Mathematically speaking, free cash flow is net income plus depreciation minus the total of dividends, capital expenditures, required debt repayments, and any other scheduled cash outlays. It’s basically a measure of how much hard cash a company generated in a given period after paying for its regular business expenses and growth initiatives. It is a good gauge of how well management is performing for its shareholders.
Some investors prefer free cash flow over earnings, in fact, because they believe that earnings, which are largely an accounting figure, can be manipulated more easily than hard cash. Also, in some cases, earnings get distorted unintentionally by accounting principles.
To help investors find companies that have a solid history of generating healthy amounts of free cash flow, Value Line produces a weekly screen that appears in the Index section of every issue of The Value Line Investment Survey that highlights this metric.
Labeled “Biggest ‘Free Flow’ Cash Generators”, the screen lists the top 100 companies of the 1,700 The Value Line Investment Survey follows based on free cash flow generation over a trailing five-year period. The long time frame is used to ensure that companies with solid histories of creating cash flow are brought to the fore, weeding out companies that have temporary boosts to their cash flow generation because of short-term or one-time events. After reviewing the screen’s recent results, we have chosen to highlight Synaptics, Inc. (SYNA).
Synaptics is a leading developer and supplier of custom-designed human interface solutions that enable people to interact with smartphones, tablets, and PCs (primarily notebook computers). Its customers include most of the largest OEMs of smartphones and PC OEMs. Net revenue for mobile product applications accounted for approximately 73%, 64%, and 49% of net revenue for fiscal 2014, 2013, and 2012, respectively. The remainder of its sales stem from PC product applications.
Synaptics dominates the notebook PC touchpad market with a near 70% market share. Thus, the performance of the PC unit generally mirrors that of the broader laptop market. The company commands a lower percentage of the touchscreen market, which we estimate to be above 40%. Its principal competition in the touchscreen market includes Atmel (ATML), Cypress (CY), Elan Microelectronics.
Its product portfolio is fairly broad, which allows the company to address high-end, mid-range and some lower-end mobile and PC devices. Every solution SYNA offers includes a chipset, customer-specific firmware, and software. The company tries to differentiate its products through ease of use, the amount of space they take up in a device, low power consumption, advanced functionality, secure access, durability, and reliability.
Synaptics posted stellar results for fiscal 2014. The top line grew an impressive 43%, on top of 20% growth in 2013. Earnings per share rose 37% even with some share-count dilution caused by the acquisition of Validity Sensors (more below).
Synaptics expects momentum to continue in 2015, with the top line rising somewhere around the mid-20s. According to the company, industry projections for the smartphone market for the period 2014 to 2015 predict a growth rate of approximately 13%, while notebook sales ought to rise around 3%. If these estimates turn out to be accurate, SYNA ought to grow its markets share.
One of the primary reasons we think a growth rate of over 20% is achievable this year is rising demand for SYNA’s display integration solutions, dubbed In-Cell, On-Cell, and single layer On-Cell. These devices are lighter and cost less because they eliminate an extra sheet of glass or plastic by putting the sensor directly on the LCD displays. This allows OEMs to create thinner smartphones with improved display and lower power consumption. We think competitors are still lagging in this area, despite catching up with other features like sensors that respond when a hand is hovering or has gloves on. The company reported that around 40% of the smartphone products it shipped in the June quarter incorporated display integration technology.
Synaptics has these kind of devices for mid-range models as well, which augurs well for its China business. Indeed, On-Cell products to Chinese OEMs were up significantly in the June Quarter, and the company is achieving a good combination of market share and volume gains. The strategy with China has been to start with leading international brands and then branch out to smaller customers. We expect mid-range volumes in emerging markets to ramp up over the next several years as LTE infrastructure is built. Overall, we think this is a good strategy considering that the high-end smartphone space in developed markets like the U.S. and Europe is starting to become saturated, and will likely be reserved to replacement business in the coming years, not upgrades.
Further, with the recent acquisition of Renesas RSG, Synaptics will be able to reduce an OEM’s bill of materials even more by integrating a touchscreen controller with a display driver (controls each pixel on the display). This will help OEMs save time, money, and space, while increasing power efficiency and synchronization of the screen and touch performance. We expect these solutions to begin ramping up in late calendar 2015.
Fingerprint technology is another major growth driver for the company. In addition to easy purchase authorization, it's simply easier in our view to unlock a smartphone using your fingerprint instead of having to type in a code. We think more and more vendors will also integrate the technology, and Synaptics is in excellent position to capitalize on this, thanks to Validity, which is now responsible for a quarter of revenue.
We think Synaptics is generally well positioned for strong free cash flow generation over the long-term. The complexity of designing custom solutions makes us doubt the theory that touch controllers will become commoditized. We have confidence that Synaptics will continue to win new flagship devices for the foreseeable future. Further, the acquisition of the fingerprint identification business demonstrates SYNA's commitment to new technology. We think the shares are still reasonably valued, and are more inclined to believe the company will beat earnings estimates ahead. Still, reliance on emerging market smartphone demand adds some risk here.