Forget Spending Money on Home Entertainment, Profit From It

Every year, many consumers spend hundreds and even thousands of dollars to upgrade their televisions, game systems, and stereo systems. With new technologies being developed constantly, people are also purchasing diverse devices such as tablet computers and electronic readers. This entertainment market rakes in billions of dollars a year, and many small and large companies enjoy profitability as consumers seek to buy the latest and greatest.

There are ways, however, for consumers to benefit from the discretionary spending frenzy.

When the average consumer thinks about home entertainment companies, firms like Sony SNE and Panasonic PC come to mind. These companies are prominent in this space and have their products in most retailers. Investors may or may not want to consider mature companies like these that have been listed on the equity markets since the 1970's. For the less risk-averse market participant, several small-cap companies in the home entertainment space may be interesting choices as investments.

Another player in home entertainment is Entropic Communications ENTR. This small-cap company specializes in designing, developing, and marketing semiconductor technologies to streamline home entertainment devices. Given its business model, Entropic may be an interesting equity to further research. However, investors must consider risks involved with Entropic, including the fact that it is a small-cap equity and that it operates in an industry laden with intense competition. The industry itself may not experience explosive growth like it has since the 90's, as some semiconductor customers are starting to produce the hardware in-house.

Entropic Communications boasts a growing balance sheet. Entropic increased its cash pile from $35 million to $98 million from 2009 to 2010, while also adding short-term investments to its portfolio. The firm's inventories have increased significantly, from $16 million to $40 million.

This large increase may mean one of two things: the company has either been having trouble selling its inventories or it has significantly increased its production capacity as a result of higher demand. Entropic has also been steadily increasing its property, plant, and equipment over the last five years, owning only $5 million of these assets in 2006 to $23 million in the year ended in 2010.

The liabilities are fairly positive for the company. Entropic has no short-term or long-term debt on its books, but its accrued liabilities and payables have increased from 2009 to 2010. Like inventories, these numbers might mean one of two things: it is either having trouble paying its business partners, or it has increased production capacity, naturally increasing short-term liabilities. Entropics' shareholders' equity has also increased in both paid-in capital and retained earnings. All sides of the balance sheet show clear trends, giving prospective investors an easier time to make an informed decision.

In 2010, Entropic earned revenues of $210 million, boosting its top-line from the previous year by $94 million. Accordingly, cost of goods sold increased from $57 million to $98 million. Interestingly, operating expenses marginally increased from 2009 to 2010; it increased from $72 million to $79 million. Given its relatively strong performance, EPS increased from -$0.19 in 2009 to $0.86 in 2010.

Entropic's earnings performance in 2010 is also reflected in its physical cash flows. The firm's cash flow from operations is primarily influenced by net income, deferred income taxes, and inventory. Some people contend that deferred taxes distort cash flow calculations, as they are not necessarily recurring items. Even if that were the case, deferred taxes lower Entropic's cash flows. Adjusted cash flows without this item would be $65 million instead of the $33 million reported.

Cash flow from investing activities changed from $2 million to -$74 million as a result of capital expenditures. This rapid change in cash outflows for Entropic indicates large investments in order to expand operational ability, for better or for worse. Cash flow from financing activities increased in 2010 significantly, as a result of $99 million worth of shares being issued. All things considered, Entropic Communication's cash position increased by $63 million from 2009 to 2010. Revenues, capital expenditures, and equity offerings all played the biggest roles in this fluctuation.

Entropic Communications may be undervalued when compared to competitors. Its stock trades at 4.5 times earnings, 1.3 times book value, and 1.3 times sales—for comparison's sake, on average, competitors trade at 12x, 2.5x, and 2.2x, respectively.

Growth prospects are also positive for Entropic. Its revenue growth over the last three years has been 19.7%, while competitors average 2.3%. The company's operating margin is also 21.9% while competitors' margins are typically around 13.7%. Entropic's return on equity is also higher than average; it has experienced 44.4% return while competitors average 22.3%.

However, certain risks are inherent in a company of Entropic's nature. It has a small market capitalization, and small-cap stocks typically carry more risk than their mature, large-cap counterparts. The semiconductor subsector is also flush with competitors, and companies are forced to design new technologies in order to garner market share. As a result, there are no guarantees Entropic will be able to continue its growth into the future. Lastly, the company's business strategy is in a niche area. Entropic caters primarily to individual consumers and does not target businesses or institutional clients. This focused business model could slow down its growth in the coming years.

Entropic Communications is a semiconductor company that strives to enhance the home entertainment experience. In an age when entertainment devices are increasingly commonplace in the average household, investors may want to consider diversifying their portfolios with companies involved in this trend. There are risks involved with investing in Entropic, but on a fundamental basis, the reward may be appropriate for some investors' risk appetites.

ACTION ITEMS:

Bullish View:
Traders who believe that Entropic Communications is an appropriate long investment might want to consider the following trades:

• Home entertainment devices and technology is increasingly commonplace for the average consumer.

• Entropic may be undervalued compared to direct competitors despite significantly improving its balance sheet over the last year.

• For a small-cap company, the accounting standards seem stringent and clearly depict its year-over-year growth.

Bearish:
Traders who believe that Entropic Communications is more suited for a short play may consider an alternate position:

• The company operates in an industry with an immense amount of large and small competitors.

• There are no guarantees that its growth is sustainable, given the rapid pace of technology advancement.

• Entropic Communications does not focus on institutional clients, which may limit its growth prospects.

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