Editor's notes: Up 54% since tech expert Valuable Insights wrote about it in March, IMOS is still undervalued and has catalysts yet to be priced in.
It's extremely unusual for a stock that's up 60% year-to-date to be the cheapest holding in your portfolio, but that's exactly the case for us withChipMOS (IMOS). Typically, only troubled companies with secular headwinds trade at 2.3x EV/EBITDA and provide a free cash flow yield just under 20%. But ChipMOS actually has some of the strongest fundamentals in the entire technology sector. With Micron (MU),ChipMOS's second-largest customer, set to report on Wednesday, we thought it worth revisiting the story, and outlining several near-term catalysts that we expect to drive over 50% upside by year-end.
We see three major near-term catalysts that should drive ChipMOS shares significantly higher in the months ahead, and believe it is likely they will approach fair value of $30-$35 by year-end. We provided detailed background about ChipMOS in a bullish article we wrote about it on March 25th (shares are up 54% since then). Below we present a brief review of ChipMOS and some major events since our last article, and then discuss the catalysts.
ChipMOS packages and tests semiconductors, primarily LCD driver-ICs, NOR flash and Mobile/Specialty DRAM. Top-10 customers include Novatek and Himax (HIMX) in driver-ICs, Spansion (CODE), Winbond and Macronix in flash, and Micron in DRAM. It is levered to smartphones, tablets, and servers - huge secular growth markets. Its products are found in the electronics of Amazon (AMZN), Apple (AAPL), BlackBerry (BBRY), Samsung (SSNLF.PK), and others. If you believe in the long-term sustainable growth of mobile electronics, but aren't sure who will emerge the winner, ChipMOS is a great play as it has broad end-customer exposure.
In addition to packaging/testing chips for explosive growth end-markets,ChipMOS is also a cash flow machine. While the semi packaging/test industry can be fairly capital intensive, management has pursued a disciplined approach to growth. The company has gone from $470 million in net debt less than 3 1/2 years ago to $32 million in net cash today.
ChipMOS: a cash flow machine
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Since our last article, ChipMOS listed its ChipMOS Taiwan operating company on the Taiwan Emerging Stock Market on April 19th. ChipMOS sold 0.8% of its holdings at $NT15 per share, for proceeds of $6.5 million, and in their first day of trading, they skyrocketed to $NT40. Currently,ChipMOS Taiwan trades at $NT28.03, on miniscule daily volume. The key aspect to the listing is that it: 1) paves the way for ChipMOS to eventually eliminate its currently complex corporate structure, 2) is beneficial in terms of tax treatment, and 3) should result in a valuation consistent with Taiwan peers at 6x EV/EBITDA (or more).
Also, since our last article, ChipMOS reported a solid 1Q and gave a healthy 2Q outlook. Perhaps more important is its expectation for continued sequential growth throughout the year. Based on its 1Q results and commentary, we expect 2013 EBITDA of at least $218 million.
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Based on 29 million shares outstanding, Friday's close of $18.54, $90 million in estimated 2013 free cash flow, and $32.8 million of net cash, shares currently trade at 2.3x EV/EBITDA and a 17.8% free cash flow yield.
We expect the following catalysts to move shares significantly higher.
Anticipate significant new business with Micron to materially increase 2014 EPS
Micron is currently ChipMOS's 2nd-largest customer. Based on its activity with ChipMOS, clearly Micron has a very favorable view of ChipMOS's capabilities. For the last two years, Micron has increased as a percentage of ChipMOS's sales, and in absolute terms, by about 40% a year. This is even more remarkable in that 2012 was a year when Micron's own revenue declined year-over-year.
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When Micron's acquisition of Elpida closes in the next month or two, it is highly likely that ChipMOS will get significant additional business. With operations in Singapore, Taiwan and Japan, an increased presence in Taiwan makes a lot of sense. Micron clearly likes ChipMOS, and a year ago ChipMOS had the prescience to spend $10 million to buy an empty building across the street from an existing facility, making it perfectly prepared for a significant new growth opportunity. This is not a unique insight, as the possibility of significant new Micron business has been discussed by management, as well as Cowen and Craig-Hallum analysts. However, we have not seen anyone dig into the potential impact on 2014 EPS. Currently, the consensus EPS estimate for 2014 is about $2.23 (which we believe is about $0.50 too low to begin with). Our best guess is that the incremental business from Micron in 2014 is likely to be between $50-$100 million (with potential to expand further) with a 22-25% gross margin and essentially no incremental SG&A expense. Taxes have been running 15-17%, but we will assume 20% out of conservatism, with 10% of profits going to minority interest. Under this set of assumptions, the EPS impact looks like this:
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At the low-end of our estimates, additional Micron business would increase 2014 consensus numbers 12%. In addition, given how well positioned Micron is, and, in our view, is likely to remain, we'd expect a deepening of the Micron relationship to lead to multiple expansion.
Expect positive estimate revisions when company reports 2Q results
With ChipMOS shares trading at current multiples, we don't think a lot has to go right to justify a higher stock price. However, we think it's likely that 2H and 2014 estimates will be revised higher when the company reports 2Q results in August. Since ChipMOS reported 1Q results almost a month ago, the industry backdrop has shown additional improvement. DRAM pricing, which rose for most of 1Q and then paused, has risen sharply again in recent weeks, with spot pricing for commodity DRAM up about 15%. Datapoints surrounding 2K4K (ultra-HD) TVs have been positive with expectations continuously revised higher. This is particularly important given that these next-generation TVs require 4x the quantity of driver-ICs as previous TVs. Next generation gaming systems will be coming out in 4Q and will also have significant memory requirements.
We believe that industry trends, which were strong at the time of the 1Q report, just a month ago, have improved further since then. While we don't expect upside to 2Q revenue guidance of 10-14% sequential growth, and expect gross margins to be toward the upper end of the company's 14%-18% guidance, we are confident that ChipMOS will guide double-digit sequential revenue growth for 3Q, and gross margins above 20% - which would take street estimates higher.
In addition, we believe the overall longer-term backdrop for ChipMOS continues to improve. The company has recently gained traction with Renesas, a major LCD driver-IC supplier for Apple. While this may be immaterial to 2013, we believe it stands to enjoy healthy growth with Renesas in 2014. In addition, Himax, which SA author Karl Guttag has confirmed is an LCOS supplier to Google (GOOG) for Google Glass, has been a top-10 customer for ChipMOS. Regardless of one's specific view on the success of Google Glass, we believe that wearable computing, and new applications playing to ChipMOS's customers' strength will drive new opportunities and growth in the years to come. We believe that as numbers go higher, and trailing numbers look more impressive, a larger institutional audience will add ChipMOS to their portfolio.
ChipMOS will sell additional Taiwan shares, eliminate the current overhang, and shares will likely spike to fair value
ChipMOS has publicly stated that it needs to sell approximately 120 million ChipMOS Taiwan (8150.two) shares to reduce its holdings from 83.4% of the company to under 70%, a pre-condition to move the listing to the main exchange. We believe that once the shares are sold,ChipMOS Taiwan will likely trade up to about $NT47, based on a 6x EV/EBITDA multiple. Our math is below:
In our view, the reason shares are currently trading at $NT28.03 and not $NT47.52 (or a slight discount to that), is that there will be 120 million shares placed in the next few months. We view the upcoming sale very much like an IPO. Once theses shares are placed, we'd expect shares to spike quickly (much like a hot IPO) - and we expect IMOS shares to follow suit.
Assuming ChipMOS were to sell 120 million shares of ChipMOS Taiwan at $NT25 and then ChipMOS Taiwan traded up to $NT47, this is our calculation of what ChipMOS shares would be worth:
We believe our view on the ultimate value of 8150.two is realistic, if not conservative, and are confident that US shares would soon follow suit. This is especially true if Micron, or perhaps additional important IMOS customers participate in the offering, which has been suggested by highly regarded Cowen semiconductor analyst Tim Arcuri. Such an endorsement could be a very powerful argument for a premium, and not just an in-line multiple.
We have spoken to some investment colleagues who have suggested that it makes sense to wait for the Taiwan share sale prior to buying shares of IMOS, since they could conceivably trade above 8150.two, resulting in an opportunity to short IMOS shares and set up an arbitrage.
While this sounds good in theory, we believe it is highly improbable. For example, imagine if IMOS traded to $22 or $23 today. The theory would be that a short could sell perhaps 100,000 shares of IMOS and go long an equal dollar quantity of 8150.two, locking in a definite profit. The issue is that 8150.two is currently almost completely illiquid. To be able to go long $2+ million of 8150.two would likely move the stock dramatically, eliminating the arbitrage. In addition, given potential positive news flow (for example, a major new program with Micron), we think it's unlikely that an arb would take the risk of a naked short. The best opportunity for an arb would be if IMOS trades up, and the arb is able to participate in the 8150.two offering at a discount.
The bottom line for us, is we have conviction that post listing, shares will be dramatically higher. If you like the story, we recommend purchase today, for if you wait for the listing to be complete, we could literally see the stock trading up 20-30% when the stock opens.
We don't see a lot of stocks trading at 2.3x EV/EBITDA, especially ones with experienced, disciplined managements, strong customer bases and fast growth end-markets. We continue to believe IMOS represents a truly unusual and exciting investment opportunity.
Additional disclosure: We conduct thorough research on our ideas, but our views are our own. Please do your own research.
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