energy efficiency from govt – they won’t get adopted. It’s been cheaper just to use older ones. But this is changing as governments are mandating their usage.

Follow-up question to ask: I want to learn more about the government angle. Is there *really* a change here? I’m skeptical.

So what? IR didn’t have any real good answer as to “why now” …but, frankly, I can live with that. My working thesis isn’t based on rapid top line growth. We’re just looking for a compelling enough of a backdrop to allow the company to grow to reach its EBIT margin goals.

Q: Who else makes variable speed motor drives?
A: Fairchild, Infineon, Mitsubishi. (just good to know).

… worth noting: IR says something similar is taking place in the Industrial area. So – not so much about refrigerators …but rather, there are all sorts of pumps and fans that you never see that are shifting to variable speed motor drives. IR acknowledges it’s a muuuuch slower cycle, but the crisis around energy efficiency is taking penetration rates higher.

Q: Similar to power management, are there new products w/higher margins in this segment?

A: Not really, no. These are more app specific. So you don’t announce one product that covers everything like a MOSFET. It’s more designing w/customer and making it to their needs and winning a socket.

Q: Why do ESP products have higher margins? (in the 40%s).

A: The competitive dynamic is such that when you are designed in, you’re good to go for 2-3 years without being displaced. The cycles are that long. In power management, the cycles are shorter so you can get designed out in 9mo’s if you’re not careful (or if you’re not competitive w/your prices).

#2: Automobiles (8% of revenues)

The idea here is, quite frankly, one that I heard about this company 10 years ago: “more electrical content in automobiles is driving an opportunity at IR”.

The question is: what’s different today? I’ve heard this argument forever but this segment is still just a $70mn per year business.

Answer:

#1: one change is that the applications that require the most electrical content are being driven into the mid-tiered vehicles. So … while things like parking lane sensors & night vision have been in high end BMWs for awhile, they’re filtering down into lower priced vehicles. IR suggested to “take a look at today’s Ford Taurus relative to what it was three years ago” – etc. (I haven’t yet done so).

#2: Oleg (new CEO) is a huge fan of the auto market. He’s been more aggressive in growing this business. In fact, it previously wasn’t broken out as its own segment. He started that, and last qtr it reached a historic peak.

Q: Why does Oleg like autos?

A: it’s like getting an annuity. The design program might go for 8yrs. So … unless you completely mess it up, you’re good to go for a long time. My add: Ah, makes sense.

Q: How does pricing work if it’s an 8 yr program?

A: It starts out w/higher gross margin but the contract will set yearly pricing declines that will mirror what kind of advancements you should be able to make in your own manufacturing costs.

And … when you get to end of lifecycle, there’s quite low opex support – so good ebit margins.

Q: Can you give me any metric about the average content you (IR) have going into a car and how that increases? (Kind of like ARM Holdings does with smart phones). Can’t you simplify this for us?

A: Not really. IR sells to the sub-component companies, so they don’t really know what’s going into the automobile. So … for instance … they’ll sell to Bosh and then Bosh puts the component into a power steering column without IR really knowing what’s in the end product.

** CONCLUSION

I’m getting more positive but questions remain. I’ll go back to Chris to see if I can get answers to a few more of these. I’d also love to get 20mins with Oleg. I’m frankly a tad freaked about the Street being sooooo far below the company’s long-term target – that’s just so unlike the Street that it makes me think I’m missing something!!! I’ll follow up with that a bit more too. For now – I suggest moving to Pre-determined game plan.

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International Rectifier Follow-up November 2010

** Conclusion: Let’s take a position. There is plenty more to learn, but I think we can do it as we go. I’ve seen enough to make me think IR belongs in the portfolio.

** The main goal today is to review the initiation report a friend sent us to see if there was anything that materially furthered or contradicted our working thesis.

First, I wanted to follow-up on my last round of work with one more perspective on security analysis. I noted last time that in the DCF / Decision Engine, the company scored quite well (well into the least expensive quintile). But another perspective: how can we make 50% in 18mo’s given EPS and PE assumptions?

** 50% IN 18 MONTHS

Here’s what it’d take for us to make 50% in IR in 18mo’s. Top line growth generally in line with Street estimates through FY 2013 with EBIT margins growing from 2011’s expected 11% to 17% by fiscal 2013.

Our starting point:

- Current top line ests (FY 2011-2013): 23%, 8%, 8%
- Current EBIT margin ests (FY 2011-2013): 11%, 12%, NA
- Current EPS (Fy 2011-2013): $1.39, $1.65, NA
- Current PE = 16x forward estimates (which are CY 2011 EPS estimates since we’re now in November).

My assumptions:

- PE: I’m going to simply pull the PE forward as I have little conviction about what the Street will use in 18mo’s. I think 16x is reasonable, anyway.

Question: what EPS will we be applying the 16x to in 18mo’s?
Answer: FY 2013 (June). That is, in 18mo’s, it’ll be May 2012 and “forward” estimates will translate to FY 2013 EPS.

So, in 18mo’s, if we’re going to make 50% from today’s $24, International Rectifier have to trade at $36 … which means that if we pull the 16x PE forward, its FY 2013 EPS would have to be $2.25.

So … what assumptions will get us to $2.25 in FY 2013?

- My top line assumption (FY 2011-2013): 23%, 8%, 8%. This is right where the Street is presently – and, I think, reasonable.
- My EBIT margin assumption: 12%, 14%, 17%. I’m assuming mgmt makes more progress toward its “high teens” target than the Street gives them credit for.
- This generates EPS of: $1.40, $1.85 and $2.25.

So what? The point: if management gets close to their margin bogeys in FY 2013 (June), 50% upside from today’s price is very doable. As I said last time, a key question is how much margin expansion can be had through restructuring (fab consolidation) … how much of that is already behind us … and how much more margin expansion is dependent on power mgmt pricing (something I have less conviction about).

All things considered, I think we ought to take a position. The company has a decent (not great) secular tailwind around power management ….and a new management team that has already demonstrated a willingness to make serious changes.

** SOME TIDBITS FROM BROKER NOTE

Conclusion: nothing material here. Just a good sanity check.
There was a bit more emphasis on new Gallium Nitride products – “a brand new technology that could revolutionize power semiconductors”.

Industrial and Auto have been – and remain – strong.
“The cloud” is driving strong orders for their server ICs such that inventories are lean and pockets of shortages exist.

EBIT margin in FY 2010 (June) = 14%. This is above the Street and is more aligned with my thinking that Street EBIT margins look rather conservative.

The Street is at 12% for FY 2012 and 13% for FY 2013.

IR reports on Thursday. The analyst didn’t seem to meaningfully tilt one way or the other regarding the upcoming set of results.

The company recently authorized more share to be bought back. It’s currently $50-60mn thru a $100mn plan and jus authorized another $50mn.

The new management has come in and made some real changes. The note didn’t go into detail … it only provided a quick overview of the company’s history and mentioned that the new mgmt has essentially cleaned things up.

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** INTERNATIONAL RECTIFIER RESULTS – NOVEMBER 2010

Conclusion: Good results, thesis affirming. The company continues to make progress on its planned EBIT margin expansion. (Fwiw – shares up 11%)

As a reminder, our thesis is that International Rectifier (IR), a semiconductor company that focuses primarily on power savings, will benefit from a turnaround driven by a new management team whose new manufacturing strategy should lead to higher EBIT margins. To be clear, we see IR as a unique turnaround opportunity as opposed to a secular investment in “power management”. We expect the “power saving” value proposition to generate a top line backdrop that is interesting but not “monumental” in and of itself. However, the margin expansion that can be achieved through fab closures, outsourced manufacturing and the consolidation of assembly and test partners is more compelling to us, and we see IR making its way toward its goal of high teens EBIT margins over the next couple years from 2010’s 2% and 2011E’s 11%.

Headline results:
- Revenues of $281mn grew 57% y/y and 7% q/q and came in above guidance ($275-280mn)
- EPS of $0.42 came in ahead of the Street’s $0.39.
- Gross margin of 38.7% was roughly 100bps ahead of the Street. Margin guidance calls for 39.5-40% in December …above the Street’s 38% citing mix as the driver (not so much ‘new product mix’ as much as segment mix. That is, higher margin products like industrial are expected to grow faster in 4Q).
- EBIT was 11%, up from last qtr’s 8% and last year’s (11%).
- Guidance of $275-285mn for December compares to the Street’s $278mn.
- By mix, auto and industrial were strong; consumer & notebook weak.

Among the key considerations in our pre-determined game plan:

** Burning question: Beyond the things that are in IR’s control (eg, outsourcing, consolidation of fabs, new product ramp), what other forces have to come into alignment in order for IR’s gross margin target to be realized? What other factors might be holding IR’s margins back? Competitor pricing, perhaps? Related “Where wrong” risk: The semi cycle may dominate IR’s fundamentals moreso than the positive changes we’ve identified.

- Update: while this comes from mgmt and therefore should be taken with a grain of salt, Oleg was asked about pricing and he offered a pretty firm & positive response. IR is not seeing any return to irrational behavior of price cutting. “It’s really a function of supply and demand and how the people feel the demand is going to be in the future. From where I am sitting and based in our intelligence on the availability of foundry capacity and internal capacity at our competitors, we see that pretty much everybody is running nearly the full fabs and it would be foolish for anybody to drop the prices at this point in time because in a matter of quarters as our cycle starts to pick up again, they will stuck with lower priced products and I think what we are seeing is quite a bit of discipline in the industry about maintaining the prices.”

So what? The good news is that pricing is firm. The not-so-good news is that implicit in his response is the acknowledgement that – yeah – these are standard products and – yeah – there’s nothing shielding them from irrational price behavior at some point in the future when the cycle turns south. Let’s not forget that.

** Burning question: On the EBIT margin targets …. Just how much can IR get SG&A down by implementing a new ERP system? How can we grow conviction *today* that the 15% SG&A goal is achievable (2010’s SG&A is 19%). Related “Where wrong” risk: If there has been a negative change in the industry structure that has led to a permanently lower EBIT margin level, it may be more difficult for management to get margins to their desired targets by the methods they are attempting (mix and scale).

- Update: IR is making very good progress toward its EBIT margin targets.
- Gross margin of 38.7% is up from last qtr’s 36.1% and last year’s 26.4%.
- SG&A of 17.2% of revenues was flat q/q and improved from last year’s 24.3%. The goal is to get this to 15%.
- Importantly, power management gross margins improved to 29.5%. As a reminder, in FY10 it was 17% and the company’s target range is 25-35%.

So what? Very good progress. On the call, some analysts asked about IR being “ahead of plan”. Oleg didn’t bite and said there is more work to do. However … he did say “to the extent we hit (the target) earlier, that’s great and we will just have to reset and up the targets (then). At this point in time, I probably do not want to comment beyond our guidance in June.”. My add: no use trying to speculate and read mgmt’s mind, but the implication that there is room to get margins beyond current targets is compelling.

All things considered – a good set of results. Though shares are on a bit of a spike, I’m modestly biased to add 20-30bps to our position and take IR higher from its “starter position”. If there’s a negative, it’s that IR mentioned that consumer & PC remained soft. While that weakness is being more than offset by strength in other segments, we ought to keep watch that IR doesn’t get too damaged by a secular decline in the PC business. Considering PCs are in their enterprise power segment, which is just 17% of revenues, I think we’re relatively well shielded.

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Feb 2011

** INTERNATIONAL RECTIFIER RESULTS

Conclusion: Great results. EPS estimates will go up substantially. Two big takeaways: (1) margins exceeded expectations by a lot. (2) a portion of the margin upside was because of an inventory build which merits watching. Still – very good results on the whole. Thesis intact.

As a reminder, our thesis is that International Rectifier (IR), a semiconductor company that focuses primarily on power savings, will benefit from a turnaround driven by a new management team and a new manufacturing strategy. The margin expansion that can be achieved through fab closures, outsourced manufacturing and the consolidation of assembly and test partners is compelling, and we see IR making its way toward its goal of high teens EBIT margins over the next couple years from 2010’s 2% and 2011E’s 12%.

Headline results:

- Revenue of $282mn grew 34% y/y and was in-line with consensus.
- EPS of $0.63 beat the Street’s $0.48 as EBIT margins reached 15.8% – up from last year’s 0% and ahead of Street estimates by about 300bps.
- Guidance for both revenue and gross margin guidance or March is ahead of the Street. Revs: $290mn vs the Street’s $275mn. I haven’t seen how all models on the Street have been updated, but March EPS will likely head toward the mid-$0.40s from about $0.40 with EBIT margins of about 12% (seasonally light qtr).

Among the key considerations in our pre-determined game plan:

** Burning question: NEW PRODUCTS: Why will a new product ramp affect mix and margins *now* given the fact that IR has thousands of products?

Update: I want to follow-up with the company to get a better understanding of the dynamics here. But I’ll note here that the gross margin upside *this* qtr was driven partially by inventory build / higher capacity utilization and partially by better mix.

Now … for context, the goal is to get margins in the low 40%s. The progression: Sept 39%, Dec 43%, March est 39-39.5%. So … they say they’re making progress but they acknowledged that the 43% in December was exaggerated by the inventory build.

More on this inventory build….

Inventory days grew to 128 days from 97 days. Their target 105-110.

Management said it expects foundry capacity to get very tight in the summer. So, they’ve taken advantage of current available capacity to replenish their dye banks for long life, high-volume products.

Why do they expect foundry capacity to get tight?

CEO says that in past downturns, utilization at the foundries would drop to 80%. Presently, they’re all running at about 90% and TSMC is actually almost at 100%. Ditto for backend assembly and test.

Also – they note that these standard, off the shelf products are the ones they outsource to foundries. And a lot of their proprietary products are only run in-house. So, they thought it was prudent for to build a dye bank for some of their high-volume, long-life products like discrete devices so that if capacity becomes too tight this summer, they’d be able to have room dedicated in their internal fabs to the single-source, proprietary products.

My take: I buy it. If I had the thought that Oleg (the CEO) didn’t know what he was doing, I’d be very troubled by this. However, our entire thesis is that he is *very* skilled w/regard to manufacturing. I’m willing to give him the benefit of the doubt here … and, in fact, it may turn out to be a brilliant move if capacity does get super tight this summer (something I frankly don’t have much conviction about right now).

** Burning question: PRICING: What forces outside of IR’s control might also be holding back margins? Competitor pricing, perhaps?

Update: management was asked about pricing for discretes on the conf call. While this is just falls into the “management controls the powerpoint” category and therefore has to be taken with a grain of salt, he was pretty direct. “Pricing is still pretty robust and I think it’s only going to if anything we may see the industry raising prices in the summer in the shortage of capacity in deed materializes at foundry in the backend assembly and test areas.”

** Burning question: MARGIN OPEX: Just how much can IR get SG&A down with a new ERP system? How can we grow conviction that 2010’s 19% will go to 15%?

Update: The upside was driven by Gross Margins, not better Opex. But the company is making slow, steady progress here. Over the past four qtr’s, SG&A as a % of sales has been: 17.7%, 17.8%, 17.1%, and 16.5%. Next qtr should bring another 20-30bps of improvement. Nothing dramatic, but the company is still target getting to ‘high teens’ EBIT margin once they get to $1.25bn in revenue. For context, the Street had been at 12% in FY11 (June) and 14% in FY12.

Conclusion: All things considered, this is a good result. Yes, the inventory spike bears watching, and yes, the inventory build helped margins reach an exaggerated level. But even without that, the company is making progress on the EBIT margin line. It’s hard to argue with this EBIT trend over the last four qtrs – 0%, 7%, 8%, 16%.!!! Let’s maintain a 1.3% long position. If anything, I’m biased toward adding a bit but lets see where new estimates shake out and what it does to our decision engine measures….