RealMoney Silver - MEMC Is the Best of the Semis

MEMC Is the Best of the Semis
By Bill Trent
RealMoney.com Contributor
1/7/2008 1:14 PM EST

I have said in other articles that the semiconductor industry supply and demand fundamentals argue for positive stock performance in the group. Semiconductor manufacturers such as Intel (INTC) should do better than semiconductor equipment manufacturers such as Applied Materials (AMAT) .

Although I think investors can profit from an ETF play like the Semiconductor HOLDRs (SMH) or the ProShares Ultra Semiconductors (USD) , I figured it was about time for me to get more specific and try to pick some stocks I think are poised to do even better than the industry as a whole.

The clear winner, in my opinion, is MEMC Electronic Materials (WFR) . MEMC is a leading manufacturer of silicon wafers for semiconductor devices and solar cells. Its customers include virtually all of the major semiconductor device manufacturers in the world.

MEMC is benefiting from a shortage of wafers, which has boosted its pricing power and profitability. According to DigiTimes, insufficient supply of polysilicon has spurred the price of silicon wafers so high that solar industry players are considering using scrap wafers that have been already been buried for years.

The tight supply has caused MEMC to drain most of its inventory. Days sales in inventory (DSI) have plummeted from nearly 70 two years ago to less than 30 in the latest quarter.

MEMC Sales Days in Inventory

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Source: Zacks Research Wizard; William A. Trent

What's more, the short supply allows MEMC to enter into highly favorable long-term supply contracts with predetermined pricing on a take or pay basis, customer-advanced funds in the form of a capacity reservation deposit and equity participation in the customer's business.

On the latest conference call, management said that its current capacity is spoken for, and most of its planned capacity increases are as well.

MEMC Gross Margin

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Source: Zacks Research Wizard; William A. Trent

Margins dipped slightly in the September quarter due in part to an incident that caused the company to lose well over a week's worth of polysilicon production at its polysilicon facility in Pasadena, Texas. Overall, though, the tight capacity has contributed to rapid expansion in gross profit margin.

Increasing sales and margins, of course, cause a steady increase in earnings estimates. Over the past 90 days, 2008 EPS estimates have risen from $4.06 a share to $4.19. The Zacks Rank, a measure of earnings revision momentum, is 2. This places MEMC among the top 20% of companies for earnings revision performance.

Of course, even the strongest fundamentals will do investors no good if the stock is overvalued. Fortunately, I don't think this is the case for MEMC.

Over the past 12 months, MEMC generated more than $600 million in free cash flow, giving it a 3.2% free cash flow yield based on the current $18.8 billion enterprise value. This is right in line with the current yield on five-year Treasuries.

So why buy a risky investment like MEMC when risk-free Treasuries offer the same yield? Because Treasuries don't offer growth, and MEMC offers tons of it. The consensus five-year growth rate is 30%, but based on its return on equity, MEMC has a sustainable growth rate of nearly 55% (its growth rate over the past five years.)

Heck, even the lowest growth estimate is 13%. I'd take that in today's market environment.

It's true that by some measures the stock looks overvalued. For example, it has a price/book ratio of nearly 12 -- well above the semiconductor industry average of 2. A reduction in the valuation multiple would offset some portion of that growth benefit.

Because total return must equal growth plus the change in valuation, let's assume that MEMC grows at the 30% consensus rate over the next five years, but its price/book shrinks to the industry average of 2. No problem. The growth still overwhelms the change in valuation, and the indicated annual return is 25%.

In my opinion, no other semiconductor player even offers close to that opportunity.