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Photronics, Inc. (NASDAQ:PLAB) is a leading manufacturer of photomasks, which are essentially master patterns used to transfer circuit board patterns onto semiconductor wafers and flat panel substrates. Notably, the demand for photomasks is dependent only on the release of new integrated circuit ("IC") designs rather than unit demand and revenue, while customer turnaround times are typically around 24 hours, making it a somewhat volatile business.

Even large companies tend to outsource their photomask activities, because the machinery needed to create them is constantly evolving and very expensive. According to one professor, "Going from 500 to sub-30 nanometers is cost prohibitive for large-scale production." As a result, companies like Photronics, Inc.have enjoyed relatively healthy profit margins, although they require high amounts of capital in order to run their operations.

Currently, the company appears interesting for a number of reasons:

  1. Shareholders' equity rose 4.6% to $586,001,000 last quarter, which represents about $7.66 per diluted share, or a ~30% discount to the current market price.
  2. Of this amount, the company's cash on hand rose 14.8% last quarter to approximately $218,043,000, which represents about $2.85 per share.
  3. Despite a 12% loss on the top-line, the company's operating cash flow fell only about 3%, suggesting much of the additional loss was non-cash.
  4. Last year, the company generated approximately $28.1 million in free cash flow, adding to its cash stockpile, despite having a down year.
  5. The company is the most cost-efficient major supplier in the business, as compared with many of its competitors that aren't as competitive.

So, why is there a discount? The obvious reason is that sales have slowed down in 2012, as manufacturers have put out fewer new designs. While the company remains diversified with some 600 different customers, Samsung Electronics Co., Ltd. also accounts for about 22% of its revenue and its five largest customers account for about 43% of its revenue, meaning a decrease in sales from any of these customers could hurt its business.

Longer-term, technologies are also evolving that could compete by working on the molecular scale. In fact, chemists can now coax individual molecules into self-arranging patterns as needed in order to ultimately create desired patterns on a nanoscale without the need for any templates, like photomasks. Given the increasing costs associated with smaller and smaller production, this could ultimately become the preferred cost-effective method.

These concerns may be overblown for a few different reasons.

First, its customers aren't hurting too badly. Samsung Electronics reported a 76% jump in its fourth-quarter profits to a record high on strong smartphone sales and higher margins in its chip business, even if it takes a $2.8 billion operating profit cut this year due to Japan and the eurozone's currency devaluations versus the South Korean won. So, there's probably not all that much risk associated with these companies cutting back on their spending.

Second, Photronics executives indicated in a recent conference call that they anticipate foundry logic to improve moving into the second part of 2013, helping boost its semiconductor side of the business. When it comes to memory, they still see a lot of inventory and systemic issues, but also consolidation and some capacity coming offline. And finally, they see high-end displays, like AMOLED scale to larger form factors, setting the stage favorably long term.

Third, the company has consistently reiterated that once it reaches a net cash position of $75 million that it would consider potentially returning some to shareholders. And until then, the company plans to pay down debt to the extent that it can, helping to further boost its balance sheet. These efforts could not only make the company's stock even cheaper over the near term, but potentially unlock value via dividends or share buybacks down the road.

In the end, I think Photronics seems to be an interesting company from a value prospective that may be somewhat misunderstood at its current levels.

Source: Photronics, Inc. Appears Cheap At Current Levels