As December draws to a close, it’s quite common at this juncture to wax poetically about the year just passed as well as prognosticate on the one about to commence. I’ll skip the fond remembrances of 2009 but will offer up my two best ideas for 2010.
It should come as no surprise that at the top of my list is Micron
(MU). I’ve commented on it a couple of times in recent months (See the most recent post, Avoid Micron at Your Own Risk
) and you can check those notes as to why I think it’s a good idea. Micron’s also a holdover from my 2009 “best ideas” (Apple
(AAPL) was the other) but the points I highlighted earlier haven’t changed, so there’s no reason to take it off the list.
The company reported its first-quarter/fiscal year 2010 last Tuesday and the results were huge. But, true to form, there were the usual “yea buts” the following morning from the nay-sayer clan. Most of their comments followed a predictable script: The stock’s had a nice run and we think it's at or close to peak margins (i.e. gross margin).
Let me suggest that none of these analysts can tell you what peak margins are for Micron because they're incapable of predicting future memory prices. (Tell me all the oil analysts that predicted $150 per barrel a year in advance). But, aside from the fallacy in that logic, investors need to look at the historical record.
I’ve commented in the past about the introduction of Windows 3.0 (1990) being a seminal event in computing history because it broke the 640k memory limitation on personal computers. However, it wasn't until a number of bugs were fixed in Windows 3.1 (1992) coupled with dramatic Intel
(INTC) price cuts that we saw a real explosion in demand for PCs worldwide. And that explosion continued for a number of years.
What’s this got to do with Micron? Simple, look at the table below for its gross margins during that period and remember the analysts comments about peak margins today. Is this the same environment? No, of course not but:
- We currently have generally depressed economic circumstances in many geographies;
- Companies worldwide have delayed upgrading their desktops for years to avoid Windows Vista; and
- Demand today derives from a far larger and broader category of devices than it did 15 years ago, including servers, networking, smartphones, set-top boxes, and Mobile Internet Devices to name a few.
Micron’s margins are obviously capable of going much higher.
My second name is FormFactor (FORM), a small-cap (about $1 billion) semiconductor wafer fab equipment company. FormFactor makes wafer probe cards used in the testing process to determine the good die on a wafer. The bulk of its revenue is from DRAM manufacturers where it has more than 50% market share but it's now moving aggressively into NAND flash and other end-markets.
FormFactor has been hit by a double-whammy the last couple of years. The memory industry went through its own excess capacity shakeout coupled with the normal capital spending reductions of a cyclical downturn. Estimates of capital spending by memory manufacturers for 2009 are at the lowest level in the last seven years. Worse, the capex-to-revenue ratio for the industry (a commonly used metric) is at a record low. Consequently, fundamentals have been a disaster for more than a year and the firm’s been through some deep restructuring.
Top-line “growth” remains negative and gross margin for the nine months ending September 30 is a meager 2.3%. It goes without saying that operating income has been more of a fantasy than a reality during this period.
So what’s so attractive about FormFactor at this point?
Unlike some other types of wafer fab equipment, the demand for wafer probe cards is not primarily dependent upon new capacity expansion plans (i.e. new fabs or new lines within existing fabs). On the contrary, process technology changes (i.e. shrinks) drive demand and that’s where you’ll see the bulk of capital spending in 2010. For example, Micron’s technology partners in Taiwan (Nanya and Inotera) are both undergoing shrinks as they shift to Micron’s stack process.
FormFactor is also a primary beneficiary of technology developments within product groups. The shift to DDR3 from DDR2 is currently taking place among DRAM suppliers. That drives new demand and will throughout next year. On the NAND side, higher densities and more bits per cell all spur growth for FORM.
Lastly, a new suite of products for DRAM and NAND flash are said to enable higher tester throughput and will extend the life of the tools for the OEM. I’ve checked with at least one fab on this subject and the feeling is that the efficiency claims are valid. Every fab manager likes to save money!
Given the extraordinarily weak demand environment over the last year or so, coupled with the changes I expect in the memory market next year, I think the opportunity for topline growth in 2010 is very real. If that can happen, what’s the potential?
Take a look back at FormFactor’s fundamentals earlier this decade in the table below. The company consistently reported gross margins approaching 50%. As part of the current restructuring, manufacturing operations are being moved to Asia so it's possible with lower costs the prior metrics may be exceeded. That’s not going to happen tomorrow but the potential for margin expansion from current levels (16.8% FQ3) is extraordinary. Operating margins were consistently in double-digits and should return to those levels again as well.
Currently, about 45% of the company’s market capitalization is net cash (about $9.30 per share) with no debt. Granted, it's been burning cash in this downturn but a little more discipline in its working capital accounts should address most of that issue and a little topline growth would take care of the rest.
FormFactor’s stock has lagged most other wafer fab equipment companies on a year-to-date basis, so this one hasn’t run away from you. Do some work on the name and, if it’s appropriate for your risk profile, jump in.
Position in MU
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