Kardan Capital rates Tower a Buy, notes Fab 2 risks

Analysts say Tower might decide to cut old foundry Fab 1 loose if it continues to bleed
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Migdal Ha'emek-based Tower Semiconductor (Nasdaq:TSEM) (TSEM) - Get Report is undervalued, say Kardan Capital Investments analysts Yaniv Pagot and Yair Spalter. They set Tower's target at $8.7 per share, compared with Tower's current level of $4.68, and affirmed the share's Buy rating.

In their third research update on Tower, the analysts note that its stock has lost half its value since the September 11 terror attacks. It has become undervalued, together with the rest of the sector's companies, they write.

The attacks and downturn aside, Tower specifically was hurt by the Israeli government freezing a $6 million grant for its first foundry, Fab 1. Extensive press coverage of the frozen grant created negative sentiment for the company. But the freeze does not affect the $250 million the government has pledged to Fab 2, the foundry under construction in Migdal Ha'emek, the analysts point out.

As for Fab 1, it's 15 years old ¿ a long run for any foundry, which typically have life-times of 10 to 12 years. More relevantly, Fab 1 is bleeding. In the third quarter the facility, which is producing at a third of its capacity, was $2.5 million cash-flow negative.

While the Fab 1 could be kept up and running for another three to four years, Spalter told TheMarker.com, Tower has little incentive to keep it on life support unless the industry revives. Tower has invested $210 million in the foundry since 1995. It recently invested another $20 million in new production technologies. But if Fab 1 continues to lose money through another business cycle, the analysts predict, Tower will shut it down.

Another weak point is Tower's third-quarter results, which attest to crisis. Third-quarter sales dropped 21% from the previous quarter, and the company expects a further dip in the fourth quarter. But leading companies such as Taiwan's TSMC and UMC assess that the worst is behind the sector and expect improved results in the fourth quarter.

Fab 2, under construction, is Tower's great hope for the future. It is also a source of risk.

To date Fab 2 investors have shown a high level of commitment. All met the last milestone, Spalter notes.

The problem is that building the foundry will cost somewhere around $1.4 billion, while to date Tower has secured commitments for $1.1 billion. Not all the money in yet, and Tower needs to keep its backers from turning squeamish, specifically Macronics, QuickLogic, Alliance Semiconductor (Nasdaq:ALSC) and SanDisk (Nasdaq:SNDK). In any case Tower needs to raise another $300 million. Prices are down in the industry. If the investment agreements had been drawn up today, Fab 2 would valued at much less.

In a worst-case scenario some of Tower's backers might find they can't or won't fulfill their investment commitments, but that would be an extreme situation. Tower Co-CEO Yoav Nissan-Cohen also frets that the government foot-dragging on its commitments to Fab 1 will frighten jittery foreign investors in Fab 2, even though the two are unrelated.

"We don't expect the herd to flee," Spalter told TheMarker.com. "To date Tower has managed to raise money very well. We believe it will continue to do so in the future. But, there are risks."

Investors defaulting wouldn't spell doom for Fab 2, it would just mean that Tower needs to raise more money than it expects to at this point.

At its current share price, that would be a problem, unless the industry picks up. Its only tool to raise more money is its shrunken share price. Investors could find themselves diluted.

"Tower itself is an interesting case at the micro level. It's investing $1.5 billion in its new foundry while its market value has shrunk to $100 million. A mouse birthing an elephant," Spalter commented.