The Fallout At GTAT - Lessons Learned (And The Impact For Apple)
Tech, Long/Short Equity, Growth At A Reasonable Price, Value
Seeking Alpha Analyst Since 2012
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I already wrote quite a few comments about GTAT's failure and its recent Chapter 11 announcement, but I would still like to write a summary:
The result is clear, see the share price tumbling to near zero in early October 2014:
As in other Chapter 11 situations daytraders and gamblers are already having a field day (see the 100+% jump in the daily chart) with the - in almost all cases in Chapter 11 and 7 situations - now worthless stock shells. Soon, GTAT stock will be traded as OTC with a Q attached - don't touch it, leave this hot, rotten potato to gamblers.
The important question remains: Why? In most cases, shares that end in Chapter 11 - or even Chapter 7 - show a much slower slide down to penny stock territory (usually interrupted by some upticks such as bailout or capital raise rumors). GTAT's demise came very quick in comparison. Also, GTAT's bonds didn't trade as if Chapter 11 was imminent, usually the bonds of a company give some good indication (beyond short sales and option volume) where things are headed if Chapter 7 or 11 is looming.
I owned some GTAT shares in the past, in 2013 and then again into mid-2014 along with a basket of other Apple suppliers and related tech companies (INVN, SWIR...).
I also recommended INVN and SWIR as my two long tech ideas for 2014 (see earlier Instablog entries on this blog, HLF was my short for 2014 using play money only). Luckily, I never recommend GTAT, but mentioned it in passing along with many other Apple suppliers.
I very rarely held stocks that go into Chapter 11 a few months later, I'm therefore interested in a post-mortem analysis on GTAT as a case study.
This is how the WSJ sums up the events:
"That may have led to the company's filing, since its cash, at $85 million, was below a $125 million trigger point that would allow Apple AAPL to demand repayment of about $440 million in loans it had advanced. Apple had agreed to lend GT a total of $578 million to help get a large sapphire factory in Arizona up and running. The tech giant reportedly withheld the last $139 million payment it was due to make, although it isn't clear why.
What is obvious is that GT effectively bet the house on a new technology with a new business model and made itself dependent on a single customer-Apple."
There are good excerpts from the 10-K summarized and discussed at Bloomberg View: http://bv.ms/1tt5NJS.
I highly recommend this linked Bloomberg article, also because it covers a possible cross-default and immediate repayment for all convertible bonds (triggered once AAPL stopped sending payments, see 10-K). As a result, GTAT would have been down so much that a secondary offering was no longer a viable option.
Here's one kicker from the 10-K: "Apple has no minimum purchase obligation and if Apple does not purchase sufficient quantities of sapphire material, our revenues will suffer and we may be unable to meet our obligations to repay advances that were provided to us."
It's of course always easier to see the red flags looking backwards, such as
- Worse and worse Altman Z score at GTAT (Z-Score model is an accurate forecaster of failure up to two years prior to distress. It can be considered the assessment of the distress of industrial corporations)
- The 10-K risk quotes (see Bloomberg View article, but then every small supplier has the same scary risks if their main customer(s) jump ship and switch to another supplier or technology)
- Single customer risk (almost everything depended on Apple at GTAT from November 2013 onwards, their solar-related business units added little revenue in 2014)
- High short interest in GTAT shares for months (but as noted above, their bonds weren't trading at distressed levels)
- Bad news out since Sept 9, 2014 (definitive confirmation that Apple was not going to adopt sapphire for iPhone6 front cover screens), as a result GTAT stock drops in September to around $10-12 area (which made some investors or traders even load up more because they felt a bottom as near...)
- The related fact that AAPL is mum on product news until the day of introduction and the high secrecy Apple wants its suppliers to maintain to avoid any leaks in advance (GTAT could have used these strict non-disclosure agreements to hide information or at least delay forwarding the bad news flow to its own shareholders. Again, that will be up for courts to decide. Lawsuits have already been filed by law firms on behalf of GTAT shareholders.)
That still doesn't answer why Apple or others didn't provide bridge financing to GTAT or resolve the situation amicably. The bold text portion from the WSJ (my highlight) is the "main course" here: Why did Apple withhold the last payment and how much advance notice or warnings did it give to GTAT (if any)?
GTAT management should have seen Chapter 11 coming for weeks and could/should have looked for additional financing, that is UNLESS one of two things happened:
- Apple pulled the plug and demanded repayment or similar based on broken contract clauses on short notice or even very short notice (as explained here in detail: http://bv.ms/1tt5NJS, same link as recommended above)
- Finance department and controllers at GTAT asleep at the switch (or even deliberate misleading, that is for courts to decide. Lawsuits will fly in any case.)
I can't wrap my head around scenario 2., they would have been asleep for a long time. On the other hand, GTAT management repeatedly made statements like this - these could play in favor of scenario 2., for example from the Q1 2014 call:
"We expect year-end cash, cash equivalents, and restricted cash of $400 million to $450 million, again reflecting the incremental CapEx discussed earlier."
And from the 10-K:
"The Company is currently in compliance [in reference to the Master Development and Supply Agreement ("MDSA") with Apple], and based on the Company's operational plans and financial forecasts, the Company expects to maintain compliance with the operating metrics and financial covenants in the Prepayment Agreement and management believes that the Company will have sufficient cash resources to fund operations for at least the next twelve months."
And finally the Q2 2014 conference call answer that really raises eyebrows in hindsight, given that the question specifically is about pre-payment risk and Q3 2014:
Stephen Chin - UBS
Okay and may be a follow-on to that. If the final prepayment does not come through by that October timeframe is there an extension possible to that or is there a scenario where you then might need to raise more cash, if you don't get that prepayment?
Tom Gutierrez - President and CEOI would say that these are milestone based, right and so when you reached a milestone, you get paid, they are not cliffs per se. And so I feel very confident based on the progress that we are making that we will achieve the milestone in that timeframe but as I indicated with the projection of having close to $400 million in the bank at the end of the year, it's not a world-ending event, if it slides, although again I don't anticipate that it will slide.
That obviously doesn't answer the Chapter 11 decision/result at all from GTAT's management's perspective - this answer from the CEO didn't even warn about a major dilution or capital raise for shareholders in case the pre-payment from Apple didn't come on time (October 2014).
When even more troubled companies (like for example RSH a few days ago) are able to get some form of - although of course expensive - interim financing in current credit environments within very short time periods the question still remains: Why not GTAT?
I see little motivation for AAPL to pull the plug on an important supplier and not help them fix the issues via a bridge loan in case of technicalities or minor delays - Apple knew Chapter 11 would be the likely result if the last pre-payment didn't clear on their side.
And Apple of course pre-financed GTAT equipment up to almost $600 million since late 2013, as outlined here in a PR blast:
"The company also announced that it has entered into a multi-year supply agreement with Apple Inc. to provide sapphire material. GT will own and operate ASF® furnaces and related equipment to produce the material at an Apple facility in Arizona where GT expects to employ over 700 people. Apple will provide GT with a prepayment of approximately $578 million. GT will reimburse Apple for the prepayment over five years, starting in 2015."
Also, AAPL had pulled off similar huge ramp-ups with other components and partners successfully (for example Touch ID fingerprint sensors IP from Authentec, such sensors were only produced in much smaller quantities before).
Apparently not this time. GTAT's Mesa facility process must have been broken in a major way or personnel not up to the task, for example a combination of issues like:
- Quality (problems with supplied machinery etc.)
- Yield/Costs (driving down process costs to target unsuccessful, sapphire production historically was expensive, GTAT could have been overly optimistic)
- Volume/Time (ramp-up troubles, major delays)
It could therefore take months before AAPL can start using more "special" sapphire (provided they have no second or third supplier ready soon, more on this later).
Buying parts of GTAT (sapphire IP) before Chapter 11 or extending a loan would have been easy for Apple if it was just about minor issues or delays. Apple spent more money on Beats a few months ago, this would have been chump change for Apple. The company pays out billions in advance payments to various key suppliers around the world every year.
The plausible reason (except for possible deliberate fraud on GTAT's side):
GTAT's products and test batches had so many quality and cost issues or delays that Apple had to pull the plug before the last payment - after exhausting all other options.
Is that bad for Apple going forward?
(I will switch out the outlook to Apple now, GTAT is done and in Chapter 11 anyway.)
Well-known AAPL analyst Kuo (who has a good batting average) doesn't think so, at least not in the near term and for the next major product release (Apple Watch). Here's his take:
Bankruptcy has no impact on Apple Watch. As the Apple Watch sapphire cover lens uses an ingot of less than 6-inches, and as drop-test requirements aren't so stringent as those of iPhone, general ingot manufacturing processes such as KY suffice for Apple Watch. This is why there are abundant sapphire ingot suppliers to choose from for Apple Watch. According to our survey, aside from GTAT, other Apple Watch sapphire ingot suppliers are Hansol (KR) and Harbin Aurora Optoelectronics (CN). We therefore don't think GTAT's bankruptcy will affect sapphire ingot supply to Apple Watch.
Source: www.macrumors.com/2014/10/07/apple-watch.../
Kuo has a quite a good track record historically, so I will leave it at that (but I'm not 100% sure myself because the Apple Watch screen allows for both simple taps and presses, we will see. Producing much smaller watch screens of course requires fewer capacity, that's an advantage).
The only other question therefore is sapphire's future at Apple for high-volume products with those special needs (for example, a future iPhone 6s or iPhone7 with sapphire front screens):
What about special sapphire requirements at AAPL that can't be met by external suppliers at the moment?
Will Apple...
- take over the GTAT remains in Mesa and try to fix the process in-house with new personnel and machinery (or even continue to work together with a GTAT under Chapter 11 and later a successor company) or
- switch to new external suppliers using GTAT's acquired IP or
- give up on the specialized sapphire idea altogether?
That answer will likely be revealed in 2015.
Analyst's Disclosure: The author is long AAPL, INVN, SWIR.
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