Fixstars: Scaling issues as cyclical downturn looms

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investment work

With strong trading of late, Fixstars (OTCPK:FXSRF) shares have had a strong year-to-date performance. However, the consulting business model is inherently difficult to scale and we expect a downturn in the semiconductor market in the near future 12 months we consider the risk profile to be high. With the shares trading at an estimate PER FY9/2023 of 43.0x, we rate the shares as Sell.

Quick primer

Founded in 2002, Fixstars is a specialized Japanese consulting firm serving domestic semiconductor manufacturers. Its largest customers in FY9/21 were Kioxia (unlisted, formerly Toshiba Memory, specializing in NAND flash memory), NEXTY Electronics (unlisted, a Toyota (TM) Group-affiliated semiconductor components trading company) and Hitachi (OTCPK :HTHIY) .

Fixstars’ key competitive advantage is its team of engineers experienced in both hardware architecture and software development, enabling performance upgrades on different types of semiconductors. These include parallel processing technology in multi-core environments, optimal programming technology for different hardware architectures (e.g. GPUs and FPGAs), and controller development that leverages the technical properties of NAND flash memory.

Its core activity is providing consulting services as part of the solutions business (98% of total revenue in FY9/2021) which includes some specialized hardware sales and a smaller niche SaaS business providing cloud products for Ising machines, online medical services and AI-based covers code review. It also has a joint venture with NEXTY Electronics to develop autonomous driving software.

Important financial figures

There is no sell-side reporting and no earnings estimates available; we have drawn up a company forecast for the current financial year.

Important financial figures

Financial figures (company)

Our goals

With recent earnings already peaking in FY9/2019, we want to assess whether this niche business with its dependency on the semiconductor cycle can sustain a steady growth profile.

A business model that is difficult to scale

As a consulting service, Fixstars is able to grow its sales and increase revenues by increasing the number of engineers, increasing utilization rates and maintaining high staff utilization rates. The company has managed to increase its workforce from 133 in FY9/2016 to 258 in FY9/2021, almost doubling in the last 5 years. However, the company acknowledges that hiring has become very competitive resulting in only 5 net hires in FY9/2021.

Increasing the workforce inevitably requires the hiring of junior staff who are essential to investing in future growth. Although Fixstars has its fair share of mid-career engineer hiring, the most recent peak was in FY 9/2019 if we look at the trend of revenue per employee for the FY. We believe this is partly due to the growing proportion of less experienced employees on the books. The other key factor seems to be Kioxia (formerly Toshiba Memory). In 2017, Toshiba (OTCPK:TOSBF) was forced to sell its flash memory business to avoid bankruptcy after a financial scandal affected its Westinghouse nuclear facility. The memory business was spun off and sold to a consortium led by Bain Capital for $18 billion after a high-stakes bidding war. After completing the transaction in June 2018, we believe that under new leadership, Kioxia has reduced operating costs in preparation for an IPO, resulting in less business and reduced utilization for suppliers like Fixstars.

Development of sales per employee

Development of sales per employee

Development of turnover per employee (company, Refinitiv)

With its key customer under some pressure, Fixstars has limited capacity to grow its business, although efforts to develop a SaaS business are consistent with its goal of developing a sustainable revenue model. On the other hand, we believe that the majority of the consultancy work carried out involves longer-term contracts and therefore earnings visibility tends to be high. As a result, actual reported results often exceed company forecasts.

The company’s guidance for FY9/2022 is powerful with revenue growth of 18.2% yoy. The results for the first half of the financial year 9/2022 were stable, with revenue growth of 9.2% yoy and an increase in operating profit of 86.2%. Despite the official stance to invest in new hires and new business development (especially SaaS), Fixstars appears to be significantly ahead of forecast with the current run rate of 79% of operating profit in H1 FY9/2022. This also seems to be reflected in the YTD share price development (plus 25%).

Despite the upside risk from earnings into H2 FY9/2022, we believe it will be difficult to maintain a sustainable earnings profile unless the company sees renewed demand from Kioxia or can attract high-end engineers in abundance .

semiconductor cycle

Deutsche Bank Research believes that the current semiconductor cycle is projected to be longer than usual (page 8) after peaking in post-COVID CY2021 and is expected to continue into CY2023. Current supply bottlenecks and the increase in manufacturing capacity could lead to a negative scenario in the medium term, in which there is a risk of demand normalizing, together with excess manufacturing capacity leading to a dramatic drop in prices. Such a scenario would mean that semiconductor manufacturers would scale back their R&D to weather the storm, and suppliers like Fixstars would be able to win less lucrative long-term deals in the mid-term.

valuation

Shares are trading at 51.6x PER FY9/2022 and assuming upbeat EPS growth of 20%y/y for FY9/2023 the resulting P/E is 43.0x. That’s not a cheap multiple, and it tells us that the market may be overvaluing the company for its status as a specialty technology company.

Given limited signs that hiring is recovering (the company is reportedly targeting around 10 hirings in FY9/2022 (page 10 of the presentation)) and a potential downturn in the cycle within the next 12 months, we don’t think stocks should trade with a high premium are traded.

risks

Upside risk comes from key customer Kioxia and a significant increase in demand for long-term consulting work – a new plant is being built in Japan and further work may be pending to support new product development.

Fixstars may also be able to attract qualified engineers from new recruitment channels, particularly for its new SaaS operations. SaaS could provide a sustainable, high-margin revenue stream that’s easier to scale than consulting.

Downside risk stems from limited employee growth, which inherently limits growth capacity as a consulting service.

A downturn in the semiconductor cycle will lead to a long-term decline in the development of semiconductor products.

Conclusion

Fixstars has proven to be a valuable resource for Japanese semiconductor manufacturers who prefer to outsource development work to limit fixed costs in their companies. Gathering engineering know-how has been Fixstars’ key competitive advantage, but that doesn’t mean the company is immune to voluntary customer spending cuts and the downturn in the semiconductor cycle. Given what appears to be daunting challenges in the industry, we are negative on the stock and rate Fixstars as a Sell.

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