Thu: What makes Silicom run?

More than technology and results, it's a matter of who has been buying the shares.

My travels through the land of small-cap stocks with potential has taken me (or brought me back) to Silicom Ltd. (Nasdaq:SILC; TASE:SILC). Ill start by saying that I know no stock that has risen more than Silicom from October 2002 to today. In December 2002, the stock plummeted to $0.20 a share. This week, it crossed the $11.5 level. This represents a 57-fold rise. Orckit Communications (Nasdaq: ORCT; TASE: ORCT), for example, rose to a value 25 times that of its all time low, while Aladdin Knowledge Systems (Nasdaq: ALDN; TASE: ALDN) only managed a seventeen-fold rise . Anyone who knows of another Israeli stock that has risen 57 times in value since 2002, is invited to step forward; I dont.

Lets try and fathom out what it is that makes Silicom run. First I should note that Silicom is one of the veteran Israeli companies on Wall Street. It was issued back in 1994 at a price, if my memory serves me correctly, of $5 a share. The laypersons among us would do well to watch their words when they try to define the companys line of business. Silicom manufactures smart electronic cards that can be used as adaptors, junction boxes, re-routers and transmitters. Its cards support transmission of all types of information between computers, over networks, and some of its products have also been adapted for use in security software. If, for example, an information stream is truncated (due to a power failure or another cause) Silicoms bypass software is activated, enabling the resumption of the information flow.

Founded in 1987 by current chairman Avi Eizenman and the Zisapel brothers, the close of the last century saw Silicom stock achieve popularity, reaching highs in excess of $20. Many other stock were also breaking records back then. The problem with Silicom was that it was, in effect, thrown out of the aircraft without a parachute. What does this mean here? Caught up in the technological euphoria of that period, Silicom abandoned its traditional lines of business and moved to a field that looked fantastic at that time, end-user connection technologies. The company developed USB connectors that were to be relevant to the development of IT. While it was still engrossed in its dreams, the market disintegrated, leaving Silicom with no business and almost no money.

The current chairman, Avi Eizenman, managed somehow to stabilize and revitalize the company. He began to look for ways in which the know-how that the veteran company had accrued could to be used to try and save its business. How Eizenman managed to take a company with no sales and $1.5 million in cash and bring it back to life is beyond me, but that is what happened. I must state that, at the end of 2002, I feared for the future of the company and its employees, since no buyers could be found for a company valued at $800,000 only. In 2001, when it looked like the company had developed a new device and had something to offer despite everything, a new CEO, Shaike Orbach, was brought in, and Eizenman stayed on as chairman. Orbach had previously served as president and CEO at Opgal, a subsidiary of Rafael Armament Development Authority Ltd.. Before that he managed Edusoft . Persuading someone like Orbach to leave Opgal for a company like Silicom must no doubt have required a bait of some sort, and it wasnt money. From the moment he took over I realized that there was something in that company, only I dont know exactly what it is.

The gains up to the start of 2004 were not related at all to Silicom but were instead, a function of market activity, an general revival in the technology stock indices.

The really important question is what caused a stock like Silicom to climb consistently to the enviable level it is at today, while stocks such as Top Image Systems Ltd. (Nasdaq: TISA), Mind CTI (Nasdaq: MNDO; TASE: MNDO), Eltek (Nasdaq: ELTK, or Alvarion (Nasdaq: ALVR; TASE: ALVR) have stayed put since the middle of 2004?

Dont assume it has something to do with results. Silicom has achieved amazing results, but I can show you several other companies that have done equally well whose stocks have not moved.

The big question is to who do the shares go to. Speculative money abandons a stock at the first opportunity, usually after it has made a profit of 200% or more. So if it's the public that is buying the stock, and the market begins to falter, the stock will come to a halt. But if the stock falls into institutional hands that have an interest, the stock will continue to rise as the dream materializes and business results are delivered.

Lets try now to understand this through the case of the Silicom stock.

If you have followed the progress of Silicom stock, you will find that it too came to a halt following the first quarter of 2004. From the beginning of April onwards the stock began a downward slide. By September 2004 it had fallen 33% its $2.7 level in April to $1.8. In other words, Silicom behaved, in 2004, in a similar fashion to all the other technology stocks. The stock began to climb again at the end of 2004.

What happened then? There was a string of impressive yet unclear announcements. They referred to preliminary OEM agreements with anonymous giants. True, the information provided was incomplete, but people following the company found that the aftermath of the massive gains left Silicom with a valuation in mid 2005 of $15-16 million only. This was, of course, a substantial increase on the earlier value of $800,000. My estimate is that as early as the first half of 2005, Silicom began talking to underwriters about a public offering to raise resources that it lacked. The underwriters realized the potential that Silicom had and agreed. Here again full credit must go to the companys management. I think that, during 2005, the companys shares transferred from private ownership - bargain hunters, speculators and a intrepid public- to the institutions.

Although the Silicom share issue in January 2006 was miniscule, raising $6 million only (excluding options), it was held on the Israeli market, which, in its hunger for shares, needed no encouragement. Note that the exercise price of the options issued, $8.63 a unit, went into the money within ten days of the issue. Bear in mind also that the volumes have increased at least fivefold since the end of January 2006. Anyone who has spent more than two days in the market will tell you that shares changed hands, that people converted a substantial quantity of options and many of them made money. All this can be credited to the management and the skill it demonstrated in the actions it took, including, naturally, selling the company to the underwriters. Please remember that when Silicom announced the public offering at the beginning of January 2006, nobody knew about the excellent results for the end of 2005, but I have no doubt that several entities were convinced that they would be just that and predicted that the public would return once the results were available. That is what happened.

Would it be worth investing in Silicom at its present level? Given that there as yet no indications of the type of agreements, the identity of the parties involved, and the direction they will take, it would be difficult to make a genuine assessment. One thing that is clear, however, is that the pace of business progress to date is one that most certainly does not justify a market cap as low as $48 million. It's unfortunate that no serious analyst has as yet checked this out. Despite the gains to date, I believe that the current price embodies more opportunity than risk, but it's a matter of a more long-term investment.

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