After recently receiving a recommendation from a friend to buy into memory chip maker Qimonda AG (QI), I began doing a survey of many of the companies in the industry. It seems like there are certain industries that I am able to gain a very good understanding of in a short time, and other industries that I struggle to learn.
Semiconductors fit into the latter category, but I do know how to analyze cost and business structures, so I examined Spansion (SPSN) mostly from that perspective and will possibly take a look at some of the other semiconductor stocks in upcoming blogs.
It doesn’t take a market guru to tell you that SPSN’s recent performance has been weak. They lost 85 cents per share in Q1 of 2008 (see conference call transcript) and 63 cents per share in Q2 (see conference call transcript), meaning that FY 2008 is shaping up to be even worse than already bad FY 2007, when they lost roughly $1.90/share for the year.
Their margins are poor, but not completely terrible by industry standards; they had a 17.8% gross margin and a -12.6% operating margin (still better than some others I've seen). All the same, you can’t stay in business if you are losing money --- unless of course, you can outsurvive similarly situated competitors. Looking at SPSN’s situation, I’d surmise they would need to see prices rise to a level high enough so that they could achieve 30% operating margins before they could actually begin churning out any significant GAAP income. From their current revenue figures, I'd estimate that they would need to see around a 15% increase in prices to achieve that. Mind you, this would not necessarily put them in good shape; it should merely get them near a break-even point. That info alone suggests to me that this company might have some rough tredding ahead.
Spansion is also not helped by the fact that they have high R&D expenses and those expenses seem absolutely critical for their long-term survival. R&D has eaten up about 17-20% of revenues in recent times. Another interesting observation I take away from the income statement is that any time SPSN churns out higher revenues, they seem to have lower margins, emphasizing the inherent problem in the industry where continual oversupply is harming all the players in this sector.
One particularly noteworthy part of SPSN’s income statement that many might neglect to analyze is their “Interest Expense.” In fact, the trend of higher and higher interest expense (compared to interest and other income) really caught my eye! In Q3 of 2006, SPSN had interest income of 3.9 Million and expense of 13 Million, giving them a net expense of roughly $9 Million. By Q2 of 2008, they only brought in 2.5 Million in other income and had nearly $28 Million worth of interest expense, giving them a net expense of roughly $25 Million! That seems like a rather dramatic increase for a company that has not grown its revenues. In Q2, the net interest expense constituted roughly 4.5% of revenues, compared to 1.9% in Q3 of 2006. In other words, the longer they continue to incur huge losses, the more difficult it becomes to return to profitability because debt increasingly eats away at their earnings. On the bright side, they probably won’t have to pay taxes for awhile given how many tax benefits they’ve accumulated!
If the income statement looks bad, the balance sheet looks much, much worse! There are a few metrics I use to try to assess a company’s finances. First off, let’s look at Current Assets over Current Liabilities. I have analyzed four different quarters in order to try to understand the trends:
- Q4 – 2006: 2.57
- Q2 – 2007: 1.78
- Q4 – 2007: 1.69
- Q2 – 2008: 1.28
I find CA/CL to be an interesting metric, but taken by itself, it’s only so useful. All the same, we see a dramatic decrease over our 6 quarter time frame. Next, we look at a metric I have created called “Liquid” over Current Liabilities. “Liquid” is my term for current assets that could potentially be used to pay the bills, namely “cash and equivalents”, “marketable securities”, and “accounts receivable”; add the three together and you get what I will clumsily refer to as “Liquid”. The results of this metric are even more disturbing:
- Q4 – 2006: 1.86
- Q2 – 2007: 0.99
- Q4 – 2007: 0.92
- Q2 – 2008: 0.65
Our ending figure is only about a third of our beginning figure, which is scary. Of course, this metric can be flawed if a company is raking in high cash flows from operations. Indeed, SPSN has been making positive cash flows even if they have negative GAAP income. Based on this, we use another H.J. Huney specialty metric --- I take “Liquid” + Cash Flows from Operations and divide it by Current Liabilities. Unfortunately, SPSN does not include a complete cash flow statement in the quarterly reports available on their website for some strange reason. Therefore, I have to dig through the SEC filings. I cut out Q2 for 2007 and had to estimate for both the Q4's since the cash flow figures on the 10-K pertain to the yearly results. Based on this, I come up with the following info for (Liquid + CFO)/CL:
- Q4 - 2006 (est): 2.01
- Q4 - 2007 (est): 0.98
- Q2 - 2008 (act): 0.70
That’s a rather huge drop! I would think that any figure under 1.0 could be problematic, but it dips all the down to 0.7 for the latest quarter! More frightening to me is how quickly it is dropping! It suddenly makes a lot of sense as to why their "interest income" is increasing so rapidly!
While we’re discussing this whole liquidity issue, it might be worthwhile to mention that while the “cash and equivalents” number for SPSN has increased slightly over the past few quarters, the “marketable securities” number has dropped dramatically, so either SPSN is getting absolutely destroyed in the market or they're dipping into that stash to help stay alive. The bad news is that this is a company with a $4 Billion value and they only have $100 million worth of marketable securities left. Keep in mind that they lost $100 million in the last quarter.
Some have argued that despite the shortcomings of SPSN as a company, their assets alone justify the current price. That might be true. They are trading under $2.50/share right now and I came up with a book value of $9.7. Once you factor in that they seem to be losing about $2-$3/share per year, that certainly makes that look less attractive, but still a potentially attractive buy for a competitor. In fact, despite the bleak picture I paint for the company, that is one of the main reasons I would be afraid to short this or pick it to underperform.
I have a few more thoughts on this stock. I’ve done a bit of research into both the flash memory makers and DRAM, and one thing I’ve concluded that is even if I don’t completely understand the trends, it seems like no one else does either. Even those with great expertise in the memory sector seem to have heated disagreements about what the future may bring. There is no consensus at all if and when pricing will improve. That said, it’s fair to say that if you believe there is a positive trend in the pricing of flash memory right around the corner and believe Spansion has a competitive advantage in the industry that can utilized in a short period of time (i.e. about a year or so), then perhaps you look at this as an opportunity to buy a good company at a very discounted price since the overall market has fears about this company’s ability to produce a profit or even survive.
As for me, I’m staying away from this one (both long and short) for reasons mentioned above, but if I had to bet, I’d bet against it due to a poor record of performance, a weak balance sheet, and no real indication that the market for flash memory will dramatically improve in the very near-term. Sure, it’s possible that this thing has bottomed out and is ready to turn the corner with an upswing in prices, but it’s also entirely possible that the worst is yet to come. In fact, the latter seems much more likely.