Toro's Running of the Bulls Market Blog

Critical Undersupply in Semiconductors Coming

So sayeth the head of the World Semiconductor Council.

The head of the World Semiconductor Council warned yesterday that recent aggressive capacity cuts in the D-Ram memory chip sector were likely to result in a severe shortage by the end of the year that could disrupt shipments of computers and other electronics.

The global D-Ram sector faced its biggest crisis in its 16 years of existence last year as industry over-expansion coincided with a drop in demand for computers.

But Frank Huang, chairman of the World Semiconductor Council and also of Powerchip, one of the biggest Taiwan D-Ram makers, said the industry would begin to recover by the second half of this year, and downstream producers of PCs and other electronic products would face "a shortage bigger than I have ever seen in the past 16 years . . . this will affect global PC shipments".

Last year's crisis, reflected in the price of D-Ram falling by more than half to below cost for most producers by the end of the year, led to a store of 1bn unsold D-Ram chips and nearly $10bn in total losses by the industry.

This prompted the biggest manufacturers, mainly in South Korea and Taiwan, to cut production. Others, such as Germany's Qimonda, fell into bankruptcy.

Nearly half of world production had been cut since the beginning of the year, said Mr Huang. This means that by June, the 1bn stockpiled chips will all be sold and by the end of the year there will be a global shortage of 2bn chips, equivalent to the D-Ram needed for 100m computers.

"It has been a difficult time but we can finally see spring coming," said Mr Huang.

Part of the reason for the impending shortage, he said, was that most D-Ram companies were facing financial difficulties and would find it hard to revive production quickly. The other reason was that "wolf has been cried too many times [on a market recovery]. Everyone is too cautious," he said.

I am very, very long semiconductor and semiconductor equipment companies.  They are, by far, my largest industry exposure.  I own a basket of 17 names, including four I have mentioned as net cash plays.

I began building a position in the chips too early, scaled back a bit, started adding more, and have been buying heavily over the past several months.

I have tended to do best buying companies in industries that have been bombed out.   Valuations are extremely low in the semis and some names in my basket could be 5-10 baggers. 

Because of extremely low valuations, I care not what happens in the near-term. I am looking 2-4 years out, not 2-4 weeks or 2-4 months.  So I sit and wait.

Another Cash Play Gets Taken Out

Three of the four cash plays in the semiconductor industry I wrote about in November have been subject to buyouts by competitors in 2009.  SiRF Technologies (ticker SIRF) and Avanex (AVNX) both caught a bid earlier this year.  And last week, Tundra Semiconductor also agreed to be bought.

Gennum Corp (GND.TO) is buying intellectual property firm Tundra Semiconductor (TUN.TO) in a cash and stock deal worth C$86 million ($69.4 million), the companies announced late on Thursday.

The deal values Tundra at C$4.43 a share. Tundra's shares closed at C$3.07 on the Toronto Stock Exchange on Thursday.

The other stock of the four was O2Micro (OIIM).

Returns since November 12 for each stock have been

AVNX  -5.0%
OIIM  53.7%
SIRF  83.2%
TUN (C$)  41.3%

Average return 43.3%

The average return far outpaces the return of the broad market or the semiconductor index.

That is what buying stocks at or below net cash can do.

Reasons to be Bullish

Frankly, I am having a hard time being bullish because everything feels so bad.

I was in the office on President's Day and watched the S&P 500 futures tick down to near-term support at 806, such that futures are indicating a 20 point decline at the open on Tuesday.  Now, it appears the market has formed a short-term double-top, and with stocks continuing to reach lower highs, it feels like we are about to break to the downside and re-test the November lows.

Emotionally, selling feels like the right thing to do.  However, cerebrally, since I have a time frame longer than my nose, there are many reasons not to sell at these levels, and to in fact buy stocks.  But it is difficult not to walk away in disgust, especially after last week's action, which was just horrible.

Everyone knows why you should be bearish - the credit crunch continues, the economy is terrible and earnings estimates continue to come down.  The reasons to hate stocks are very well known.  So I made a list of reasons why stocks could be substantially higher within the next year or so.

• Credit spreads have improved.  Credit remains tight, but spreads have come in.  Over the past 50 years, the average gain to stocks has been 18% when credit spreads are falling.

 

• Cash spreads are improving.  The TED spread and swap spreads are at levels last seen before the crisis began last fall.
• Treasuries are backing up and yields are rising.  The bond market has experienced a violent sell-off in the long end of the curve, while short-term T-bills - which were yielding negative returns a few months ago - have seen rising yields.
• The yield curve is steep.  When the curve is this steep, it almost always signal economic expansion over the next 12 months.
• Corporations issued the highest volume of debt in January than in any month since May.  In fact, debt issuance was greater than the last four months of 2008 combined.
• The dollar may be topping.  Some may argue that this is because of all the debt that the Treasury will flood onto the market.  However, a rising dollar has also been indicative of fear and a flight to safety.  A falling dollar may indicate that fear is seeping out of the market.

• The euro/yen cross has been moving sideways for months and may be basing.  The euro/yen carry trade had been popular over the past several years as investors bought higher-yielding euro-denominated bonds and financed the purchases by borrowing in lower-yielding yen.  This carry trade has been seen as a proxy for risk appetite in the global capital markets.  It may be signaling that investors are becoming less fearful.

• The gold/silver ratio has fallen below 70.  The ratio was as high as 80 a few months ago.  Both gold and silver have been rising the past few months, but silver has been rising faster than gold.  From September through November, silver fell 30% to the trough whereas gold fell 10%.  Silver is a thinner market but it is also an industrial metal and more exposed to the general economy than gold.  Gold is a haven during crises.  Silver prices rising faster than gold prices may be signaling that the economy is going to get better in the future and/or investors are less fearful about financial markets.
• Metal prices may be bottoming. Though it is still early, a bottom in stocks is sometimes presaged by a bottom in metals and commodity prices. 
• Commodities may be bottoming.  Oil may be putting in a bottom as well.

 

• Canadian stocks may be bottoming.  Energy and metals comprise roughly half of the total market capitalization of the Toronto Stock Exchange.  Materials stocks in Canada have been performing fairly well.

• Chinese stocks may be bottoming.  Stocks in China have been acting well as of late.  I am long the FXI.

• Semiconductor stocks have been outperforming and may be in the beginning of an uptrend.  Semiconductors are often an early indicator of the health of the technology industry.  I am long a basket of semiconductor and semiconductor equipment stocks.

• The VIX is acting like it wants to break below 40.  On Thursday's intra-day reversal, the VIX closed sharply down.  On Friday, when the market sold off during the last 20 minutes of the day, the VIX gave up less than half the decline of the prior session.  This may be a sign that investors are getting more confident of the future.

• Asset allocation by individuals towards equities is at or near all-time lows whereas allocations towards cash is at or near all-time highs.  The public is generally positioned like this at bottoms.
• Cash levels are at multi-decade highs.  There is nearly $9 trillion in cash on the sidelines currently.
• Hedge funds are heavily in cash.  There are very few hedge funds that are bullish now.
• Private equity investors are sitting on their hands.  After incurring large losses in their portfolios and wary of the cash crunch of their limited partners, private equity funds are doing little.  It seems that everyone is waiting for a turn before investing.
• Everybody whom I talk to is negative.  I have had in depth discussions with two dozen highly knowledgeable investors this month, and they are all overwhelmingly and uniformly bearish.  Every.  Single.  One.  Even those who are buying because they see value in the market are bearish on the market and the economy as a whole.  I had to talk a friend and a 20-year veteran of the business off the proverbial window ledge last week.
• Reversion to the mean suggests at least a bounce.  Last year was one of the worst years on record.  Tremendous selling usually begets a significant rally.
• Stocks are cheap.  Whether you want to measure by the 10-year moving average of earnings, Tobin's Q, or measures of book, sales and normalized earnings, stocks are inexpensive.

Now, as I tell you all this, I think there is a fairly good chance - 60% or 70% perhaps - that the market is about to re-test the lows over the next week or two.

Even after I listed all those points above, I cannot tell you that I feel bullish.

Maybe that is a sign a bottom is near.

Cash Plays Updated

Three months ago, I highlighted four stocks trading below net cash.  Since that time, two of those companies have been subject to buyout offers, the second coming today as the British company, CSR, offered to buy SiRF Technologies.  Let us see how each has performed since, starting with SiRF.

SiRF Technologies (ticker SIRF)

Price on date of mention: $1.25
Closing price: $1.68
Return: 34.4%

SIRF was perhaps the most problematic of the four examples, given that the company had lost several court rulings regarding their GPS navigation patents.  Despite their problems, CSR offered to swap 0.741 shares for each share of SiRF.  It is not hard to see why.

Currently, SIRF has $98 million in cash net of debt on its balance sheet, 62 million shares, $163 million of shareholders equity, and $137 million of tangible equity.  At the close yesterday, SIRF stock was quoted at $1.08. 

CSR trades on the London Stock Exchange and closed today at 198p.  With the pound trading at $1.45, the value of the offer for SIRF closed at $2.13, valuing the equity at $136 million, a 27% premium, reflecting the lack of financing for risk arbitrage.  With $98 million in cash, CSR is effectively paying $38 million for SiRF, the book value of all tangible assets excluding cash.  Thus, disregarding any asset writedowns, CSR is getting SIRF's technology for free.

With the stock closing at $1.68 today, shareholders who bought at $1.25 when SIRF was highlighted in my post have earned 34%.  If the arb spread closed tomorrow, the return would be 70%.

I do not know much about CSR.  However, the financial metrics look very appealing.  After the merger, the company will have net cash of $361 million, or $2.01 per share.  With the stock trading at 198p, or $2.88 after currency conversion, net cash represents 70% of total market capitalization.  The combined company would have been free cash flow positive over the past 12 months.

The stock is dirt cheap on other metrics.  The new company trades at 0.56x sales and 0.61x book value.

Semiconductor companies are highly cyclical.  At the prior peak in 2006, CSR traded at 7.43x book value.  With a book value of the new company at $4.70, at the prior peak multiple of book, the stock would trade at $34.89, a 1,112% return from today's levels.  Owning SIRF would yield a return of 1,977%.

I do not know if CSR will reach that peak again.  However, I have no doubt that the semiconductor cycle is alive and well, and one day, chip stocks will be markedly higher.  Even if CSR retraces a quarter of its prior peak, owning SIRF now will be incredibly profitable some time in the future.

Avanex (AVNX)

Price on date of mention: $1.61
Closing price: $1.68
Return: 4.3%

Two weeks ago, Avanex was subject to a bid by Bookham.  Avanex shareholders will receive 5.426 shares of Bookham for each share of Avanex.  Bookham trades at $0.32 per share.

Shares outstanding for Bookham are currently 101 million and 16 million for Avanex.  Post-deal, the new company will have 186 million shares outstanding for a market capitalization of $73 million.  The combined company will have $73 million in net cash.  Thus, Bookham/Avanex is currently trading at the cash value of the new entity.  The combined company would have been slightly free cash flow negative over the past 12 months.

Bookham printed $128 million in shareholders' equity in their last filing while Avanex had shareholders' equity of $63 million, giving the combined company a total book value of $190 million.  The company currently trades at 0.3x book value.

At the previous peak in 2006, Bookham traded at 3.85x book value.  If the stock hits the same peak at the height of the next cycle, the share price will be $3.94, giving equity holders a return of 1,130%.

O2Microdevices (OIIM)

Price on date of mention: $2.18
Closing price: $2.77
Return: 27.1%

Tundra Semiconductor (TUN.TO)

Price on date of mention: C$3.29
Closing price: C$3.15
Return: 4.4%

A basket of the four stocks equally weighted would have returned 17.6% since November 12.  On that day, the S&P 500 closed at 852.30.  With the index finishing at 827.16 today, the market has fallen 2.9% since then.

I am long all four stocks.  With potential returns of 500%-1,000% over the next several years, and the stocks all trading near or below cash value, I could not care less about the technical action, nor do I care about market levels.  I sit and wait.

Semiconductors Hit Decade Lows

Today, the Philadelphia Semiconductor Index, aka the SOX, took out its 1998 low of 182, closing at 177 this afternoon. 

In other words, Mr. Market is telling us that no value has been created over the past decade in the semiconductor industry, even though at the lows in 1998, chip stocks were trading at lows on book value and nearly at cash levels.

The 1996 low was 170.  The 1994 low was 139.

I am a buyer of semiconductor and semiconductor capital equipment stocks.

Panic

I woke up this morning, groggily turned on CNBC, and noticed that the futures were down 60.

"The Dow is down 60 this morning," I thought, "that's not bad."

Then the Dow futures flashed "Dow down 546."

Those were the S&P 500 futures that were down 60.  Lock-limit down.

The Great Hedge Fund Liquidation / Investor Panic continues as global markets are melting down across the world, with indices falling 8%-9% today.

My skill at picking a near-term bottom appears to be lacking. (A lot appears to be lacking. - ed.) However, I remember the 2002 bottom when you would wake up in the morning and see the futures getting crushed before the open whereas all the crushing in equity prices in the days prior occurred in the cash market when the market was open.  Could we be approaching a bottom now?

I have no idea.  However, I have spent much of my time since I started this blog telling you how markets were getting stupid, most recently in commodities - here and here - and also real estate - here and here.

Now, stock markets are getting stupid on the downside. 

Stocks are being thrown out the window because the margin clerks are in control and retail investors are in panic mode.

I have been in two minds about this market recently.  On the one hand, I have a trading long, and want the market to go up.  On the other hand, I want the semiconductors to get crushed so I can back up the truck for the inevitable cyclical upswing in a year or three hence, and its much easier for the chips to get hammered when the market is getting whacked.

I am eying a basket of semiconductor and capital equipment companies as well as the ProShares Ultra Semiconductor Index, ticker USD.  The USD closed at $15 on Thursday.  It was $100 last summer.  I expect it will approach those levels again in the future.

Apple

Okay, things are getting silly again in the stock market.  Stocks are being taken out and shot indiscriminately because of the Giant Hedge Fund Liquidation, regardless of quality.  Many, if not most stocks, are now on sale.

Take Apple, which reported a great quarter yesterday but gave conservative guidance (as it usually does).

Apple closed today at a shade under $97.

Apple has 887 million shares and a market cap of $86 billion.  As of the end of the most recent quarter, the company had $24.5 billion in cash and no debt.  Thus, net cash per share is $27.  Cash is 28% of the company's market capitalization.

The company earned $5.48 over the past 12 months.  On trailing earnings, Apple is trading at 17.7x earnings.

Net cash, the stock is trading at $70 per share.  Apple is trading at 12.8x trailing earnings net of cash. 

Analysts are expecting the company to earn $6.50 next year.  At $97, the stock is trading at 14.9x earnings.  Net cash, the stock is trading at 10.8x earnings. 

Let's say analysts' estimates are too high.  Instead, Apple earns $6.  On that number, the stock is trading at 11.7x earnings.

Right now, Apple is perhaps the greatest consumer company in the world.  Well, if not the greatest consumer company, then certainly the greatest consumer technology company.  10x-12x earnings net of cash seems down right cheap to me.

Does that matter?

No, of course not.  Valuation means squat in the short term.  The stock could fall to $50 for all I know, especially given the irrational selling that is hammering the market almost every day. 

And I'm not buying the stock now, nor am I recommending anyone buy anything at the moment (even though I have been buying).

But great values are being created all over the market for anyone having a time horizon longer than a week.

Semiconductor Update

I have traded the semiconductors over the years.  It is one of my favourite groups since the swings can be so wide.

The SOX is down 57% from its high in this bull market.  It is within 10% of the decade lows.  It is 22% away from the 1998 low and 40% from the 1996 low.

This is a graph of the ProShares Ultra Semiconductor ETF, which tracks the daily moves of the Dow Jones US Semiconductor index by 2x.  It is down 82% from its highs.

I track 42 semiconductor and equipment companies.  Fifteen are currently trading at their lowest levels in a decade.  Seventeen are trading below book value.  Twenty-two are trading below their book value lows of 2002.  The median stock is trading 14% below its decade lows while the median stock is within 3% of its book value low.  The median price to book is 1.1x.

Thirty-three have net cash on the balance sheet and 36 generated free cash flow over the prior 12 months.  Of those that have net cash on their balance sheets, the average net cash to market cap is 33% and the median is 27%.

I am long semiconductors.  I was waaaaaay too early in my initial purchase.  It was a horrible trade and demonstrates why you should not do what I do.  Heck, I did not do what I usually do as I violated my primary principal when trading the group - buy when the stocks are dirt cheap.  They were not dirt cheap.

But they are getting dirt cheap.

I will get much, much longer the chips some time in the future.

Portfolio Shift

Over the past few weeks, I have been buying the semiconductors, particularly semiconductor equipment companies but also some of the chip names.  The group did not get as cheap as I usually like, but with the cycles becoming muted compared to prior years, growth slowing and more capital discipline, I do not think valuations will get as low as they have in the past.  Also technically, they appear to be bottoming.

To fund the purchase, I have liquidated my Canada short, my emerging markets short, and my energy and coal longs.  I believe the market wants to move higher, regardless of the economic problems we are facing.  The trade most likely to frustrate most investors - which is the modus operandi of the market - at the moment is an upward move, I believe. 

I also believe that we are in a very wide trading range, and this is not the start of a new bull market.  I believe the next few years will see a great deal of gyration but little forward progress as the problems in the economy take time to sort themselves out.  This means that when expectations are low and the data shows that the economy is not on the verge of collapse - like today - the market will rally.  However, when investors think its clear skies ahead, the economic weakness will reveal itself as being prolonged, disappointing investors and causing violent sell-offs.  Thus, at some point, I will get aggressively short again.

I also think the commodity bull market is in the latter-stages.  However, many commodities will not see their prior normalized levels.  For example, I would be shocked to see oil at $40 again.  But oil at $70 is very possible.  I remain long some commodities that are a long ways from their inflation-adjusted highs.  Oil is not one of them.

The market action this month has been, to some extent, nonsensical, in that groups that should not move together have been moving together.  Today, both the price of crude and airline stocks went up.  One explanation I saw for the strange move today was that a swap was being unwound, with corresponding anecdotal evidence to support this assertion.  I have no idea if it is true, but schizophrenic action makes the most sense in a liquidity driven market.

Asyst Technologies - Holding Out for More

Occasionally, I have mentioned that I own a third-rate semiconductor equipment company.  That company is Asyst Technologies, ticker ASYT. 

Asyst is an automation company.  It's products are sold to manufacturers of both semiconductors and flat panel displays.  Asyst's products sort, handle, transport and track silicon wafers during the production process. 

The company's products are designed to minimize imperfections in the manufacturing process.  For example, people used to walk wafers from bay to bay in the semiconductor fabrication plant.  However, as processes became more complex and wafers more expensive, chip companies sought to decrease the probability of error and automated the transport of each wafer around the fab.

I bought the company a few years ago as part of a basket of half a dozen chip and chip equipment companies that had become dirt cheap. 

Semiconductor stocks have generally followed a somewhat consistent cyclical pattern.  At the bottom of the cycle, they are cheap relative to sales/book value/cash flow/asset value/normalized earnings, etc.  When inventories have cleared out and demand begins to pick up, ordering accelerates, and sales and earnings shoot up.  Stock prices lead this cycle in anticipation of a bottom.  At the top of the cycle, double-ordering occurs, inventories build, stocks are expensive, and inevitably, business slows considerably.  Again, the stocks anticipate the top and turn over before the business tops out.

With a few exceptions, the semiconductor industry is maturing.  Thus, the cycles are becoming more muted as the frantic boom/bust cycles dissipate.  That's too bad, in my opinion, because one could make (and lose) considerable sums of money playing the cycle.

My strategy for trading the group has been to identify prior low and high valuations during the cycles, making an approximation of where I think the stocks could hit this cycle, allocating a set percentage of capital to the trade, then buying and selling based on my specific price targets.  I like to buy a basket of companies because, frankly, I'm not exactly the world's sharpest technology whiz, and spreading my capital around mitigates specific company risk.

So it was with Asyst when I bought it a few years back as part of a basket of chip companies.   I dumped the other five at a profit but miscalculated the top for Asyst and rode it back down.  Had I not already owned the stock, I would have bought it below $3, where it was until last week.

Today, it closed at $4.14, up from $2.50 a few days ago.  The company has caught a bid, with the venture capital firm Menlo Ventures, the private equity firm Gores Group LLC, and an automation company run by Asyst's former CEO, Aquest, offering to take the company private for $5 to $6 per share.  The company has rejected the offer.

The reason why I described Asyst as third-rate is because the company has not been well run.  Execution has always been a problem. Asyst recently entered the flat-panel display business which is fiercely competitive, ridden with irrational competitors competing for market share at the expense of profit. There is little organic growth in its core markets.

Historical financial results have not been pretty.  The company has recorded a GAAP loss six of the previous seven years, with 2007 the only one to show a profit since The Bubble collapsed.  This year is likely to revert to a loss before the company sees black in 2009.

Given its recent history, one might expect an investor to jump at the chance to sell out at double or more the price of just a few days ago.

However, the semiconductor equipment industry is approaching the trough of its cycle and valuations are falling.  Until a few days ago, Asyst was sitting at rock-bottom multiples.  Thus, it is not surprising that the former founder, backed by private money, would take a run at the company.

I think the company is right to reject the offer as too low, and if given the chance, I will vote against it.  I think the company is worth more, and would not tender my shares at the offer price for the following reasons

• The company trades at 0.4x sales.  The stock traded above 1.0x sales six quarters ago.  I'd take 0.8x sales.
• Estimates ex-stock compensation for FY09 are around $0.50. The offering consortium values the company 10x-12x FY09 earnings.  (The fiscal year begins in April.)
• Lack of profitability?  True, but a good operator should be able to increase margins, and Gores claims to be a good operator.
• The firm is established in 300 mm fabs around the world.
• The new operators can sell the old Shinko business.
• There may be an opportunity in solar.
• Since the bottom of the market on October 10, 2002, there have been 1352 trading days.  Asyst has traded above $5 per share on 973 days, or 72% of the time.  The stock has traded above $6 per share on 788 days, or 58% of the time.
• The stock was $7 just a few months ago.

I think the guys making the bid are smart, and I think they believe Asyst is worth more.  Thus I'm holding out.

I also believe the bid is a signal that the bottom in the semiconductor and the equipment stocks is near.  I have compiled a list and expect to start buying if the stocks continue to fall.