As a long-time value investor, I don’t often have a reason to analyze and invest in technology companies: These stocks often trade at extravagant multiples of book value per share and have an insatiable appetite for additional equity as they seek a foothold in an emerging industry. But, I recently made an exception in the case of Photronics Inc. (PLAB-Nasdaq).
After all, who wouldn’t be attracted to an US$8 stock trading at a 25-per-cent discount to tangible book value, with US$450-million in revenues in a US$4-billion industry and cash on the balance sheet of US$350-million?
Photronics manufactures photomasks, which are used as stencils to transfer circuit patterns onto semiconductor wafers in the making of integrated circuits and flat panel displays. The company has been listed on Nasdaq for over 30 years and, although the headquarters are in Brookfield, Conn., over 75 per cent of revenues are generated outside of the United States. This is an important competitive factor as the market for photomasks is global in scope and so are the customers. The top five customers, which include global giants such as Samsung, typically account for 50 per cent of Photronic’s revenues, so the loss or gain of a customer can have a major impact on revenues.
The cash position of US$350-million will decline by about US$250-million over the course of the next year as the company has two major capital investment projects under way in China which total US$320-million. These are joint venture projects with Japanese printing giant Dai Nippon Printing, which reduces the financial and marketing risk. Production from these facilities should start in early 2019. At present, about 10 per cent of revenues are generated in China, so the company already has feet on the ground in the country.
The success of the company is not entirely dependent on the China projects: According to management, a recently completed capital expenditure in South Korea has placed Photronics at the leading edge of photomask manufacturers in that country involved in various flat-panel-display technologies.
With these positive developments under way, why does Photronics stock trade at a big discount to book value, at less than eight times broadly defined price-to-cash-flow and only a small premium to revenues per share – all ratios that are attractive to a value investor?
The simple explanation is that the last few years have been a tough operating environment for the company. Revenues have shown little or no progress and return on equity has averaged 5 per cent at best. If this track record persists, then the stock is no bargain even at today’s price. Investors may also be reluctant to pay up for the potential offered by China and South Korea at a time when headlines focus on the possibility of a trade war in the Pacific Rim.
In addition, the nature of the industry is such that the order turnaround time is very short. As a result, Photronics never develops a meaningful backlog of orders and the quarterly revenue numbers can be volatile. Few analysts want to follow a company that can leave them wrong-footed at the last minute, so it is not surprising there are only three sell-side analysts following the company.
These are legitimate reasons why Photronics currently trades at a valuation discount and why this discount may persist into early 2019. But it is not too early to put the stock on your radar screen or take a small initial position. Although recent revenue volatility has been on the downside, management struck a positive note on the outlook in the 2017 annual report: “We anticipate that the momentum that we generated at the end of 2017 will continue in 2018. Our markets are healthy and over the near to medium term our customers are growing and expanding. As our top line grows, the operating leverage in our high fixed-cost model should deliver faster growth in earnings than revenues.”
In the first quarter ended Jan. 28, this forecast proved to be correct: Revenues increased 12 per cent to US$123-million while earnings per share tripled from 3 cents to 9 cents. The second-quarter report will be released on May 22. If the momentum persists, the turnaround may be closer than the market thinks and the stock price will react favourably.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
Robert Tattersall