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The Curious Case Of Tower Semiconductor

|Includes: Tower Semiconductor Ltd. (TSEM)

Small cap stocks - the niche that is often overlooked and receives no love "on paper." While the financial press does a great job of ignoring small cap stocks (in relation to Blue Chips, etc.), there are exceptions that do receive a decent amount of exposure. For the most past, this exposure tends to either make or break a company's stock price over a relatively short time frame. But, there are always exceptions to the "rule." Such an exception to the rule within the small cap sector is Tower Semiconductor (NASDAQ: TSEM).

For those of you unfamiliar with Tower, here is a very brief overview. They are an Israel-based company that specializes in chip manufacturing and production, specifically in the analog sector. They are considered to be the global specialty foundry leader in terms of total annual revenue. However, Tower has had to navigate some very rocky roads over the past 10+ years. It is likely for this reason that they have received a great deal of exposure for a small cap stock.

When trying to analyze Tower though, it seems to be an impossible feat. Major analyst houses give Tower a one year stock target of anywhere between $18-28. Short sellers have given Tower a fair value of $5/share. Even the market seems to be uncertain of how to price Tower stock, and the market always knows. There is no in-between price between the two views on Tower. So two questions come to mind. A) How can this happen? B) How can we accurately price Tower's stock?

I have been following Tower Semiconductor for seven years now, and, not to brag, but I likely have a better understanding than most people who own Tower in their portfolio. In this article, I will try and give my best explanations on some key factors regarding Tower and the best way to price its stock.

Management

Before breaking down a company's financials, it is imperative to look at their executives and who is leading the business to success. The key figure behind Tower's explosive revenue growth over the past decade? Russell Ellwanger - a highly successful semiconductor executive with over three decades of experience in the field. Unfortunately, some traders and hedge funds are skeptical of Ellwanger given his lack of educational achievements. Unfortunately for these skeptics, in this specific instance, this lack of a university degree with a focus on chips is of zero importance. Russell Ellwanger has done a fantastic job of turning this company around, especially given its circumstances a decade ago when they were on the verge of bankruptcy. You don't need to have a university degree to run a successful business. At the end of the day, a degree is generally received in a person's "20's," and is far less valuable than business experience and understanding of the market they are in.

Dilution

One of the major issues for Tower shareholders has been management's decision to dilute (seemingly at will) ever since Ellwanger took over. When I first started following the company back in early 2009, Tower had a little over 100 million outstanding shares. Though Tower currently has approximately 107 million fully diluted shares, it is important to note that Tower completed a 1:15 reverse split a few years ago. Besides the fact that reverse splits are almost always a bad indicator for investors, this means that Tower's share count has shot up by almost 400% since I have been following this stock. To be fair, Tower's "new" management under Ellwanger had very little to work with. The company was debt ridden (about $500 million in total debt) and, as mentioned above, was a hair strain away from going under. The logical strategy for turning around the business was via dilution. It is illogical to think that banks would have given them a loan. While management does need to take into consideration its shareholders, reviving the company and growing the business is more important. As such, Tower's executives and board members diluted shareholders to no end. Now, though, they are in far better financial shape. Other than the dilution from the Panasonic JV and the Maxim acquisition (minimal dilution vs. excellent value), Tower's management has not diluted its shareholders in two years - a record. Still, shorts are skeptical, rightly so, that the management team at TowerJazz will continue to dilute in the future. And really - this is one of the only factors that can hold Tower's stock back from really rising in the future. If you are going off of history, then history says to stay away from investing in Tower due to almost near certain dilution (whether through bonds or ESOP or other forms - doesn't matter). However, two years of virtually no significant dilution is impressive and is, in my opinion, a strong sign.

Revenue

I have seen Tower grow from a measly $200 million in annual revenue to over $1 billion in annual sales (forecasted FY 2016). This has been the most impressive figure for Tower. Though a large chunk of this revenue increase comes from both the Panasonic JV and the Maxim acquisition, Tower's organic growth has simply been extraordinary. Revenues will continue to rise until at least 2018, when their JV technically expires with Panasonic. This, aside from dilution, is the only other factor that could harm Tower's stock price. Should Panasonic decide to cut ties with Tower, it will be extremely difficult for Tower to find $400 million in annual revenue replacement, even with their strong organic growth.

COGS/Gross Margins

Several years ago, I harped on the fact that Tower's COGS was anywhere around 85%. Needless to say, this is very high and makes it difficult to turn a profit. However, Tower is now doing a lot of (sales) volume, and that's the name of the game. Should Tower ever hit $2 billion in annual sales, even if COGS is at 90%, that's still a nice chunk of profit. Here's the problem: several quarters ago, Tower moved COGS to R&D within their balance sheet. It is for this reason why Tower is now showing 40%+ gross margins. Let's set the record straight. ON PAPER, Tower's gross margins are 40%. But in reality, they are not. Nevertheless, Tower has improved gross margins. COGS is no longer at 10-15%. Unfortunately, I don't have this information so it's impossible to know the exact figure in regard to COGS. However, we can see that Tower has improved in this area. Gross margins, on paper, have improved from 28% to 40%. A safe estimate for real COGS is around 20%. I would also like to mention that analysts frequently point out Tower's fantastic gross margins and non-GAAP EPS (likely to be well over $3 in FY 2016). But as I mentioned, this is flawed. Thus, both shareholders and shorts alike are unable to accurately price Tower's stock.

Depreciation

Here is where things really get interesting. Tower stopped recording depreciation as a separate expense a few quarters ago as well. Furthermore, they spontaneously increased depreciable life from 7 years to 15 years. Hence, we see a solid balance sheet. Here, though, I am inclined to stick on the side of long term shareholders and people who back Tower. The shorts that came after Tower clearly did not understand the difference between the digital and analog landscape. Within the digital semiconductor world, depreciation should be anywhere between 2-5 years. However, within the analog market, 15 years is truly an accurate figure as nicely pointed out here. Unfortunately, it seems the market is not convinced and is therefore likely using the "7 year" depreciation figure that Tower has used since its inception.

The Future

So where do we go from here? The market is confused about how to price Tower. Furthermore, we have two sides fighting to no end about Tower's books and reporting. One side says Tower should be valued at $5 while the other says it's extremely undervalued and should be ~$21-22/share, especially given Tower's EPS and low P/E. Is anyone right? Probably not.

Analyst Targets

Since I have watched Tower, I have seen analysts give Tower very high price targets. The results? None of them have hit. In fact, none have even come close. Example: back in early 2010, Tower was given a one year price target of anywhere between $3-5 (pre reverse split) by various analyst houses. Throughout that one year period, Tower peaked at $1.87 before trading at about $1.50 over the next few months (and then slowly trailing down thereafter).

Short Sellers

Short sellers are in the business of making quick money. They do a very good job at scaring the public by nitpicking at certain information. Just as Tower's management did, the shorts exploited some of Tower's data in their favor to make their case. This isn't something new. The point is that like analyst houses, shorts can never deliver an accurate target of what Tower should be trading at.

But don't worry; though I am in no way stating that I am a professional investor, I believe I have found one way of measuring what Tower should be trading at: price to sales ratio.

Price to Sales

Yes, price to sales is often overlooked and most investors look at this as a last resort. I get it. However, due to reporting inconsistencies and the inability to see the real total financials, I believe that looking at the price to sales ratio is the best way to accurately price Tower's stock. I have noticed that over the years, Tower has traded at roughly 1x sales consistently (with the exception of the market crash in 2008-2009). When Tower was in bad shape, they traded at roughly 0.6-0.8x sales. When they were in good shape, they traded at 1.3-1.4x sales, and even reached 1.5x sales for a very brief period of time. However, for the most part, Tower has traded at around 1x sales. Due to Tower's improved financials though, they currently trade at about 1.15-1.2x sales. And as I stated above, when Tower outperforms, their price to sales ratio tends to increase.

Real One Year Price Target

Over the next year, I assume that the P/S ratio will rise to about 1.3-1.4x given Tower's strong performance. Assuming we use the non-fully diluted share count of 90 million and a conservative 1.3x price to sales, Tower's stock price should reach close to $16/share within a one year period. Worst case scenario (excluding future dilution) is a one year price target of around $14.50 - on a fully diluted basis. However, this is unlikely. I won't get into it too much but Tower will never be fully diluted. Kenon will almost certainly never fully sell all of its shares in Tower. This is a no brainer if you understand the relationship between Tower and Kenon as do most Israeli investors. Furthermore, all 7 million ESOP shares won't be converted either. Thus, using the 90-95 million figure for share count when determining Tower's stock price is accurate. Best case scenario? Tower trades at a 1.5x sales ratio, no further dilution occurs, and thus Tower's one year stock price should be over $18/share. Given shareholder sentiments regarding Tower and its dilution habits, frequent short articles bashing Tower's management for aggressive ESOP distribution and random dilution, favorable debt terms whereby the company can take on cheap debt (low interest rates) rather than more dilution at shareholder expense, and GAAP net profit they can use, it is unlikely that Tower's management dilutes over the next year.

In conclusion, any way I see it, Tower's one year price target is anywhere between $15.75 - $18.50, or between a 20-40% increase over today's price.

Disclosure: I am/we are long TSEM.