What to make of the price action in MEMC Electronic Materials (WFR)? After kissing an intra-day high of $15.04 on February 18, the stock dropped 41.8% to $8.76 by close of trading Friday, June 10. When a Stifel Nicolaus analyst belatedly changed his recommendation to “Hold” and lowered his 2011 revenue projection to $3.29B from $3.61B and EPS to $0.75 from $1.09, intra-day losses reached 6.2% before buyers stepped in to mitigate the decline to 3.5%. A key reason for the change was deteriorating solar wafer prices.
My interest gets piqued whenever the stars align and:
- A sell-side analyst receives attention for revealing information I believe to be old news;
- The target of the analyst’s ire drops in a parabolic trajectory on a 52-week chart;
- Trading volume is at least twice the average.
MEMC easily met all three conditions on Friday morning, so I decided to take a closer look. My first stop was rounding up other sell-side research from Bank of America, Needham, Wunderlich, KBRO, Credit Suisse, Citigroup, UBS and Goldman Sachs to understand others’ sentiments and projections. The current (median) consensus on 2011 and 2012 EPS among the group is $1.14 and $1.50, respectively. The Stifel Nicolaus 2011 estimate of $0.75 is $0.20 below the most pessimistic of the bunch, Goldman Sachs, which also pegged 2011 revenues at $3.3B at least as far back as May 11. The differences in gross and operating margins appear to be the source of Friday’s blow off.
I thought to myself, “Why should a company that is expected to grow EPS by a third between 2011 and 2012 trade at 7.7x this year’s earnings? And at 5.8x those of next year?” A quick background on the company – MEMC has three operating segments:
- Semiconductor Materials. This segment makes silicon wafers, into which microchips are stamped. To the purists out there, pardon the oversimplification. UBS equity research believes the segment represents 19% of contribution profits (i.e., operating income before unallocated expenses) in 2011.
- Solar Materials. This segment makes solar cells and solar cell modules that you may have seen on rooftops. The business is believed to represent 34% of 2011 contribution profits.
- Solar Energy. This segment develops utility-, commercial- and residential-scale solar power systems. MEMC makes money by selling the power systems, operating and maintaining them and selling solar power under long-term agreements. The business is believed to represent 47% of 2011 contribution profits.
I originally intended to validate and write about the various possibilities driving MEMC’s multi-month slide, but I realized that once you get past the copious noise in the company’s story, you are left with two major downside catalysts.
First, it is impossible to develop an independent view on forward looking earnings per share. Equity analysts are at the mercy of management’s guidance more so than for other companies. Remember the $1.14 consensus estimate for 2011? It is a non-GAAP number, as are all the others. Without going into eye-glazing details, GAAP rules require the Solar Energy segment’s profits be booked over long periods of time or not at all (if you’re really interested, see the six-point font on page 66 of the company’s May 2011, Capital Markets Day presentation). Not booking profits on the income statement may sound surreal, but cash is still coming into the company’s coffers. Consequently, management must diligently guide analysts in projecting cash flows for inputs to discounted cash flow valuation models. Non-GAAP numbers are a means to this end.
Secondly, MEMC is a company in transition. Literally. It is moving production facilities to low-cost geographies. It is ramping up internal production of solar cells / modules to diminish reliance on JV partners and third-parties. It is blazing a trail with a vertical integration strategy that I suspect many people either do not get or do not have the patience to get.
The market may have begun valuing MEMC’s stock on a GAAP alternative to management’s numbers: price-to-tangible book equity value. The consensus December 31, 2011, tangible book equity value is $8.97 per share among the sell-side analysts mentioned earlier. Bank of America’s estimate is the lowest at $8.46 per share, and the value was $8.41 on March 31, 2011. Friday’s closing price places MEMC’s stock at just a hair under 1x the forward tangible book value.
What about the system procurement headwinds in Europe? Only 28% of the Solar Energy segment’s 2,250 MW fast expanding pipeline is European, and management went on record saying 25 MW to 30 MW of projects could be in jeopardy in Italy, from where the most amount of consternation seems to be emanating. Given that (i) Italy represents about 71% of the European pipeline, per the Credit Suisse report I read, and (ii) the Italian at-risk quantity is at most 1.3% of the global total, I just can’t seem to get too riled up about the chatter.
What about Europe’s impact on the Solar Materials segment? It is a valid point but one I suspect will be mitigated by the company’s vertical integration. MEMC can sell cells and modules to its Solar Energy segment.
What about the company’s relatively uncompetitive cost structure? It is another valid point. The Q1 2011 operating expense margin of 14% (inclusive of non-recurring expenses) is higher than Chinese competitors’ 5% to 10%. But again, the difference is not exactly jaw-dropping, and MEMC’s investments in technology and intellectual property appear to be resulting in better mousetraps than the commoditized offerings pumped out by China.
With these considerations in mind, I have begun buying MEMC’s stock while acknowledging that in the near-term the price may fall a bit further. The stock’s year-to-date beta relative to the S&P 500 (NYSEARCA:SPY) is 1.64. The S&P 500 reaching 1,250 seems like a given, and talk of 1,150 is on a noticeable uptick. The near-term macro backdrop is indeed becoming quite pessimistic, but an investor with a six-month time horizon or longer should find MEMC of interest. Currently valued at 1x tangible book value with a promising future, the company seems like a Ben Graham textbook example of a buying opportunity.
Disclosure: I am long WFR.
Disclaimer: The contents of this article reflects the author's personal viewpoint and is neither a solicitation nor an advertisement of any sort. Readers should conduct their own due diligence prior to making investment decisions.