LTX-Credence: Long-Term Potential, Short-Term Risk

| About: Xcerra Corporation (XCRA)

Heading into last Tuesday's earnings report, it was clear that LTX-Credence (LTXC) was facing a key inflection point. The maker of test equipment for semiconductors had already issued dire guidance for the October quarter in conjunction with fourth quarter earnings back in August. That guidance knocked the stock down 14% despite the company's conclusion of a successful fiscal year, with earnings of $1.19 per share ($1.12 non-GAAP), and nearly $3 per share in net cash. Coming into the week, LTXC, trading at just over $6/share, looked like a strong value play.

Unfortunately, on Tuesday the company reported a net loss of 10 cents per share (8 cents non-GAAP) -- the low end of the guided range -- on sales of $33.75 million, below the company's target of $35 to $39 million. That revenue figure was down some 56% year-over-year. Second quarter guidance was even worse: revenue of $26-$30 million, with a non-GAAP loss of 15 to 20 cents (roughly 17 to 22 cents GAAP). The stock closed down 7.4% on Tuesday, and over 19% for the week, finishing Friday's trading at $4.91.

The back-to-back earnings disasters have knocked much of the luster off of LTXC. At the midpoint of January guidance, trailing twelve-month earnings will be 41 cents per share (26 cents non-GAAP), and just 11 cents GAAP excluding a $15 million merger breakup fee paid by Verigy in March. Net cash fell in the quarter to $2.77 per share, as cash from operations was negative $3.5 million. The swiftness of LTXC's revenue collapse has radically altered the fundamental case for the stock -- and helps to explain why the stock is 50% off its 52-week high set back in February.

Despite the struggles, there was a surprising amount of optimism on the first quarter conference call. Analysts noticed that gross margins held up well -- two points above expected -- despite the sharp slowdown in revenue, and the company claimed that changes in cost structure would increase margins -- and profits -- during the next industry upturn. Management also seemed confident that the coming fiscal second quarter -- ending in January -- would represent the low point for sales. CEO David Tacelli elaborated on the Q&A portion of the call:

Christian Schwab – Craig-Hallum Capital

Perfect. And then lastly, as we call the bottom this quarter, instead of me trying to figure out the math, what do you guys believe the pace of the recovery is going to look like from here, then?

David Tacelli

That’s the $64 million question. If you go back to historical trends, it could be flat for a quarter and then rise slowly, and I’ve also seen rapid rise in the 20 to 30% range on a quarter-over-quarter basis. Which one this is going to be? I wouldn’t make a guess on right now; but based on the level of activity with programs, based on the level of activity with customers going into production using our equipment that they haven’t used in the past, I’m pretty confident that we’ll [see] some kind of rise. The pace, I couldn’t guess at this point, Christian.

If LTXC is correct, and the fiscal second quarter will be the "trough quarter," the stock could be putting in a bottom, as the (theoretically) forward-looking market anticipates the rebound in revenue. And a snapback could make the stock significantly undervalued: in FY2011, the company generated $70 million in free cash flow. That represents nearly 70% of the company's current enterprise value of $103 million (including $15MM in long-term liabilities). When the company can take advantage of an updraft in the semiconductor business, it can make money, and quickly. A bottom in the second quarter could mean a return to profitability in the spring, and a corresponding bounce in the share price.

The problem for LTXC investors is: how much confidence can we have in a semiconductor supplier that is calling the bottom? Firms across the industry seem to have been doing it for most of 2011, yet the sector continues to falter:

SOX 1-year chart

1-year chart Philly Semi Index (SOX); chart courtesy

If the company is right, and calendar 2012 will be stronger, then LTXC looks undervalued. With over half of its market cap in cash, and the potential for substantial earnings leverage in a rebound, the stock could be an interesting long-term play.

But, in the meantime, LTXC stock seems to offer significant downside risk. Will the February report produce another round of disappointing guidance, and another 15-20% haircut? And will semiconductor stocks continue to struggle, perhaps breaking through the multiple support established over the last few months?

For now, it looks like LTXC should stay on value investors' watchlists, pending some kind of stabilization in the sector or good news from the company. Further decline in the stock price -- particularly toward the company's tangible book value of about $3.79 per share -- might provide an attractive entry point. But, right now, investors have to be wondering when the bottom is truly coming, and how much more damage will be done to the LTXC share price before their market finally turns around.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.