Mr. Bruno Guilmart
President and Chief Executive Officer
K&S Corporate Headquarters
23A Serangoon North Ave 5 #01-01
Congratulations on what can only be described as first-rate execution since taking over as CEO of Kulicke & Soffa Industries (NASDAQ:KLIC) in 2010.
The firm's focus on transitioning to copper wire bonding proved timely, while your and Jonathan's operational acumen appear to have contributed significantly to K & S's sizable war chest of approximately $556 million and its near-flawless balance sheet.
Additionally, your leadership team deserves much credit for achieving an important shift in corporate culture that has fueled higher employee morale, while lowering turnover.
After following your progress over the years, Lemelson Capital, on behalf of its clients, has picked up some 368,429 shares over the last 14 months, increasing the positional size some 65 percent since YE 2013 alone, which is indicative of a firm conviction that the market continues to radically undervalue the company and its future prospects.
Lemelson Capital intends to continue buying on behalf of its clients.
As you know, cash and cash equivalents now represent approximately 60 percent of the company's market capitalization. The wedge bonder business remains undervalued on the balance sheet, and the flexible operating model that has been adopted has reduced OpEx when needed. Also, the steady, high-margin expendable tools business, combined with the absence of the convertible debt that was paid off in 2011 have worked to minimize the correlation in the share price to the overall semi-conductor industry cycles, while "juicing" cash flow. As a result of these changes, short interest in K&S has never been lower.
At the same time, the thin analyst coverage the firm has received has been either dead wrong in its appraisal of the firm's value, or significantly underestimated the Total Addressable Market going forward. All of this has contributed to the shares remaining unappreciated for a curiously long period of time.
However, the purpose of this letter is not only to recognize the recent achievements of management, but also to express to you directly (with the expectation that you will, in turn, share this letter with the company's board of directors) Lemelson Capital's unwavering belief the time is long overdue for the company to authorize a sizable (at least $250 million) share buyback. While it is appreciated that a substantial part of K&S's cash is held offshore, the company could easily use debt to finance such a repurchase at very favorable interest rates.
Lemelson Capital considers K&S to be one of its most important commitments, and to be abundantly clear, is very much supportive of your leadership and strategy. The sole criticism outlined in this letter stems from the conspicuous absence of a significant buyback program.
There are two drivers of a share buyback, the first is that the current share price is absurdly low in relation to the company's intrinsic value.
Time is of essence. Vivid price/value disparities, such as that occurring at the moment in the shares of K&S, typically remain for but a short time, as the market eventually comes around to more or less correctly weighing the value of a growing balance sheet and an unusually high growth in per share book value (K&S's growth in per share book value has averaged a remarkable 36.3% over the last five years).
You have indicated in the past that you would like to reserve this abnormally large cash position for potential acquisitions, but this argument is increasingly losing merit, as the future of the company, which rests in large part on advanced packaging, has already developed its own next-generation solution, with a commercially viable product that is, by your own estimate, just six to nine months away. Meanwhile the underlying wire bonding business has become a steady source of free cash flow that you acknowledge is easily projected many years into the future.
K&S currently holds roughly $556 million in cash and cash equivalents, while average free cash flow between 2010 and 2013 equaled 131 million. With 2014 EBITDA likely to approximate at least $85-100 million and future bonding technology emerging as a home-grown solution, it is becoming increasingly difficult to defend any further delay in initiating a large repurchase program.
The forward PE ratio of the S&P 500 is about 15.7. After backing out net cash, K&S trades at just 5.4 x conservative forward earnings estimates. This does not account for the company's 10% tax rate, which is significantly lower than that used by analysts in such calculations.
This (cash adjusted) discount becomes even more significant when viewed in terms of projected free cash flow. If future cash flows approximate the average of the last four years, then the cash-adjusted price-to-free cash flow ratio is just 2.9x. That is to say, the company arguably may generate enough free cash flow in the next 2.9 years to cover its entire enterprise value.
With such a massive valuation gap and an inordinate amount of cash on the balance sheet, it is difficult to understand why the board would not act now to aggressively buy back stock by immediately announcing a tender offer for at least 250 million (financed with either debt or a mix of debt and cash). K&S generates more than enough cash flow to service such an amount.
For example, if the company decided to borrow the full $250 million to commence a buyback at $12 per share, the result would be a reduction of 20.8 million, or ~28% of the shares outstanding. This, in turn, would result in a ~38% lift to earnings per share (based on 2013's anomalously low earnings), and a commensurate 38% increase in the value of the shares. This conservative math assumes no multiple expansion of the forward PE or the ridiculously low P/FCF ratio outlined above.
In the not-too-distant future, if such a buyback were executed, today's forward (and conservative) EPS estimates of just 89 cents per share would grow to $1.23, based on a reduced ~55 million share count. It seems reasonable to expect that with these enlarged figures, the share price would appreciate beyond $19, if the market prices the shares at approximately the same forward multiple as the S&P 500 (a multiple at any rate substantially lower than the company's peers).
The second driver of a share repurchase is the perpetual dilution of long-term owners in order to compensate management.
Management teams that insist on holding large amounts of cash typically do so out of a fear that they will not be able to effectively compete in the future based on ability. This widely understood premise, when taken with management's perpetual stock sales, is sending a message (perhaps wrongly) to owners, both existing and prospective.
It is also worth pointing out that management's shares sales have unfailingly excluded management from participating in gains, as the price of the shares has risen steadily over the years. This pattern of share issuance and near-immediate selling (perhaps perceived as de-risking) is being done at the expense of ongoing owners, indicating that while management's operational ability is solid, it appears to have little understanding of how to properly value a security. Needless to say, this has serious implications when discussing an election to repurchase shares.
Delaying the execution of a buyback any further will only serve to validate this point.
Ideally, management would keep its financial interests significantly aligned with that of long-term owners, particularly in light of the highly undervalued nature of the shares. However, if management insists on selling as quickly as options vest, then at a minimum, the board must act quickly to mitigate the resultant damage caused to long-term owners.
A significant component of the board's responsibilities is to be aware of occasions to increase owner-shareholder value. There are few things the board could do at this time that would be more effective than to implement a large and well-timed buyback.
Commencing the proposed buyback will likely result in considerable stock appreciation of at least 60% for owners who choose not to sell into the proposed tender offer. Lemelson Capital can be counted as first amongst those committed to long-term ownership.
Disclosure: Long KLIC.