MEMC Electronic: Glass Half Empty or Half Full?

With MEMC Electronic (WFR) getting hammered yesterday on disappointing earnings (see conference call transcript), investors are faced with the always difficult assessment of what to do with the stock. I make no claim to deep expertise on WFR, but here are some general comments on the quarter, the valuation and the stock market reaction.

Top line was about $10mm below the low end of management’s April 24^th guidance. Operational issues were the cause. Some analysts are concerned because this is the 2^nd quarter of such issues. Thus, the tendency is to extrapolate. But that is a human flaw. For a complex manufacturing process, operational problems are either indicative of poor process controls, or they are simply random events. Engineering types who follow the stock can perhaps answer this question. For now, let’s give the company the benefit of the doubt and call it random events, non-recurring glitches.

My red flags on the quarter would be: decline in gross margin yr/yr (but up sequentially), leading to modest negative operating leverage, and a slowdown in revenue growth. For growth investors, these are major issues.

In terms of the market reaction, it is useful to think about the sociology of the ownership. Pure quant funds will sell the stock today, no questions asked, owing to the negative surprise and slowing growth and negative estimate revisions and adverse stock reaction. Indeed, quant funds are successful because using the law of large numbers and disciplined decision rules, the batting average on success using these criteria is typically 55 to 65%, which is a significant statistical edge over pure random selection.

Some fundamental growth managers will also sell the stock today regardless of price, because they come to an unfavorable judgment about WFR’s future growth prospects. This is more of a qualitative decision, based on nuanced evaluation of a lot of different factors.

The really tricky part is whether WFR has dropped below a minimum hurdle rate of adequate growth versus its valuation. In other words, pure deep value managers are not likely to step up to it at this price, but a GARP manager would, in my opinion.

Guidance: My back of the envelope using management’s current Eps guidance produces a point estimate of $1.05 for next quarter, on the non-GAAP metric used by management and the Street. So sequential improvement. And the ballpark figure for Q4 is $1.34 using the midpoint of management’s annual guidance, and $1.19 using their low end. This compares to $0.97 in Q4 ’07, so a pretty robust improvement. The reader is cautioned against the apparent precision of these numbers, the proper way to think about it is a wide range. WFR management will provide an interim update on Sept. 2^nd. Current Street numbers for the full year will come down by 15 cents or so. On the midpoint, $4.15. 2009E will also come down. But for rough purposes if we grow the earnings 15% off the ’08 midpoint next year is $4.75+.

Now for the GARP valuation. At $43, the stock is a little over 10X current year guidance. The company is not falling apart, there is still unit growth, margins are intact, and expenses are well controlled. As is typical when a stock is headed for freefall, the company announced a major increment to share repurchase, another $500mm to bring current authorization to $1 billion. At an average price of $50/share, this would shrink the cap by about 9%, lending some leverage to out year earnings. WFR has almost $1.4 billion of cash and investments on hand so no need to borrow to fund repurchases. And debt on the balance sheet is minuscule. I calculate the free cash flow yield at 4.5% using the H-1 earnings results. So for WFR this is a good use of cash compared to the yields available in high quality short term investments today.

Is this a compelling FCF yield for an investor? Well yes and no. It is not nearly as attractive as many other stocks. So that begs the question, is WFR still a growth stock, and I suggest affirmative. The company produces prodigious free cash flow, so that makes it more appealing than other companies with FCF yields in the 8 to 10% range that have much lower margins.

Another exercise we can use is to calculate the P/E multiple ex cash on the balance sheet. Cash net of debt is $5.88 per share. That makes the stock price net of cash $37.12. ($43, minus the net cash). Interest income net of tax is running about 12 cents annualized. Subtracting that from the low end of ’08 guidance of $4.00 results in $3.88 in operating Eps, non-GAAP, and an adjusted P/E of 9.6X. That is certainly low enough to attract most any investor willing to make the assumption that WFR is just experiencing temporary stumbles in its operations.

Finally, we have the phenomenon of severe over reaction to news, driven by the disgorging of stock by the quant and other owners mentioned above. If the company is fundamentally sound and the problems are temporary, the patient investor can use short term volatility to advantage. Often a month or two later, the stock is higher. So this is just a matter of 1/ Making the right fundamental call and 2/ Using common sense instead of emotions to make a decision.

Disclosure: Author holds a long position in WFR

Comments

[User 232468]

great article. i hnave decided to hold my shares

[Paul Price]

Very good analysis. Balanced and fair.

[Mark G.]

Good analysis R.J. I bought some yesterday.

[copperbaron]

I agree. The reaction to WFR Wednesday night was way overdone. This company is solid, and the business is stable. Although the economy is challenged right now, the imperative toward alt energy is big, and will be huge in the next admin.

Even T. Boone Pickens is on board to move away from oil. Everybody is in this, and solar will play a part. So don't dump WFR, in fact, add to positions aggressively below $50.

This is a buying opp, for sure.

[Semi-Concious]

Way over-reaction is more like it. So if a company with multiple plants has two issues related to equipment, they are a bad company? A new heat exchanger failing is not WFR's fault - it is the manufacturer's fault. This company is making so much money, it is almost ridiculous to think they are in trouble. Yes, they did not meet the Street's expectations, but in this economy, they still made a TON of money! Isn't that what is important? Yet when certain automobile companies LOSE a ton of money, we get encouraged to invest in them?

No thanks -- I'll keep buying WFR, knowing the company is a huge profit maker.

[fatcat]

I bought shares yesterday on a whim,I don't know the company,but a quick look at the earnings told me the price move was overcooked.Thanks for filling me in on the company.

[User 174375]

Gross margin delined y-to-y? According to the press lease, gross margin in Q2 of 2008 was 53.2% of net sale vs. 52% one year earlier.

[firboy4]

I feel better now. I listened to the conference call yesterday and it all seemed fine to me! But I still was totally confused as to why the stock had plummeted. Your statements of Quants? dumping it helped me understand it better. I hope some good, decent people have been able to take advantage of the quants dumping this stock, as it is bound to rise back to over 50 dollars, and even more over the year. Just wait until the next oil crisis occurs, and people wake up to the fact that we are going to HAVE to move much faster to solar. I can't wait for that day to come. Solar energy, charging batteries for our cars. Solar power heating and cooling our homes. And much quieter roads maybe.

Anyway, it's good for me to hear others say something that I suspected, that there was a horrific over reaction to the earnings report. It makes me wonder if anyone actually read the report or listened to the conference call. I noticed two analysts at least upgraded the stock afterwards.

[alpha24seven]

What you are missing is that Gareeb is not well liked by anyone in the industry nor is he given any slack from Wall St. Do some research on past dealings (ESLR for example) and you will understand why this stock will always be vulnerable.

[ezrent]

Let me set things straight the world is not ready for thin film yet because of much lower efficiency. I think that WFR is a very safe bet on the the overall future of solar and at this price is a very good buy.
WFR's profit margins and lack of debt plus exclusive technology puts them in the drivers seat for years to come. This not a company to sit on their past accomplishments they are on the leading edge of this solar revolution and have the management skills to follow this through.

[Garry]

Good post. I was looking at them several months ago and their financial ratios were too rich. Now looks like a good entry point. However, AMAT is selling equipment to open competition. Solar is still a new industry and could have major disruption with new technology, WRF could face new competition going forward. What barrier to entry is there? Poly's prices are supposed to drop, making margins harder to maintain.

I do question whether the two problems completely explain the shortfall. But their huge cash reserve, large ROE do give some measure of management's ability.

[bootstodirt]

Interesting view in the article but perhaps we should go farther with the extrapolation idea. One notion is that the impending doom scenario based on polysilicon production from competitors is likely to have similar problems, especially for new companies learning the technology compared to an experienced player like WFR. Although not all use the same technology, there will be manufacturing glitches, so my take is that if WFR can get these resolved now they can ramp faster than the competition.

I am a little confused on the whole margin question, because as I understand it, their margins for solar are higher than for semiconductor sales, and its the semi conductor sales that are the most in flux, so solar should become a larger share and margins go up. The thing that is more concerning is this reset of some large contracts. I think a lot of the big move in the stock was driven by the idea of them locking in long term supply contracts at high prices driven by the shortage. If those are unenforceable, then the profit projections are less secure. Any idea on how much risk there is to more of that action?

[2-cents]

I like the net of cash valuation approach. However, the current FCF is about 7% not 4.5% and heading to 9-10% next year

[User 225623]

A screaming buy compared to other solar companies such as Energy Conversion ( ENER ) which doesn't make any money and sells at $65. The analysts knocked it down and now have a buy rating on it.Trust them about as far as you can throw them.l