An Indirect Apple Supplier to Keep On Watch
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Value-focused investors have generally had a positive experience over the past several years in purchasing companies that supply popular electronics manufacturers. Unlike the larger enterprises that they supply – i.e. Apple (NASDAQ: AAPL) – many of these component producers are much smaller and are significantly less followed by institutions. As such, the strategy can often isolate relatively cheap firms that operate in small niches within the vast semiconductor market. One of the most exciting of these picks over the past several years has been compound semiconductor substrate producer AXT Inc. (NASDAQ: AXTI).
Experiencing the two-fold effect of the bursting of the telecom bubble in the early 2000s and troublesome in-house quality control issues in the mid-2000s, AXTI fell from highs in excess of $45/share at the turn of the millennium to sub-$5/share throughout most of the pre-2009 recessionary period. Through strengthening prices in the raw materials used in the production of compound semiconductor substrates, a significant in-house cleanup and rightsizing of operations, and a meaningful level of new business that was acquired, however, AXTI investors enjoyed a near 15x return within the two years ending in January 2011. The strengthening in company performance was fueled by a huge increase in both top line and gross, which expanded by more than 100% and 400% between Q3 2009 and Q2 2011, respectively.
The corporation’s 2012 experience has been less than rosy, however. Driven in part by a significant reliance on several key customers – iPhone/iPad component supplier TriQuint (NASDAQ: TQNT) among them – the corporation has witnessed a significant drop in demand in all three of its key semiconductor markets (gallium arsenide, indium phosphide, and germanium substrates). Revenues of $21.2 million and $23.5 million in the past two quarters were off 21% and 4.5% from the comparable periods in the previous year, and operating margins have tanked as discounts have been used to drive sales volume and relatively low volume has increased SGA expenses as a percentage of sales. Average operating margins in Q4 2011 and Q1 2012 of 15.4%, as a result, were more than 800 basis points lower than the comparable averages in the prior year.
Despite the slip in performance and the meaningful drop in share price, the AXTI investment hypothesis has changed very little. The corporation is not only cheap at current valuations (94% of book), but there are some very attractive extras thrown in:
- Hidden Value of Joint Ventures: AXTI has made very smart strategic investments in five Chinese raw materials companies. Not only do these JVs grant the corporation continuous access to rare raw materials, but it also allows AXTI to take advantage of favorable pricing terms. Such an arrangement has given AXTI a substantial advantage over the competition in the recent past, and will continue to do so going forward.
- Vertical Integration: The corporation uses its own proprietary vertical gradient freeze (VGF) technique to produce high-quality, lower-cost products than the competition.
Despite these positives that help AXTI stand out among the other smaller players in the semiconductor industry, there is reason to believe that the bottom of the corporation’s recent price downturn has not yet been reached.
- Prices for gallium continue to be soft, and with the relatively strong yen, the corporation will continue to generate less revenue per volume on raw materials for the foreseeable future. Partly fueled by these two drivers, gross margins in the most recent quarter were nearly 1,200 basis points lower than their Q2 2011 highs.
- A significant amount of the stock’s daily trading volume is attributable to its inclusion in the Russell 2000 index. A possible booting from the index may be the result from the corporation’s huge 40+% market valuation drop over the past two months.
- There is a large uncertainty about the corporation’s inclusion in the upcoming Apple iPhone 5. TriQuint, one of AXTI’s largest customers and a provider of components to Apple product assembler Foxconn, has recently provided significantly reduced guidance for the current quarter. Management was rather elusive throughout the conference call, and there is reason to believe that the slip in product demand might be driven by the corporation’s exclusion from the iPhone 5 design. TriQuint does expect performance to return to “normal” levels in the latter half of 2012, which may indicate that the drop in top line is simply due to the reduced demand for the current iPhone generation in anticipation for the upgrade in Q3 of this year.
There are many reasons for the long term-focused investor to be bullish on AXTI, yet uncertainty surrounding its experience over the remainder of 2012 should lead investors to hold off purchases for the time being. Prior to the most recent run-up in price – starting at sub-$3.70/share in November 2011 – the corporation was selling for around 5.2x trailing 12-month earnings, which is close to a 50% discount from today’s valuations. With very few positive catalysts that are expected to boost AXTI stock over the next several quarters, patient investors may very well be rewarded with a further market price drop, which will yield an even more attractive entry point for an AXTI investment.
gibbstom13 has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple and TriQuint Semiconductor. Motley Fool newsletter services recommend Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.