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In an otherwise overvalued market, Photronics (NASDAQ:PLAB) is a deep value stock with good near-term growth prospects. After the release of F1Q21 earnings, the stock received an analyst downgrade and subsequently traded down. I believe that upcoming 2Q21 earnings, coupled with likely management guidance and commentary, will be a trigger for broader market interest and upward price revaluation. If so, new purchases now will likely be rewarded before Summer.
Photronics manufactures photomasks, used by its customers in the production of integrated circuit (IC) chips and flat panel displays (FPDs) such as television and cell phone screens. Note that this article is not intended to provide an introduction to readers new to Photronics, but rather to provide a basis for believing in the likelihood of a near-term upside. For those who want more company background, I highly recommend the company's Virtual Analyst and Investor Day presentation from December 2020 and Paul Franke's recent article "The Bottom Fishing Club: Photronics."
Photronics is Downgraded
On February 24, Photronics reported fiscal 1Q21 earnings. Revenues and EPS both exceeded mid-range guidance, but both were down sequentially and yoy for understandable reasons, to be discussed below.
The next morning, the stock was downgraded by Stifel from Buy to Hold with a $13 price target, stating, "Near term, we do not see any new catalysts for the name."
I disagree. Instead, I believe that there will be renewed optimism regarding the company post-F2Q21 earnings release in late May. If management simply executes on its near-term guidance, and then reiterates current expectations for the remainder of the year, that should be sufficient to drive the stock significantly higher.
First, an explanation regarding F1Q21 results. The declines versus comps were largely the result of two issues: the ban, instituted late last year, on sales to Huawei, a major purchaser of FPD photomasks for AMOLED cell phone screens; and, oddly enough, the sold-out nature of the semiconductor industry, which has resulted in Photronics' chip fab customers working overtime on mainstream vs. high-end chips to get back to meeting their customer needs. With those chip manufacturers focusing primarily on mainstream IC products (>28 nanometers), rather than releasing new designs, they are purchasing fewer high margin photomasks for new designs.
Photronics also noted that the quarter started weakly in November (the Huawei ban had just been instituted) but was then followed by strong months in December and January. The implication is that future quarters will not be hampered again by such a weak month.
Photronics' Deceptively Strong F2Q21 Guidance
Photronics' guidance for F2Q21 revenues and EPS is strong in two ways. First, it is the company's highest set of quarterly guidance ranges ever. Second, the low end of each range exceeds both sequential and yoy comps.
Finally: Note below how conservative Photronics guidance has historically been. As the table illustrates, Photronics' revenue has exceeded midpoint of guidance nine of thirteen quarters, and only fallen below the low end of guidance once, the first quarter of COVID (2Q20). Similarly, EPS has exceeded midpoint of guidance eleven of thirteen times, and has only fallen short of the low end twice, during the first quarter of COVID and the first quarter of sanctions against Huawei (4Q20).
Photronics Historical Quarterly Revenues and Earnings vs Guidance:
| Revenues ($M) | EPS | ||||||||
| Guidance | Actual | Guidance | Actual | ||||||
| Low | High | $ | v mid | Low | High | $ | v mid | ||
| 1Q18 | $ 110 | $ 118 | $ 123 | $ 9 | $ 0.02 | $ 0.09 | $ 0.09 | $ 0.04 | |
| 2Q18 | $ 120 | $ 128 | $ 131 | $ 7 | $ 0.04 | $ 0.09 | $ 0.15 | $ 0.09 | |
| 3Q18 | $ 128 | $ 136 | $ 136 | $ 4 | $ 0.12 | $ 0.18 | $ 0.18 | $ 0.03 | |
| 4Q18 | $ 133 | $ 141 | $ 145 | $ 8 | $ 0.14 | $ 0.19 | $ 0.18 | $ 0.02 | |
| 1Q19 | $ 120 | $ 130 | $ 125 | $ (0) | $ 0.01 | $ 0.07 | $ 0.08 | $ 0.04 | |
| 2Q19 | $ 125 | $ 135 | $ 132 | $ 2 | $ 0.03 | $ 0.10 | $ 0.13 | $ 0.07 | |
| 3Q19 | $ 132 | $ 142 | $ 138 | $ 1 | $ 0.05 | $ 0.14 | $ 0.10 | $ 0.01 | |
| 4Q19 | $ 143 | $ 151 | $ 156 | $ 9 | $ 0.11 | $ 0.17 | $ 0.15 | $ 0.01 | |
| 1Q20 | $ 146 | $ 154 | $ 160 | $ 10 | $ 0.13 | $ 0.18 | $ 0.16 | $ 0.01 | |
| 2Q20 | $ 145 | $ 155 | $ 143 | $ (7) | $ 0.11 | $ 0.17 | $ 0.10 | $ (0.04) | |
| 3Q20 | $ 145 | $ 155 | $ 158 | $ 8 | $ 0.11 | $ 0.17 | $ 0.17 | $ 0.03 | |
| 4Q20 | $ 148 | $ 158 | $ 149 | $ (4) | $ 0.12 | $ 0.19 | $ 0.10 | $ (0.06) | |
| 1Q21 | $ 145 | $ 155 | $ 152 | $ 2 | $ 0.07 | $ 0.14 | $ 0.13 | $ 0.03 | |
| 2Q21 | $ 153 | $ 162 | $ 0.14 | $ 0.20 | |||||
Source: Created by Author from Photronics Earnings Press Releases.
So, recent history indicates that management guidance is trustworthy. In fact, if any criticism is to be made regarding quarterly disclosures, it would be for sandbagging.
Management Commentary Supports the Guidance
In Photronics 1Q21 Earnings Transcript, management noted that the Huawei ban is being resolved by the market, as cell phone competitors steal share from Huawei, resulting in an accelerating AMOLED flat panel display business stream for PLAB from new customers. Sequentially, my expectation: a small incremental cash contribution in the range of $0.5 - $1.0M for each of the next two quarters.
The above-noted IC chip shortage is likewise getting sorted out. As chip fabs run hard to resolve the current mainstream shortage and satisfy their customers, those fabs will eventually return to their normal cycle of launching new high-end designs, many of which are already residing on the shelf. Photronics only gets significant high margin IC business with the launch of new high-end IC designs.
Those orders are lumpy, sporadic, and quick, with little visibility or backlog. Still, management expressed confidence that this type of business cycle has happened frequently in the past. As per Photronics 1Q21 Earning Call Presentation, Photronics has recently sold ~$100M IC photomasks per quarter, with $65M - $70M dedicated to mainstream. My expectation: $5M of that stream shifts to high-end, yielding an incremental 20% margin, resulting in $1M sequential cash contribution for each of the next two quarters.
Furthermore, for the first time in Photronics' CEO's career, he is seeing sold-out conditions for mainstream IC chips resulting in price leverage for photomask suppliers on legacy IC products. Normally, legacy, mainstream product lines can never justify new photomask tooling because of the decreasing cost curve for the end product. Photronics now expects to be able to increase product pricing on mainstream IC photomasks for the first time ever, at least until reinvestment economics justify new photomask tooling for legacy products (which is probably never). My expectation: a 5% price increase on half of the $68M mainstream IC business yields an incremental $1.7M cash margin for each of the next two quarters.
Also, two new Photronics FPD tooling lines are soon to be qualified and become operational. They will ramp quickly, and will be marketed to the Chinese market. The Photronics CEO says they are significant, and will be sold out quickly, some time in 2H21. In aggregate, the two lines are already contracted at $40M annually. My expectation: incremental sequential revenues of $3M/$7M/$10M and incremental cash contributions of $0.5M/$2M/$3M in the coming quarters.
Finally, 2Q21 guidance effectively incorporates a one-week shutdown of Photronics' Texas facility due to recent power outages. My expectation: $1M cost versus 1Q21, rebounding back in 3Q21.
The size of each of the above estimates is debatable. They are relatively small increments and difficult to quantify. My point is that there is good operational basis for optimism on rising sequential performance.
Based on the above, my conservative quarterly 2021 EBITDA stream is $36M/$39M/$45M/$46M, or full year of $166M. This tally is low by comparison to Photronics' guidance for annual operating income to grow by the same percentage (+23%) as in 2020, which would result in $78M operating income and $170M - $175M EBITDA.
So What if Photronics Meets 2Q21 Guidance?
All of the above is nice, but so what? So what if the upcoming quarter meets guidance and beats comps? Why will that result in a rising stock price?
2Q21 earnings and corresponding management commentary are likely to incorporate the following:
- Results will be at the midpoint or better of the guidance range, implying near-record levels for both revenues and EPS.
- Management will again reaffirm full year 2021 operating income growth similar to that of 2020 vs. 2019 (+23%), implying $78M operating income and $173M EBITDA. With the first half at $27M - $30M, that implies 2H21 operating income of ~$50M and 2H21 EBITDA at a record-shattering ~$95M.
- Written F3Q21 guidance will support the above near-term optimism.
- Management will reaffirm three-year strategic guidance from the December Investor Day, implying a longer-term growth runway well beyond 2H21.
- As a result, new attention will be paid by investors to valuation. At the current $11.60 per share, they will see a growth company trading at a deep value ~4.5x LTM EBITDA and ~4.0x next twelve months; generating ample free cash flow for reinvestment and share repurchases; with a price-to-net-book value < 1.0; a balance sheet with ~$175M net cash; strong growth prospects for at least the next couple of years; and with a trustworthy, conservative, management team guiding for large quarterly performance increases.
Summary
The upcoming May earnings release feels like the trigger for an impending awakening for this stock. A conservative, post-2Q21 valuation, based on 5.5x next twelve months projected EBITDA of $180M, is $990M, justifying a $16 price target. Versus today's close of $11.60, that represents a three-month, 38% upside.
My longer term target, based on 6x EBITDA, and assuming management achieves its strategic goals of 5-7% annual revenue growth with steadily widening margins, is $24.
