William Gabrielski

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MEMC Shines as Play on Silicon Shortage

William Gabrielski

There is a shortage of silicon to go around the semiconductor and solar power industries, and MEMC Electronic Materials(WFR Quote) is benefiting. Though shares are up 37% to $23.24 since I first highlighted the stock in August, there is no reason to expect ample silicon supplies to come online anytime soon, and MEMC's growth appears limited only by its ability to execute, though I doubt this will be an issue.

Very few publicly traded companies offer a way to play a silicon shortage, but MEMC, which I found using CapitalIQ to search for companies with silicon exposure, is stealthily becoming a favorite among more speculative investors. The company produces wafers for the semiconductor industry and the solar power industry, but its leverage to solar power remains so far under the radar that it's not even mentioned in the MEMC's description on some financial Web sites.

Surge in Solar Powers Silicon

According to data from First Albany's alternative energy team, the solar power industry's consumption of silicon represented 40% of total silicon usage in 2004. This is somewhat surprising when you consider that the entire global solar power market would hardly be enough to power New York City for any considerable length of time. Even so, based on the 30% annual growth rate of the solar industry worldwide, it is not a stretch to assume the solar industry will soon grab the top spot for silicon consumption.

Silicon supply constraints have led to a doubling in the price of polysilicon, the type of silicon used by the solar industry, over the last 18 months. Because of this surge, MEMC has executed an operational turnaround without experiencing a sharp decline in operating profits.

Recent Stumbles

However, management has had a few missteps that I believe have affected the shares. Most recently, on Nov. 15, MEMC restated its revenue and earnings slightly lower for the first three quarters of 2005 due to a change in revenue recognition policy. The revenue will be recorded this quarter. The restated results were largely as Wall Street expected and had no impact on the stock price. As a side note, MEMC confirmed that pricing for its wafers remains strong, and that it expects prices to increase by 4% in 2006; I don't expect any more earnings issues going forward.

Also, 25% stakeholder Texas Pacific Group was a big seller of the stock over the summer, and the fresh supply is probably what has weighed on the share price. While TPG continues to hold a sizable stake in the company and further sales are possible, strong industry trends and improving investor sentiment are likely to more than mitigate them.

Strong Trend, Indeed

Germany, Japan and the U.S. represent the three largest solar power markets in the world. Tax incentives and government subsidies coupled with skyrocketing oil and natural gas prices have improved the cost/benefit equation for solar power generation. The break-even period for businesses that elect to install solar panels is approaching the critical three-year time period; 40% of respondents to a survey conducted by First Albany said they would consider using alternative energy products if they could recoup installation costs within three years. As costs come down and solar installations increase, the supply/demand imbalance probably will exacerbate the shortage further.

For decades, silicon was mainly a feedstock for the semiconductor industry to make chips, and supply has been more than adequate to meet demand even during the peak of the dot-com bubble. However, the proliferation of solar power as an economical and clean power source has changed this dynamic dramatically. Now solar power producers are scrambling to lock in supplies as far out as contractually possible.

Silicon producers are doing their best to bring new capacity online. Most recently, German company Siltronic announced plans to spend about $150 million to expand one of its plants. But growth in solar power consumption is likely to outstrip any additional supplies for the foreseeable future. That said, UBS said in a research note it expects silicon supply to expand only 13% in 2006 to 34,000 tons, which probably won't be enough to cover the surge in demand from the solar power industry.

Powering Higher

All of this good news could drive earnings upside for MEMC in 2006. As it stands now, Wall Street is looking for the company to earn $1.38 a share in 2006, up from estimates for $1.02 a share in 2005. Part of the earnings growth is forecast to come from cost controls, and the remainder should be driven by 16% top-line growth to $1.31 billion.

At its recent quote, shares trade around 3.5 times 2006 sales forecasts and 17 times 2006 earnings estimates. I believe the earnings part of the price-to-earnings ratio has the potential to expand beyond analyst expectations in 2006 should solar demand, coupled with strong semiconductor volumes, continue to curtail supplies. Either way, shares currently trade at roughly a 30% discount to the industry.

There are very few secular growth markets with pricing power, but MEMC appears well-positioned to benefit from strong pricing trends and surging demand. I believe that continued excitement surrounding solar power and greater investor recognition of the current silicon shortage will drive shares higher in the coming year.

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