Yesterday I decided to take a modest position in Verigy Ltd. (NASDAQ:VRGY), purchasing the stock on a dip at $22.49. Those familiar with the problems in the semiconductor industry recently may be scratching their head and wondering why I have chosen to venture into the sector, so I have put my thoughts to paper below./p>
Verigy, which was spun off from Agilent Technologies (NYSE:A) in 2006, is a company that makes semiconductor testing equipment. The semiconductor market has been quite weak for some time, as the semiconductor industry deals with a glut in supply and narrowing profit margins over the last 12 months. However, Verigy has shown a solid operating performance despite the overall market weakness, and recent restructuring efforts are starting to create significant value for shareholders and fall down to the bottom line.
Verigy’s restructuring efforts, which began in 2006, consist of outsourcing manufacturing of their test systems [to Flextronics (NASDAQ:FLEX)] and shifting personnel and manufacturing away from the U.S. and Germany and into Asia. This restructuring, which is just about finished, should begin to show up in the form of lower costs for the company. Moreover, Verigy is also better positioned geographically to take advantage of Asian growth.
From a margin standpoint, Verigy has already begun to see the benefits of restructuring. Gross margins jumped to 45% in the quarter ended July 30th, up from 43% in the April and January quarters. Operating margins showed an even greater expansion, jumping from 11.5% in April to 15% in the July quarter. While many of the cost benefits of restructuring have been passed on, there remains a bit more to be squeezed out of restructuring, so we could see margins improve a bit more over as operations in Germany are closed at some point in the next two or three quarters.
From a revenue standpoint, the company has also shown solid performance in spite of general weakness in the semiconductor sector. In comparison with most of its competitors [Advantest (NYSE:ATE), Teradyne (NYSE:TER)] whose revenues have fallen off by 5 percent or more, Verigy’s ability to maintain stable revenues looks impressive and indicates that the company appears to be gaining market share in the sector’s current downturn. All in all, VRGY has shown strength amidst the weak overall outlook for semiconductors, a fact that cannot be overlooked when trying to find the winners when the industry turns.
As for when the sector will finally turn around, the semiconductor industry is notoriously difficult to predict. While VRGY said on its most recent call that it was seeing strength in the SIC and SOC markets that use Verigy’s 93000 series test equipment, it also noted that the outlook for flash and NAND had dimmed, thereby reducing visibility for its Versatest system. With the 93000 series providing 45% of product revenues, it appears that the strength in this market is more than likely going to be offset by weakness in the flash market. This fact led the company to guide revenues for next quarter to $195-205 million and EPS to between $0.46 to $0.51. While this indicates flat sequential revenues and earnings, the numbers are certainly nothing to panic over.
However, while the outlook for semiconductors remains cloudy, Verigy shares appear to have a healthy bit of pessimism baked into the current price. Verigy currently trades at under 14 times 2007 projected earnings and 11 times 2008 projected earnings. For a company that is showing solid margin expansion and gaining market share, this is a very cheap multiple, and the multiple is ripe for expansion when the industry outlook improves.
Additionally, Verigy sports one of the best balance sheets in the business, with $391 million in cash equivalents (on a $1.3 billion market cap). This fact, along with the $35 million in operating cash flow the business is producing each quarter, gives Verigy a lot of room for an acquisition or a potential buyback. Many analysts and investors are currently clamoring for a buyback, and management said that they would provide more information as to the plans for their cash in their year end conference call in November.
With Verigy’s business creating mounds of cash, I believe the company is going to have little choice but to use this cash to announce a buyback at the next conference call, and the value of the buyback could be anywhere from 8 to 15 percent of the company’s market cap ($110 to $200 million). This buyback is currently not factored into analysts earnings estimates for the fiscal year 2008, and if we do get the buyback, analysts will be forced to revise estimates significantly higher.
By my calculation, a buyback of $110 million could boost Verigy’s 2008 EPS to at least $2.10 per share (assuming revenues meet expectations), and a larger buyback of $200 million could boost VRGY earnings to up to $2.30 per share. If we slap a 15 multiple on 2008 earnings to the stock (which is more or less where it is currently trading), that yields a price target of somewhere between $31.50 and $34.50. If by chance we get some improvement in the outlook for the sector, this price target could be aided by some significant margin expansion, adding further potential upside to the stock.
Overall, the analysts for Verigy seem to be playing it safe with regard to 2008 earnings, waiting for the confirmation of a buyback before raising their estimates. That makes the stock attractive at its current valuation, as we can see a near term catalyst to drive the stock higher if earnings estimates are raised in reaction to a buyback. Though significant uncertainty remains surrounding the semiconductor industry outlook, VRGY’s current valuation seems to have taken much of the uncertainty into account. Meanwhile, the company continues to print cash and appears ready to undertake a major buyback, and getting in ahead of the buyback should be a very profitable opportunity.