MEMC Electronic: Glass Half Empty or Half Full?
With MEMC Electronic (WFR) getting hammered yesterday on disappointing earnings (see conference call transcript), investors are faced with the always difficult assessment of what to do with the stock. I make no claim to deep expertise on WFR, but here are some general comments on the quarter, the valuation and the stock market reaction.
Top line was about $10mm below the low end of management’s April 24th guidance. Operational issues were the cause. Some analysts are concerned because this is the 2nd quarter of such issues. Thus, the tendency is to extrapolate. But that is a human flaw. For a complex manufacturing process, operational problems are either indicative of poor process controls, or they are simply random events. Engineering types who follow the stock can perhaps answer this question. For now, let’s give the company the benefit of the doubt and call it random events, non-recurring glitches.
My red flags on the quarter would be: decline in gross margin yr/yr (but up sequentially), leading to modest negative operating leverage, and a slowdown in revenue growth. For growth investors, these are major issues.
In terms of the market reaction, it is useful to think about the sociology of the ownership. Pure quant funds will sell the stock today, no questions asked, owing to the negative surprise and slowing growth and negative estimate revisions and adverse stock reaction. Indeed, quant funds are successful because using the law of large numbers and disciplined decision rules, the batting average on success using these criteria is typically 55 to 65%, which is a significant statistical edge over pure random selection.
Some fundamental growth managers will also sell the stock today regardless of price, because they come to an unfavorable judgment about WFR’s future growth prospects. This is more of a qualitative decision, based on nuanced evaluation of a lot of different factors.
The really tricky part is whether WFR has dropped below a minimum hurdle rate of adequate growth versus its valuation. In other words, pure deep value managers are not likely to step up to it at this price, but a GARP manager would, in my opinion.
Guidance: My back of the envelope using management’s current Eps guidance produces a point estimate of $1.05 for next quarter, on the non-GAAP metric used by management and the Street. So sequential improvement. And the ballpark figure for Q4 is $1.34 using the midpoint of management’s annual guidance, and $1.19 using their low end. This compares to $0.97 in Q4 ’07, so a pretty robust improvement. The reader is cautioned against the apparent precision of these numbers, the proper way to think about it is a wide range. WFR management will provide an interim update on Sept. 2nd. Current Street numbers for the full year will come down by 15 cents or so. On the midpoint, $4.15. 2009E will also come down. But for rough purposes if we grow the earnings 15% off the ’08 midpoint next year is $4.75+.
Now for the GARP valuation. At $43, the stock is a little over 10X current year guidance. The company is not falling apart, there is still unit growth, margins are intact, and expenses are well controlled. As is typical when a stock is headed for freefall, the company announced a major increment to share repurchase, another $500mm to bring current authorization to $1 billion. At an average price of $50/share, this would shrink the cap by about 9%, lending some leverage to out year earnings. WFR has almost $1.4 billion of cash and investments on hand so no need to borrow to fund repurchases. And debt on the balance sheet is minuscule. I calculate the free cash flow yield at 4.5% using the H-1 earnings results. So for WFR this is a good use of cash compared to the yields available in high quality short term investments today.
Is this a compelling FCF yield for an investor? Well yes and no. It is not nearly as attractive as many other stocks. So that begs the question, is WFR still a growth stock, and I suggest affirmative. The company produces prodigious free cash flow, so that makes it more appealing than other companies with FCF yields in the 8 to 10% range that have much lower margins.
Another exercise we can use is to calculate the P/E multiple ex cash on the balance sheet. Cash net of debt is $5.88 per share. That makes the stock price net of cash $37.12. ($43, minus the net cash). Interest income net of tax is running about 12 cents annualized. Subtracting that from the low end of ’08 guidance of $4.00 results in $3.88 in operating Eps, non-GAAP, and an adjusted P/E of 9.6X. That is certainly low enough to attract most any investor willing to make the assumption that WFR is just experiencing temporary stumbles in its operations.
Finally, we have the phenomenon of severe over reaction to news, driven by the disgorging of stock by the quant and other owners mentioned above. If the company is fundamentally sound and the problems are temporary, the patient investor can use short term volatility to advantage. Often a month or two later, the stock is higher. So this is just a matter of 1/ Making the right fundamental call and 2/ Using common sense instead of emotions to make a decision.
Disclosure: Author holds a long position in WFR
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