GT Advanced: Short Margin Squeeze Can Lead To Long-Term Value

| About: GT Advanced (GTATQ)
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GT Advanced Technologies, Inc. (GTAT), a specialized semiconductor company, is involved in the provision of crystal growth equipment and solutions for the solar, LED and electronics industries. Technologies of the company include HiCz™ mono crystalline growth systems, silicon carbide (SiC) sublimation furnaces, HVPE gallium nitride (GaN) systems and Hyperion™ implant technology. The company is divided into three segments for reporting purposes; photovoltaic (PV), polysilicon and sapphire. The PV segment is concerned with the development, manufacture and sale of crystallization growth furnaces that are used to produce silicon ingots, which are then used in the production of solar wafer. The polysilicon segment of the company offers silicon deposition reactors, related technologies and equipment along with engineering services to polysilicon producers. The sapphire segment, which has recently been in the spotlight, currently markets and sells ASF (Advanced Sapphire Furnace) systems; these systems are used for the production of sapphire materials. The chart below summarizes the revenue generation by each segment in the calendar year 2012 and until the 3rd quarter of 2013.

Source: Company Disclosures

Market Performance

Shares of GTAT are listed on NASDAQ and are currently trading at around $12. The valuations of the company have grown by 220% in the last year or so, with the shares trading at around $3 at the start of 2013 when the upward trend started. This positive surge in the stock is mainly a consequence of a deal between Apple and GTAT which will be looked at later on. Revenue estimates for 2014 are more than 2x the revenues of 2013 and this also contributed to the stock's rising valuation.

Financial Performance

Revenue and EPS

The revenue and EPS of the company have been following a declining trend in the recent past. Revenue has declined at an alarming CAGR of 41% in the last 2 years. However, the revenue is set to recover in the current year but it is still not expected to reach the level posted back in 2011. The declining PV revenues, caused by an oversupply in the solar industry, contributed to the decline in the company's earnings. The solar industry seems to be recovering recently and GTAT's PV revenues should improve as a result. However, the company says that 80% of its 2014 revenue would be from the sapphire segment; meaning that PV sales are not expected to match the highs of 2011. As a result of the management's comments, we believe the revenues from PV will shrink further.

Source: Company Disclosures and Analyst Estimates

The EPS of the company is almost in line with its revenues and it is expected to post a positive EPS in the current year. GTAT's business model is changing as it is in transition from being an equipment supply company to a sapphire producer. According to Nigam Arora, a Forbes contributor:

"GT has already lowered its FY13 adjusted EPS view to a loss of $0.50-$0.40 from previous projection of a gain of $0.25-$0.45. The company has also lowered FY13 gross margin projection to 30-32% from previous projection of 35-37%".

The graph below shows the EPS trend of the company.

Source: Company Disclosures and Analyst Estimates

Overall, the revenue and EPS is set to recover due to the expected increase in the sapphire segment but due to the changes in the business model, cost structure and gross margin, the recovery will be limited.

Balance Sheet Metrics

The company has a cash balance of around $258 million. The current ratio is 3.11, indicating no short-term liquidity problems, but the industry average is around 5.50 meaning the company is not up to par with the industry. OCF position of the company also worsened as compared to 2012 and it used $151.59 million operating cash in 2013 (TTM) as compared to $217.6 million cash generated in 2012. This indicates that the company is facing cash problems from changing its business model. The reason for the declining OCF was mainly the decline in the net income.

The performance and position of the company in the recent past does not appear to be too promising. Its revenue and EPS have shrunk over the last two years and it was unable to generate a positive operating cash flow in the year 2013. However, the expected increase in the revenue and net income this year means the OCF position will also improve.

Future Prospects

Industry Prospects

PV and Polysilicon

GTAT has been facing a challenging situation in the recent past as far as its PV business is concerned. The company mentioned in its 2012 annual report that it does not expect growth in its PV business in 2013 and beyond because of an oversupply in the solar industry. However, the scenario of the solar industry changed in 2013 and most of the researchers are now predicting growth in 2014. According to Finlay Colville, vice-president at NPD Solarbuzz:

"With a more stable pricing environment and the prospects of increased end-market globalization, NPD Solarbuzz forecasts a return to annual growth above 30% for the PV industry in 2014."

Moreover, IHS has predicted double digit growth for the solar industry in 2014. Therefore, GTAT may experience an improvement in its PV business but the recent comment that 80% of revenues will be generated from the sapphire segment indicates that the company's management is not optimistic about the performance of either PV or polysilicon.

Sapphire Business

The demand for sapphire glass is expected to rise by 50% by the year 2016. A Taiwan-based firm expects the demand for non-LED uses of sapphire will increase by 20% in the current year. IHS expects the consumption of Sapphire ingots will increase at a CAGR of around 16% (2013-2016). A report by Yole Development projects that the industry, which currently stands around $1 billion, will grow to $3 billion by 2018. All in all, the industry is set to grow and this growth will be supported by the smartphone industry. Smartphone screens are not the only application of sapphire; it also has applications in optics and high-end wearables. In addition, sapphire wafers are used in the semiconductor industry for the development of gallium nitrate-based device LEDs. GTAT will benefit from these growth prospects because it is shifting its business towards sapphire. However, the future of the company depends upon the successful execution of the task at hand from Apple (NASDAQ:AAPL). If the company successfully completes this project, potential sapphire consumers will gain confidence in GTAT's abilities and it will lead to the growth of its business at the expense of the competition. If things go south, the industry will grow but GTAT will not be able to benefit from it. So, much rests on the successful execution of the company's current manufacturing obligations. From the investors' perspective, this is the risk they have to take if they seek capital gains by holding GTAT's shares. In our view, the risk seems to be acceptable because GTAT has past experience with sapphire and there is nothing to suggest that it won't be successful in its current ventures.

Apple-GTAT Deal

GT Advanced Technologies announced in November 2013 that it has entered into a multi-year agreement with Apple for the supply of sapphire material.

Terms of the deal:

  1. Apple will provide GTAT with a prepayment of $578 million. GTAT will reimburse Apple over a five-year period starting 2015.
  2. The deal contains an exclusivity clause that will prohibit GTAT to supply sapphire material to Apple's counterparts.
  3. GTAT will own and operate ASF (Advanced Sapphire Furnace) equipment at an Apple facility in Arizona.

Moreover, GTAT is expected to employ 700 people at the Apple facility. The company also believes that the gross margins for the business will be substantially lower than its historical equipment margins.

It appears that the company is banking on sapphire for future growth and is trying to improve its image via the Apple deal, hoping that an improved image will attract customers in the future. The deal with Apple is expected to enhance the company's expertise in sapphire-related technologies. Moreover, it will generate recurring and more predictable revenue streams in the future which we did not see in the previous business model. Sapphire displays are expected to be featured in upcoming Apple products. The production capacity and the cost of sapphire-based displays is a hurdle but recent developments point toward the fact that the cost factor may be managed to some extent. Matt Margolis, a Seeking Alpha contributor, is quite optimistic about the cost reduction. According to Yole Development:

"We estimate that the current cost of manufacturing a sapphire display cover is around $22 but could drop to $12 and ultimately below $10."

We believe Apple and GTAT may be able to manage the costs, but not to the extent that Matt estimates. The point is that even with the high cost of sapphire displays, Apple can go through with it because of the consumers' willingness to pay high premiums for Apple products. Therefore, if Apple launches its next iPhone with a sapphire display it will directly benefit GT Advanced Technologies.


GT Advanced Technologies has been facing challenges on the PV and polysilicon front in the past couple of years due to an oversupply of silicon. This has resulted in declining revenues and EPS. The company does not fancy its prospects in the PV and polysilicon industry over the short-term horizon. As a result, it has shifted its focus towards the sapphire business. The sapphire business currently has low margins and the earnings will remain on the low side even if the revenue grows. However, the upside is that the company will gain traction as a result of its collaboration with Apple and that is why it is foregoing high margins in the short term in order to benefit from the long-term prospects of the industry. We believe that the Apple deal will be the key to the growth of the company and its future depends on the success of the project. Therefore, in our view, the company's stock is a buy for investors with a tendency to take a slightly higher than average risk. The stock is not recommended for risk-averse investors because of the historic financial performance, current balance sheet outlook and the fact that its success is tied to the deal with Apple.

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

Additional disclosure: Equity Flux is a team of analysts. This article was written by our Technology analyst. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.