Stock Pick of the Week: Sell/Short Integrated Device Technology, Inc. (IDTI)- Very Dangerous Rating

We closed this position on February 8, 2016. A copy of the associated Position Update report is here.

Our view of the technology sector is more positive than most of the other sectors, but it still gets our neutral rating because of stocks like Integrated Device Technology, Inc. (IDTI). Of the 561 technology stocks we cover, IDTI is one of the 77 that get our “very dangerous” rating and one of the few that make our most dan­ger­ous stocks list for January. The tech sector is tricky because there are several large-cap excellent stocks (MSFT, ADI and AAPL) that make the sector look very good and offer good hiding for some “very dangerous” smaller-cap stocks such as IDTI. For example, I recommended investors buy IBM, MSFT and ADI in previous “stock pick of the week” articles. In addition, in an interview on CNBC, we were very bullish on another semiconductor company, Intel (INTC), as one of our “most attractive” stocks when it made the list for August 2006. IDTI does not measure up to these other tech leaders and is riding the coattails of the better tech stocks.

Like all of our most dan­ger­ous stocks, IDTI has (1) mis­lead­ing earn­ings = account­ing prof­its are pos­i­tive and ris­ing while true, eco­nomic prof­its are neg­a­tive and falling and (2) high val­u­a­tion = very high expec­ta­tions embed­ded in the cur­rent valuation.

Specifically on “mis­lead­ing earn­ings”, I refer to the fact that IDTI reported a $1,085mm increase in GAAP earn­ings while our model shows eco­nomic earn­ings declined by $14mm (a dif­fer­ence of $1,099mm, about twice the company’s revenues) during the last fiscal year. The majority of this disconnect comes from two sources:

1.     Asset-write offs of $1,385mm (most of which occurred in the last 2 years), which equals 215% of reported net assets and is greater than the market value of the company. Given that management is supposed to create value, not destroy it, writing-down $2.15 for every $1 on the company’s balance sheet does not bode well for their ability to create shareholder value. Our recent article on Management Failures explains why investors need to beware of large asset-write-downs like those incurred by IDTI.

2.     Large non-operating charges taken by the company in 2009 which drove down 2009 results so they compare well against 2010 results, which are boosted by non-operating income.

Specifically on the stock’s high valuation, I refer to our discounted cash flow analysis of the current stock price of $6.46, which shows IDTI must grow its revenues at over 20% com­pounded annu­ally for at least 20 years while also improving its return on invested capital from -1% to +5%. A 20-year growth appre­ci­a­tion period with a 20%+ com­pound­ing growth rate sets expectations for future cash flow performance quite high. Historical growth rates are much lower. In addition, the stock’s upward movement is handicapped by the current, outstanding stock option liability of $31mm or 3% of current market value. As the stock price climbs, that option liability grows larger as all the outstanding stock options move more in-the-money and become more valuable.

Our report on IDTI, available here, has detailed appendices for you to see how we perform all calculations.

Over­all, the risk/reward of invest­ing in IDTI’s stock looks “very dan­ger­ous” to me. There is lots of down­side risk given the mis­lead­ing earn­ings while there is lit­tle upside reward given the already-rich expec­ta­tions embed­ded in the stock price.

In a business where investors make money by buying stocks with low expectations relative to their future potential, IDTI fits the pro­file of a great stock to short or sell.

Note: Stock pick of the week is updated every Tuesday.