GT Advanced Technologies: A Solar/LED Equipment Supplier Market Leader With Almost 80% Upside

| About: GT Advanced (GTATQ)
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Introduction

GT Advanced Technologies (GTAT) is a key equipment supplier to many of the world's leading solar, polysilicon and LED companies. Over the years, GTAT has grown to have a very large presence in Asia as most of the companies it serves are based there.

Business economics

1. High switching costs

Equipment supplied to customers is often very deeply embedded into their manufacturing lines. Switching of suppliers at a replacement cycle might bring in equipment which is incompatible with other parts of the manufacturing line. Such incidents will bring about downtime or lower the productivity of the factory of which is very detrimental to the customer's business. This, therefore, discourages customers to switch suppliers at whim.

Secondly, changing of equipment suppliers often ranks as one of the few most important manufacturing decisions due to the high price tags of the equipment. Furthermore, customers are often not able to "sample" the products to understand their full working capabilities before a purchase. Hence, customers would often prefer to work out any differences with their "tried and proven" equipment suppliers first while leaving the option to change suppliers only to the very last resort.

High switching costs not only lock in customers, but also grant GTAT pricing power.

2. High entry barriers

Very niche knowledge and expertise are required to operate in the solar and LED industries. New entrants have to spend a lot of capital on R&D and on hiring talent to acquire sufficient know-how to compete effectively in the market.

Also, as explained above, new entrants face very high switching costs from their customers. Henceforth, huge amount of expenses on marketing is guaranteed in order to convince customers to switch.

Finally, one order would usually need an amount of equipment that provides the production capacity the customer intends to build. No customer is willing to order from a supplier who is only able to fulfill part of their intended order. For example, if a new customer hopes to build a new factory equipped with 100 solar furnaces, customers would prefer to work with an equipment supplier who can provide all 100 instead of those who can only provide 50. So, new entrants need to have a minimum amount of operating capacity to be able to fulfill the demands of the customers; of which requires a lot of capital.

3. Diversified revenue streams

As GTAT deals mostly with emerging industries, revenues are expected to be very volatile. Consequently, diversification into the polysilicon and LED markets has allowed it to stabilize its revenue streams.

Many who have been following this company would point out that even with diversification, the company still suffered massive losses in terms of revenues and profits due to the plight of the solar industry. In my honest opinion, the company would have been bankrupt if not for its diversification into other markets.

4. Large size

With equipment being deeply embedded into the manufacturing lines and being very costly, customers would want to work with companies that they can trust. So, being large in this industry brings benefits to GTAT as it gives the company credibility.

Additionally, being large gives GTAT bargaining leverage over its suppliers. Being able to keep costs low is exceptionally important in this industry. In the far away future, technology for solar and LED furnaces is eventually going to mature, and efficiencies of the equipment supplied across all competitors are going to converge. In other words, like many other equipment types, the furnaces that GTAT supplies are eventually going to be commoditized. Thus, the winners in this industry will only go to those that operate at the lowest cost while being able to offer the most efficient equipment.

Based on this premise, GTAT owns some traits which grant it a cost edge:

· Large size: As mentioned above, it gives them more bargaining power against suppliers

· Operational efficiency honed by years of competition with Asian competitors: As mentioned in the introduction, GTAT has a large presence in Asia, the number one "go-to" place for manufacturers as they offer the lowest costs. Besides GTAT, there are numerous other local equipment competitors who are able to sell their products at a lower price due to their lower operational costs. Ergo, GTAT has to keep pushing the boundaries of its operational efficiencies in order to compete head to head against these local competitors. By doing so, GTAT has created a cost edge for itself when competing with competitors in other parts of the world.

· Designing and assembling: The last attribute that GTAT has that helps it attain its low costs is its focus on only designing and assembling. It does not build huge plants to create its equipment from scratch. It has its suppliers do it, and it will just assemble the equipment before shipping it off to its customers- helping it to keep its costs low.

Due to the commoditized nature of its customer's products (solar panels), the only way for solar manufacturers to survive in the industry is to be the lowest cost manufacturers. Therefore, on top of assisting its customers achieve lower costs by delivering more efficient furnaces that create great material quality for better cell efficiency, it can also help its customers achieve lower costs by selling its equipment cheaper with its cost advantage.

The business economics described above can be seen in the company's high gross and EBIT margins

08 to 12

Ave. Gross Margins

37.64%

Ave. EBIT Margins

19.39%

Business trends

1) Solar

· Increasing solar adoption

Over the past two years, due to the massive drop in the price of solar panels, adoption of solar energy have increased as can be shown in the graph below;

Source: EPIA

2008

2009

2010

2011

2012

Global PV cumulative (MW)

16,229.00

23,605.00

40,670.00

71,061.00

102,156.00

Growth

45.45%

72.29%

74.73%

43.76%

Moreover, new financing techniques now available, such as having the costs of rooftop installations spread among future payments of the electricity generated by the system, has greatly lowered the costs of installing a solar energy system, and boosted solar energy adoption.

In China and Japan, the push to switch to much cleaner sources of energy are further motivated by the haze situation that hit Beijing in early 2013 and the nuclear reactor meltdown in Fukushima in 2011. Also earlier this year, it was reported that the Chinese government has plans to double its installed capacity for solar electricity by the end of 2013, making them the country with the highest demand for solar for the year. Other countries with massive demand include Germany, US and Japan.

One final factor that will be pushing solar is the fact that it is cheaper and faster to build as compared to grid expansion.

There has been, however, an over capacity problem in the solar industry since 2011 and this issue will be addressed later.

2) LED

· Increasing LED lamp adoption

For a start, China has banned imports and sales of certain incandescent light bulbs since 2012 to encourage adoption of more energy efficient lighting sources such as LED lamps. Besides China, many other countries such as UK, India and more has also initiated similar plans to phase out incandescent light bulbs.

The adoption of LED lamps for street lighting is further boosted by efficiency improvements and significant declines in costs. According to Pike Research, "By 2015, LEDs will become the second-leading type of lamp for street lights in terms of sales, behind only high pressure sodium lamps". Furthermore, LED lamps allow for: better dimming control and easier integration of control nodes; higher energy efficiency and lower amounts of wasted heat; and it is best for areas with low clearance, excessive moisture or dust, corrosive atmospheres, and high ambient temperature.

· Push for sapphire smartphone screens

Ever since last year, GTAT has been pushing for sapphire to be used as a screen for smartphones due to them being much harder and scratch resistant as compared to gorilla glass. Although significant uptake has not yet been seen, there has already been much interest shown in the subject. Additionally, a few months ago, it was announced that Motorola adopted GTAT's sapphire for its scanners. If this adoption was to be successful, mass adoption of sapphire for smartphones would be nearer than we think.

3) Hyperion, HiCZ, Silicon carbide production furnace

Just recently, GTAT introduced its silicon carbide production furnace to meet the demand for more high quality silicon carbide material to be used in advanced high power, high frequency devices. Also, later this year and the next, GTAT is planning to introduce its next generation PV equipment, the HiCz equipment, which further pushes production and cell efficiency, and its Hyperion technology. As mentioned above, in a largely commoditized solar panel industry facing huge over capacity, GTAT's latest products will certainly be a panacea to their troubles by lowering manufacturing costs.

Reasons why the undervaluation will be corrected

Summary Table

Economics

Trends

High Switching costs

Increasing solar Adoption

High Entry Barriers

Increasing LED Adoption

Diversified revenue streams

Introduction of next generation furnaces

Large Size

Based on the economics and trends above, GTAT would be a great long term hold. My estimated value per share for GTAT is $9.30 as compared to $5.10 (as of July 30th closing). The current undervaluation, I believe, is largely due to: a) The overcapacity of the solar and LED industry b) reduction of subsidies for solar energy c) trade war between China, US and Europe. The following will be a discussion of these factors and why it will soon be altered.

a) Over capacity of the solar and LED industry

The Chinese PV module suppliers have always been the largest providers of PV modules. A ramp up in production in the industry from 2009 to 2011 has resulted in over capacity. As many Chinese solar suppliers diversified into the LED markets, over capacity is seen there too. Further compounding their problems is the fact that Chinese banks are unwilling to loan them more money due to over exposure to the solar industry.

The Chinese government has pledged to continue pouring money into the industry in a bid to protect the jobs of thousands of Chinese citizens in it. Although this move does protect the jobs of many, it does not put into firms sufficient cash for them to purchase much more efficient equipment to lower their costs and be profitable. Additionally, non-profitable firms will be allowed to stay in business, and capacity can't be reduced.

However, things are beginning to look up for the industry. Adoption of solar and LED are increasing as described above, and just recently, Navigant research has reported that the world wide solar PV market will finally stabilize in 2013.

Moreover, the Chinese government is encouraging Chinese solar companies to choose consolidation over expansion by offering them tax incentives.

Besides that, many Chinese solar panel manufacturers are forward integrating to build solar systems to soak up the additional capacity. To assist them, the Chinese government has demanded grid companies to build networks to match with systems built by the Chinese solar panel manufacturers and give them priority when distributing electricity.

Finally, many solar panel manufacturing companies such as Suntech, Siemens and Bosch have either announced bankruptcies or that they will fully exit the industry- leading to a cut in capacity.

b) Reduction of solar subsidies in Europe

Many European governments have lowered subsidies for solar, due to the current economic problems in Europe. The impact is, however, cushioned by a few developments:

· Solar technology has grown much more efficient over the years, and in many parts of the world it has already reached grid parity. According to Applied Materials, 105 countries have already achieved grid parity for solar energy.

· Due to the over capacity, prices of solar panels have nose-dived and made solar energy systems very cheap to construct. The energy source for solar installations is essentially the sun while where the source of energy of other power generators comes from fuels such as coal, oil or natural gas. Therefore, while power generators have to keep paying higher and higher prices for fuels, solar installations essentially has it free. In other words, bulk of the costs of solar energy comes from the installation of solar systems, and with solar panels being very cheap now, solar energy can be distributed at a much cheaper rate.

· The increase in demand of solar energy in Asia and US will offset the loss of demand in Europe due to the lowering of solar subsidies

Based on the points listed above, the reduction of solar subsidies would not create a long term dent in the global demand for solar energy.

c) Trade war between China, US and Europe

The last and final factor resulting in the undervaluation would be the trade war between China, US and Europe. Things have worsened as time passed with the US and Europe slapping a huge import tax on all Chinese solar panels and the Chinese has retaliated by imposing tariffs as high as 57% on polysilicon; a material that US exports.

The effects of the trade war include higher prices for solar panels and consequently, lowered demand for solar energy. This is especially negative for the solar adoption in Europe as they have been cutting subsidies too.

Although the industry and many governments have raised objections and concerns over all the tariffs imposed, it does not change the fact that these tariffs are here to stay.

However, one can take comfort in the fact that the tariffs are mainly aimed at products produced and shipped from China. The Chinese manufacturers can always still relocate some of their manufacturing to other countries not affected by the tariffs; for example, Africa. Hence, although solar panel prices will no doubt increase, there will not be such a huge jump in prices that would make solar energy uncompetitive to other forms of renewable energy and ergo creating a great loss of demand for solar energy.

Disclosure: I am long GTAT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.