Pure Wafer - A Polished Performance

http://www.purewafer.com


Wafer reclaim specialist Pure Wafer (LSE:PUR) hailed 2013 as being "A Transformational Year" with Chairman Stephen Boyd commenting that "The last financial year has been a transformational one for Pure Wafer and I am delighted to report very encouraging results which move the Company firmly back into pre-tax profits. The forecast global growth in the semiconductor industry was in evidence during the period, enabling Pure Wafer to continue to enjoy increasing and sustained demand for its wafer reclaim services across all geographical areas in which we trade and across all sectors of the industry." It was therefore a little odd to see him sell down a quarter of his holding just a month later. Currently, the company is trading towards the upper end of its historic range at 79p, and is capitalised at £21.8m. Can more be read into the share sale, or is the company set to rise from its low rating?


Pure Wafer's (abbreviated as Pwafer from here on) technical position is unclear as it stands, because the company is moving within a tight horizontal range. Within that range, which spans from the high 70s to the high 80s, the pivotal level is 80p, which the share price is currently just below. Given that there have already been 2 false upward breakouts, and 2 false downward breakouts, investors should keep an eye on the direction of the next break. The direction of the breakout will probably determine the picture over the next few months. The downside is relatively well protected with two areas of support, and given the price rating it would require a deterioration of the company's fundamentals. Any upward breakout would target 100p as a first target, where there is likely to be substantial resistance from limit sells. The shares are fairly illiquid though, so whilst the spread is currently good at just a couple of percent, it can grow to as much as 4-5% when volumes are thin.

As noted earlier, the Chairman sold down a quarter of his stake in early November, which is often a bad sign, especially when the size of the sale is into six digits. However, the size of the sale broadly tallies with an additional stake which Hargreave Hale picked up on the same date, so there is little doubt that the bulk of the shares were transferred straight over to the institution. This alleviates most of the worries, although ultimately, the Chairman has to agree to sell over the shares, and I certainly wouldn't do that if I foresaw substantial upside - I would make the institution buy in the market and drive up the price. Several directors hold fairly large stakes in Pwafer, and the institutional backing is strong - perhaps this is the cause of some of the illiquidity. Roughly 17m of the 27.6m shares in issue are held by directors and institutions with a notifiable stake.

Pwafer operates within two divisions. The principal division focuses on providing silicon wafer reclaim services to the electrical circuits - silicon being a good semiconductor. Wafer reclaim revolves around cleaning and polishing silicon wafers sent by semiconductor manufacturers, and numbers run well over 250,000 wafers per month. The market for this exists because semiconductor manufacturers have to use a large quantity of test wafers, and rather than simply disposing of these, it is more economical (potential to recover up to 70% of test wafer costs) and efficient to have them cleaned for re-use. These wafers are widely used in chips for technological appliances including smartphones, but also in cars. Due to exposures to growing markets, the outlook for wafer reclaim is good, with the sector is expected to grow by around 7% over the course of 2014 and 2015.

The second, far less important division focuses upon the design, manufacture and installation of solar panel systems, so that is easier to understand. However, Pwafer is experiencing problems with operating in these two sectors. Starting with solar, there has been a well publicised drop in the pricing of solar panels that has stemmed from producers, located in far east countries such as China, being able to manufacture them at much lower costs. That said, prices are expected to find a floor, with many businesses and firms opting for the generally 'higher quality' European solar panels. The reality is that the solar division only accounts for 1-2 percent of revenue so this division can be completely sidelined, and any concerns ruled out, especially since it operates at a loss according to the last set of results.

The more pressing issue surrounds the wafer division, where concerns came to light in January after the company commented that "Whilst the Board remains confident of meeting market profitability expectations for the full year, revenue is likely to be slightly below expectation due to greater pricing pressure in the global wafer reclaim market. Specifically, our competitors based in Japan are benefiting from changes in the USD/YEN exchange rate, giving them a competitive advantage relative to their home based costs. This has enabled them to offer competitive pricing to worldwide customers. We estimate group turnover for the current year as a whole is likely to be circa 5% below market expectations. "

Importantly, the profitability is touched, although this issue is a problem. If competitors in Japan can offer a competitive advantage on price alone, then it suggests that Pwafer does not have a lot of differentiation in its offering, but that makes some sense given that the end result of cleaning and polishing is likely to be broadly similar regardless of the company used. Considering that it is estimated that Japan accounted for around ~40% of large diameter (200mm-300mm) wafer reclaim sales in 2013, it is not a hollow threat. Moreover, the USD:JPY exchange rate has stabilised at this higher platform, so that could further dent the revenue growth potential for Pwafer.

The chart on the right shows the USD:JPY exchange rate over the past few years. The current rate is: 1 USD = ~103 JPY. When the JPY figure on the right rises, it means that one US dollar can purchase more Yen, thus the Yen has depreciated. That is what has happened over the past few years, hence the strong upward movement. This means that a Japanese firm can operate wafer reclaim services at lower costs, yet still sell them at the same US dollar price, abroad. Ordinarily that would give them higher profits, but the firms have dropped their US dollar price in order to boost their competitiveness, and that is what has impacted Pwafer. The currency problem is not massive given that the substantial appreciation in 2013 only hit revenues by a low level, but it certainly a concern, and could keep the share price grounded.

The risk in the future is that the Japanese Yen will continue to weaken. Whilst the underlying reasons for exchange rate fluctuations are complex, the weakness can be attributed to the monetary expansion that Japan is undergoing. A massive plan for continued quantitative easing (injecting more money into an economy) in Japan is being undertaken, and that lead to the weakening. This quantitative easing increases the supply of Yen. Furthermore, the Federal Reserve aiming at cutting back its own monetary expansion, with further leads to a weakening of the exchange rate.

In addition, expectations about future interest rates impact the exchange rate. The Japanese exchange rate is at 0% so that gives minimal incentive to hold Japanese currency as there is no interest for investors to seek. The issues in Japan extend further because consumer confidence is at rock-bottom levels, which makes it difficult to stimulate the economy, and that isn't helped by Japan having one of the highest national debts in the world. Add to this picture plans for a substantial hike in the sales tax and the outlook is bleak for the Japanese Yen versus the US dollar, and there could be material weakening in the future. That is the general industry consensus as well, with the Yen expected to continue to weaken over H2 2014, albeit the rate of depreciation is unlikely to be nearly as fast as during 2012/13. A weak exchange rate does eventually mean that Japanese goods/services are 'relatively' cheap and that could help narrow their trade deficit, but that is a slow process.

This opens up another dynamic to any investment in Pwafer - investors must keep an eye on the USD:JPY rate as a precursor to future results. To date, the company has been able to offset the bulk of the rise through cost cutting initiatives, hence why the profit forecasts were unchanged, but any substantial depreciation could well cut revenues further, and falling/stagnant revenues lead to a lower PER being attributed to a stock.

In light of this risk, it is therefore not particularly surprising to see Pwafer trading at a discount compared to sector valuations at the moment, although I'd say that the currency risk is perhaps being overplayed. That said, investors don't take kindly to currency risks as they act as an investment deterrent. The latest set of interim results featured these figures:

- Revenue marginally down year-on-year to $18.2m (vs. $18.5m)
- Pre-tax profit up 46% to $2.1m
- Net cash inflow from operations of $3.2m
- Net cash of $1.3m at period end -> Board expects to commence a final dividend
- Basic EPS of 7.6c. Diluted EPS of 6.7c. There are a lot of low priced options/warrants on the books, which will undoubtedly be converted barring a collapse in the company's share price

Those headline figures are certainly encouraging, albeit the profit was aided by materially decreased amortisation/depreciation charges - given that adjusted EPS tend to exclude these, the underlying improvement in profits stemmed from cost savings. During the period, the company also invested in expanding its processing capacity, so the cash position for the end of 2013 is expected to be lower at circa $0.6m. That's not a particularly strong balance sheet, especially if the company wants to start paying dividends, but the cash from operations should support that. Any dividend is also likely to be well covered by earnings, so whilst the predicted net cash position is unlikely to be strong, the situation is better than the single figure suggests. There is strong property, plant and equipment backing on the balance sheet, which covers a major proportion of the market cap. On the whole, the balance sheet is comfortably strong with 2.7x more current assets than current liabilities.

Market forecasts are for a token 0.3p dividend this year, rising to 0.6p in 2015, with EPS in 2014 and 2015 at 8.79p and 9.56p respectively. That puts Pwafer on a particularly low PER of 9 this year, dropping to 8.3 in 2015. Revenues are forecast to increase only at a slow pace over these two years, so ultimately it's difficult to see a current year price-earnings ratio above ~14 in the medium-term (accounting for strong cash generation, but also the currency risk). Even so, that would give Pwafer a share price target of 123p, which represents pretty good upside from current levels. The question will be whether or not the share price is capable of reaching there - the currency doubts alluded to earlier in 2014 have undoubtedly slowed down the share price, and could cap near-term upside.

Beyond that, the results of a recent board re-organisation will determine sentiment. That was announced in mid-March and featured a complete shake-up of the board with Chairman Stephen Boyd stepping down, CEO Peter Harrington moving into the role, and CFO Richard Howells moving into the CEO role. The purpose and results of this restructuring remain to be seen, albeit the announcement concluded with Harrington saying: "I am very much looking forward to leading the board and overseeing the implementation of a strategic plan that will ensure the continued success and growth of Pure Wafer and one which will maximise shareholder value and returns."

I appreciate that a fair chunk of this article was talking about the Japanese Yen and the situation that investors are faced with. At a single digit PER, I have little doubt that the concerns are being overstated by the market (as it stands), but ultimately the shares have failed to break upwards to date. It is that concern that is capping the upside, and could continue to do so until the market is sufficiently convinced that the company can cope with competitive pressures. The catalyst for being convinced is likely to be a trading statement or a set of financial results, which show the company to be in good health. The low rating certainly makes the shares attractive, although investors may be better off adding Pwafer to a watchlist and waiting for a breakout from the current trading range, and monitoring the Yen in interim - a significant weakening is a deterrent and signs of it strengthening should be an attraction. There is value in Pwafer, but it's a case of waiting for the market to recognise it, rather than keeping cash tied up - investors who can tolerate the currency risk will find Pwafer interesting. Considering the site's 20 portfolio slots are currently full, I have put Pure Wafer on a No Rating tag.

3 comments:

  1. Nice summary in particular about the yen dilemna

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  2. Nice piece of work. thanks

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  3. Interesting article - I think the solar panels can be ignored as it is small and loss making.
    Regarding the Yen issue there was a credible article that the Japanese manufacturers were going to use the extra profits to build up cash and to increase wages and if so would not have such a major impact. Only time will tell. I thought PW was increasing its capacity by 40% - if this can be done without a significant increase in overheads, it could become a lot more profitable.
    There are a lot of risks and potential rewards and I am in at about 80p. The future will be interesting

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